The Pros & Cons of Investing in a DST vs. a REIT

As a real estate investor aiming for greater returns, selecting the right type of investment can be challenging. While Real Estate Investment Trusts (REITs) offer diversified and relatively low-risk exposure to the real estate sector, Delaware Statutory Trusts (DSTs) provide access to larger, higher-yielding deals that could generate considerable returns—if managed correctly. At 1031 Exchange Place, we are committed to helping you make informed decisions that align with your financial goals. In this guide, we’ll explore the pros and cons of investing in a DST versus a REIT, empowering you to choose the best option for your unique situation.

What Is a DST and the Benefits of Investing in One?

A Delaware Statutory Trust (DST) is a legal entity created under Delaware law that allows multiple investors to pool their funds to purchase and hold real estate. This structure is particularly appealing for investors looking to participate in larger, more lucrative real estate deals that would otherwise be beyond their financial reach.

Key Benefits of Investing in a DST

1. Diversification: DSTs offer a significant advantage in terms of diversification. By pooling resources with other investors, you can gain access to a variety of property types, such as commercial buildings, multi-family apartments, industrial facilities, or even healthcare properties. These properties are often located in different geographic areas, which further spreads your risk. This diversification can help mitigate the impact of market volatility, as not all property types or locations will be equally affected by economic changes.
2. Tax Deferral Opportunities: One of the most compelling reasons investors choose DSTs is the potential for tax deferral through a 1031 exchange. Under Section 1031 of the Internal Revenue Code, you can defer capital gains taxes on the sale of an investment property by reinvesting the proceeds into a “like-kind” property of equal or greater value. Because DSTs qualify as like-kind properties, they offer a powerful tool for deferring taxes while simultaneously diversifying your investment portfolio. This can be particularly beneficial for investors looking to preserve and grow their wealth over time.
3. Passive Income: Investing in a DST provides a source of passive income without the hassles of day-to-day property management. The trust itself is managed by a professional sponsor or trustee who handles everything from property maintenance to tenant relations. As an investor, you simply receive your share of the income generated by the property, typically distributed on a monthly or quarterly basis. This makes DSTs an attractive option for those seeking to enjoy the benefits of real estate ownership without the time and effort required to manage a property.
4. Lower Entry Barriers: DSTs allow individual investors to participate in high-quality, institutional-grade real estate deals that would otherwise require significant capital outlay. By pooling resources with other investors, you can access these opportunities with a relatively modest investment. This lowers the barrier to entry, making DSTs accessible to a broader range of investors, including those who may not have the resources to purchase a large property outright.
5. Estate Planning Advantages: DSTs can also be a valuable tool in estate planning. The fractional ownership interest in a DST can be more easily divided among heirs compared to a single piece of property. Additionally, the tax deferral benefits can potentially be passed on to heirs, providing a way to transfer wealth to the next generation with minimized tax implications.

What Is a REIT and Why Should Investors Consider It?

A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-producing real estate. REITs offer a unique opportunity for individual investors to earn a share of the income produced through commercial real estate ownership—without actually having to buy, manage, or finance any properties themselves. REITs are traded on major stock exchanges, making them a liquid and accessible way to invest in real estate.

Key Reasons to Consider Investing in a REIT

1. Consistent Income Generation: REITs are required by law to distribute at least 90% of their taxable income to shareholders in the form of dividends. This structure makes REITs an attractive option for income-focused investors. The steady stream of rental income generated by the properties within the REIT portfolio is passed on to investors, providing a reliable source of income. This consistency can be particularly appealing for retirees or those looking for a stable cash flow from their investments.
2. Long-Term Capital Appreciation: In addition to regular income distributions, REITs also offer the potential for capital appreciation over time. As the properties within a REIT’s portfolio increase in value, so does the value of the REIT’s shares. Investors can benefit from this appreciation, particularly if they hold the REIT shares for an extended period. This combination of income and potential for growth makes REITs a balanced investment choice for those looking to build wealth over time.
3. Diversification and Reduced Risk: REITs typically invest in a diverse range of property types, including residential, commercial, industrial, and retail spaces. This diversification helps to spread risk, as different property types may respond differently to market conditions. Additionally, REITs often hold properties across multiple geographic locations, further reducing the risk associated with regional economic downturns. This broad exposure to various sectors of the real estate market can help stabilize returns and reduce the impact of localized issues.
4. Liquidity and Accessibility: Unlike direct real estate investments, REITs are highly liquid and can be bought and sold on major stock exchanges like any other publicly traded stock. This liquidity allows investors to enter and exit positions with relative ease, providing flexibility that is not typically available in traditional real estate investments. Additionally, REITs have a relatively low minimum investment threshold, making them accessible to a wide range of investors, including those just starting to build their portfolios.
5. Professional Management: REITs are managed by professional teams with expertise in real estate acquisition, development, and management. These professionals are responsible for making strategic decisions about the properties in the REIT’s portfolio, including when to buy, sell, or develop properties. This professional management ensures that the assets are actively managed to maximize returns, which can be a significant advantage for investors who prefer a hands-off approach.
6. Tax Efficiency: REITs offer a tax-efficient way to invest in real estate. While the dividends received from a REIT are generally taxed as ordinary income, certain types of REITs, such as mortgage REITs, may offer additional tax advantages. Moreover, REITs often benefit from favorable tax treatments at the corporate level, allowing them to pass on more of their earnings to shareholders. This tax efficiency can enhance the overall return on investment for REIT shareholders.

Investing in REITs can be a compelling choice for those looking to gain exposure to the real estate market while enjoying the benefits of liquidity, professional management, and regular income distributions. Whether you’re seeking to diversify your portfolio or generate steady income, REITs offer a flexible and accessible option that deserves consideration.

Comparing Costs, Risks, and Expected Returns

When it comes to choosing between a Delaware Statutory Trust (DST) and a Real Estate Investment Trust (REIT), understanding the associated costs, risks, and potential returns is crucial. Each investment type offers distinct advantages and challenges that can significantly impact your overall financial strategy.

1. Costs

DST Costs

• Initial Investment: DSTs typically require a higher initial investment compared to REITs. The minimum investment can range from $100,000 to $500,000 or more, depending on the property and the sponsor. This higher entry point may be a barrier for some investors but is reflective of the institutional-grade properties that DSTs often involve.
• Ongoing Fees: Investors in DSTs must also consider management fees, which are typically deducted from the income generated by the property. These fees cover the costs of property management, asset management, and other administrative expenses. While these fees are usually transparent, they can vary widely depending on the sponsor and the complexity of the investment.
• Exit Costs: Since DST investments are illiquid, there can be significant costs associated with exiting the investment early. These costs might include penalties, fees for finding a buyer, and potential loss of value if the sale occurs during an unfavorable market condition.

REIT Costs

• Initial Investment: REITs generally have a much lower entry cost. Shares in publicly traded REITs can be purchased on stock exchanges, often for less than $100 per share. This makes REITs more accessible to a broader range of investors, including those with limited capital.
• Management Fees: Like DSTs, REITs charge management fees, which are typically built into the operating expenses of the trust. These fees tend to be lower as a percentage of the investment compared to DSTs due to economies of scale and the larger, more diversified nature of REIT portfolios.
• Transaction Costs: Buying and selling REIT shares incurs standard brokerage fees, similar to trading any other stock. However, these fees are generally minimal and do not significantly impact the overall cost structure.

2. Risks

DST Risks

• Illiquidity: One of the most significant risks associated with DSTs is their illiquid nature. Once invested, your capital is typically tied up until the property is sold, which could take several years. This lack of liquidity can be a major drawback for investors who may need access to their funds on short notice.
• Concentration Risk: DSTs often involve investing in a single property or a small portfolio of properties. This concentration can increase risk, as the performance of your investment is heavily dependent on the success of a specific property or location. If the property underperforms or encounters issues (e.g., tenant defaults, natural disasters), it could significantly impact your returns.
• Sponsor Risk: The success of a DST largely depends on the competence and experience of the sponsor managing the property. If the sponsor fails to manage the property effectively, the investment could underperform. Investors must thoroughly vet the sponsor’s track record before committing funds.

REIT Risks

• Market Volatility: Publicly traded REITs are subject to the same market fluctuations as other stocks. This means that REIT share prices can be volatile, influenced by broader economic conditions, interest rates, and investor sentiment. While this volatility can provide opportunities for gains, it also introduces a level of risk that may not be present in direct real estate investments like DSTs.
• Dividend Risk: Although REITs are required to distribute at least 90% of their taxable income as dividends, these payments are not guaranteed. In times of economic downturn, a REIT may reduce or suspend dividend payments, which could impact the income stream you rely on from the investment.
• Interest Rate Risk: REITs are sensitive to interest rate changes. When interest rates rise, the cost of borrowing increases, which can reduce a REIT’s profitability. Higher interest rates can also make other income-generating investments, such as bonds, more attractive, potentially leading to a decline in REIT share prices.

3. Expected Returns

DST Expected Returns

• Income Stability: DSTs generally provide stable and predictable income, as they are often tied to long-term, net-leased properties with creditworthy tenants. This makes them appealing for investors seeking steady cash flow.
• Appreciation Potential: While the primary focus of DSTs is income generation, there is also the potential for property appreciation. If the real estate market performs well, the value of the underlying property may increase, leading to higher returns upon the sale of the asset.

REIT Expected Returns

• Dividend Yield: REITs are known for their relatively high dividend yields, which can be particularly attractive in a low-interest-rate environment. Investors can benefit from regular income distributions, which are typically higher than those from traditional equities.
• Capital Growth: In addition to dividends, REITs offer the potential for capital appreciation. As the properties in the REIT portfolio increase in value and the overall economy strengthens, the share price of the REIT may rise, providing an opportunity for capital gains.

Pros and Cons of Investing in DSTs vs. REITs

Pros and Cons of DSTs

Pros

• Direct Ownership: DSTs provide investors with fractional ownership of real, tangible assets. This direct ownership can offer greater control over specific investment decisions, such as property selection and management strategy, compared to REITs.
• Tax Advantages: Through 1031 exchanges, DSTs allow for the deferral of capital gains taxes, which can be a significant financial benefit, especially for investors looking to roll over proceeds from one real estate investment to another without incurring immediate tax liabilities.
• Income Stability: Due to the typically long-term leases and the creditworthiness of tenants, DSTs often generate stable and predictable income streams, making them an attractive option for income-focused investors.

Cons

• Illiquidity: DSTs are not easily liquidated, and investors may find it challenging to access their funds before the trust reaches maturity. This lack of liquidity can be a significant drawback for those who may need to sell their investment prematurely.
• High Initial Investment: The entry cost for DSTs is generally higher, which may limit participation to more affluent investors. This higher barrier to entry can exclude smaller investors who might otherwise be interested in real estate.
• Complexity: DSTs can involve complex legal and tax considerations. The intricacies of these investments require thorough due diligence and professional advice, which can add to the overall cost and complexity of the investment.

Pros and Cons of REITs

Pros

• Liquidity: One of the primary advantages of REITs is their liquidity. Investors can buy and sell shares on the open market just like stocks, providing flexibility and easy access to capital if needed.
• Diversification: REITs offer exposure to a wide range of property types and geographic locations, which helps to spread risk. This diversification can protect against downturns in specific sectors or regions of the real estate market.
• Low Entry Cost: REITs are accessible to a broad range of investors, including those with limited capital. This low entry cost makes it easier for individuals to add real estate exposure to their portfolios without needing substantial upfront investment.
• Professional Management: REITs are managed by experienced professionals who handle all aspects of property acquisition, management, and disposal. This expertise can be particularly valuable for investors who prefer a hands-off approach.

Cons

• Market Volatility: The share prices of publicly traded REITs can be subject to significant fluctuations due to market conditions, interest rates, and other external factors. This volatility may not align with the risk tolerance of all investors.
• Dividend Taxation: Dividends from REITs are typically taxed as ordinary income, which may result in a higher tax burden for investors, especially those in higher tax brackets.
• Less Control: Unlike DSTs, where investors have a direct stake in specific properties, REIT investors have little to no control over the individual assets within the REIT portfolio. This lack of control may be a disadvantage for those who prefer a more active role in their investments.

Both DSTs and REITs offer compelling opportunities for real estate investment, but they cater to different types of investors and financial goals. DSTs may be better suited for those seeking direct ownership, tax advantages, and stable income, while REITs might appeal to investors who prioritize liquidity, diversification, and ease of entry. By carefully weighing the costs, risks, and potential returns of each option, you can make an informed decision that aligns with your financial objectives.

Tax Implications of DSTs and REITs

Understanding the tax implications of your investments is crucial for optimizing returns and minimizing liabilities. Both Delaware Statutory Trusts (DSTs) and Real Estate Investment Trusts (REITs) offer unique tax advantages, but they also come with specific considerations that can impact your overall financial strategy.

DST Tax Implications

1. 1031 Exchange Benefits: One of the most significant tax advantages of investing in a DST is the ability to participate in a 1031 exchange. Under Section 1031 of the Internal Revenue Code, investors can defer capital gains taxes by reinvesting the proceeds from the sale of an investment property into another like-kind property. DSTs are considered eligible for 1031 exchanges, allowing you to defer taxes while diversifying your portfolio. This can be particularly beneficial for investors looking to transition from active management of a property to a more passive investment, without incurring immediate tax consequences.
2. Depreciation and Tax Shield: Like direct real estate ownership, DSTs allow investors to benefit from depreciation, which can offset taxable income. The depreciation deduction is based on the cost of the buildings and improvements (not the land) and can significantly reduce the amount of income tax owed on the cash flow generated by the property. However, it’s essential to note that if you eventually sell your DST interest outside of a 1031 exchange, the depreciation taken over the years will be subject to recapture at a 25% tax rate.
3. Pass-Through Taxation: Income from DST investments is passed through to investors and reported on their personal tax returns. The income is generally taxed at the investor’s ordinary income tax rate. However, because DSTs typically hold real estate with long-term leases, they often generate significant tax deductions (such as depreciation), which can reduce the taxable income and potentially lower the investor’s tax burden.
4. Estate Planning Considerations: DSTs can play a strategic role in estate planning. Upon the death of an investor, the heirs receive a step-up in basis on the inherited DST interests, which can significantly reduce or eliminate capital gains taxes if the property is sold. Additionally, the fractional ownership structure of DSTs can make it easier to divide the investment among multiple heirs.

REIT Tax Implications

1. Dividend Taxation: REITs are required to distribute at least 90% of their taxable income to shareholders, which is typically in the form of dividends. These dividends are usually taxed as ordinary income, which means they are subject to the investor’s marginal tax rate. However, a portion of REIT dividends may qualify for a 20% deduction under the Qualified Business Income (QBI) deduction, depending on the specific nature of the income and the REIT’s structure. This can effectively reduce the tax rate on a portion of the dividend income.
2. Capital Gains: REITs can also generate capital gains, which occur when the REIT sells properties at a profit. These gains are passed through to shareholders and are typically taxed at long-term capital gains rates if the assets were held for more than a year. This can provide a tax-efficient way to realize gains compared to the higher ordinary income tax rates.
3. Tax-Deferred Accounts: Holding REITs in tax-deferred accounts, such as an IRA or 401(k), can be advantageous as it allows the dividends and capital gains to grow tax-free until withdrawal. This strategy can help you avoid the immediate tax impact of REIT dividends and allows your investment to compound over time without the drag of annual taxes.
4. REIT-Specific Deductions and Depreciation: REITs benefit from significant depreciation deductions on their properties, which reduces their taxable income at the corporate level. These tax savings are often passed through to shareholders in the form of higher dividend distributions. Additionally, because REITs do not pay federal income taxes at the corporate level (provided they meet certain requirements), they can offer higher after-tax returns to investors compared to other dividend-paying stocks.

Tips for Finding the Right DST or REIT

Choosing the right DST or REIT for your investment portfolio requires careful consideration and strategic planning. Here are some tips to help you make an informed decision:

1. Research Performance History

• DSTs: When evaluating a DST, it’s essential to examine the historical performance of both the property and the sponsor managing the trust. Look for sponsors with a proven track record of managing successful DSTs, as their experience and expertise are critical to the trust’s performance. Analyze the occupancy rates, rental income, and any past distributions to get a sense of how the property has performed over time. Additionally, consider the market conditions in the area where the property is located, as this can impact future performance.
• REITs: For REITs, review the historical performance of the REIT’s share price, dividend yields, and total returns. Pay attention to how the REIT has performed during different market cycles, including periods of economic downturn. A REIT that has demonstrated resilience and consistent dividend payments, even in challenging times, may be a more reliable investment. Also, examine the quality and diversity of the REIT’s property portfolio to assess its potential for future growth.

2. Evaluate Fees and Costs

• DSTs: DSTs often involve various fees, including acquisition fees, management fees, and disposition fees. These fees can significantly impact your overall returns, so it’s important to fully understand them before investing. Compare fees across different DST offerings to ensure you’re getting a competitive rate. Also, consider the impact of these fees on the net income generated by the property, as high fees can erode your cash flow.
• REITs: REITs have operating expenses and management fees that are typically reflected in the expense ratio. A lower expense ratio generally indicates that more of the REIT’s income is being passed on to shareholders as dividends. However, don’t just focus on fees—evaluate them in the context of the REIT’s performance. Sometimes, higher fees can be justified if the REIT delivers superior returns or offers exposure to high-quality properties.

3. Consider Management Quality

• DSTs: The success of a DST largely depends on the quality of its management. A competent sponsor will have a strong track record in property management, acquisition, and asset disposition. Research the sponsor’s background, including their experience with similar properties, their approach to property management, and their reputation in the industry. Also, consider how the sponsor handles tenant relations, property maintenance, and any potential challenges that could arise.
• REITs: The management team of a REIT plays a critical role in its success. Look for a REIT with an experienced management team that has a deep understanding of the real estate market and a strong track record of making profitable investment decisions. Consider how the management team has navigated previous market downturns and whether they have a clear strategy for growth. Good management can be the difference between a REIT that consistently delivers returns and one that underperforms.

4. Assess Market and Economic Conditions

• DSTs: Before investing in a DST, assess the current and projected market conditions for the property type and location. Research the local economy, job growth, population trends, and demand for the type of real estate in which the DST is invested. Properties in growing markets with high demand are more likely to maintain or increase their value over time, reducing the risk of your investment.
• REITs: For REITs, consider how broader economic trends may impact the sectors and geographic regions in which the REIT operates. For example, a REIT focused on commercial office space might be affected by trends toward remote work, while a residential REIT could benefit from population growth in suburban areas. Understanding these trends can help you choose a REIT that is well-positioned for future growth.

5. Seek Professional Advice

Whether you’re considering a DST or a REIT, consulting with a financial advisor can provide valuable insights tailored to your specific financial situation. A financial advisor can help you evaluate the risks and benefits of each option, ensure that the investment aligns with your overall portfolio strategy, and assist in navigating the complexities of real estate investments. They can also help you understand the tax implications and develop a plan for managing your investments over time.

We Can Help Decide Which is Right For You

Choosing between a DST and a REIT requires a careful evaluation of your financial goals, risk tolerance, and investment strategy. At 1031 Exchange Place, we recognize that both DSTs and REITs offer unique advantages and challenges. DSTs may be the right choice if you’re looking for direct ownership, tax deferral opportunities, and a steady income stream. On the other hand, REITs offer liquidity, diversification, and ease of entry, making them an attractive option for many investors.

Understanding the tax implications, assessing management quality, and thoroughly researching your options are key steps to ensuring a successful investment. By taking the time to explore these factors and seeking professional guidance when necessary, you can make a well-informed decision that aligns with your financial objectives and maximizes your potential returns.

Whether you’re just starting to explore real estate investments or looking to expand your existing portfolio, 1031 Exchange Place is here to assist you. Contact us today to learn more about how we can help you achieve your investment goals through DSTs, REITs, or other real estate opportunities.