Due diligence for DST
Like any type of investment, it is absolutely necessary for Delaware Statutory Trust (DST) investors to conduct rigorous due diligence to ensure financial safety and minimize the potential risks. A number of conventional considerations for property investment apply here as well, such as property assessment, evaluation, and ongoing management after establishing the trust. There are a few levels of due diligence process and each of them can provide aids for an investor to make his or her final decision.
First, a DST sponsor will be required to provide detailed information about the DST and its property invested. From the start, it is important for an investor to have a thorough investigation about the sponsor’s prior records which should unveil the sponsor’s overall capability and his or her experience on particular types of investments.
Second, for any DSTs that acquired loans, the lender would inevitably carry out due diligence independently. Its evaluation can also be a valuable reference for an investor. Because of the unique nature of DST, there are several challenges that lenders must face. Among the notoriously well-known “7 Deadly Sins” of DST, the most significant restriction is that once a DST is concluded, the trustee cannot renegotiate loan terms, refinance or raise additional capital. It means that a DST has a restricted capability to cope with potential financial difficulties. The only possible way out would be to convert a DST to an LLC. Once a DST becomes LLC, the deadly limitations would be dissolved. Such conversion does not change the ownership, but rather the form of organization. Hence, an LLC agreement is often attached to the DST trust agreement as its fall-back plan. It is vital for lenders not only to study the trust agreement, but also the LLC agreement so that the process of conversion could be fully understood.
Third, a broker dealer’s due diligence. A broker dealer normally supervises a group of representatives who are registered under its name. The dealer, in theory, determines whether a DST property is safe and appropriate for its representatives to offer to the clients. Consequently, the broker dealer will enter into and sign the selling agreement. For this reason, a broker dealer will indeed need to conduct due diligence to assess the DST. However, always be aware that the broker dealer’s satisfaction on a due diligence assessment does not guarantee the 100% safety and profit return of the investment, though it adds an extra degree of assurance. One may have heard of the Financial Industry Regulatory Authority (FIRA), a well-known private and self-regulatory organization. It is influential in terms of the regulation on brokerage investment firms. It oversees around 4,250 brokerage firms, 162,155 branch offices, and approximately 629,525 registered securities representatives across the United States. Among its membership qualifications, FIRA expressly requires the adequate skills of “providing customers with information about investment strategies, risks and rewards, and communications relevant to the market, investment, and research data to customers.” In general, the process of due diligence for a broker dealer could include an examination of the Real Estate Provider (Sponsor), analysis of the Properties, analysis of the market, analysis of DST program structure, and evaluation of 1031 tax compliance. As explained earlier, it is possible that a broker dealer could reject the offering of a DST based on the outcome of the analysis. Indeed, for the same DST property, different broker dealers might come to different conclusions.
Fourth, investors can hire a third party to evaluate the DST property independently and retain an unbiased opinion.
Lender Reserve
Because DST possesses its own legal personality, the obligation of paying back loans procured from the lender is solely undertaken by the trust itself. Such loans for a DST must be a non-recourse loan. It means that if the borrower defaulted or bankrupted, the lender could only retrieve money from the collateral under the agreement. No other assets could be acquired by the lender for the purpose of getting its money back in full. Hence, a non-recourse loan is essentially favorable to the borrower. For this reason, the lender may request a “Lender Reserve” which is pooled by the investors. Its sole purpose is to cover a certain amount of unpaid debts if the trust defaults. Once the total loans have been paid off by the trust, the money in the “Lender Reserve” must be returned to the investors.
Sponsor Reserve
After a DST is concluded, a property manager will discharge the responsibility to manage the DST property so its value could be maintained over time. It implicates standard repairs and minor non-structural changes. However, if there is an unexpectedly high cost for the repairs, then the sponsor reserve serves as a means to provide temporary financial aids to sustain the necessary operations of the DST. The size of the sponsor reserve is predetermined in the trust agreement. The money ultimately belongs to the investors. It is worth noting that the trustee cannot upgrade the property like an investment. Therefore, the utilization of the sponsor reserve is quite limited in practice.
Duty of Care
Between the investors and the DST trustee, there exists a fiduciary relationship. Pursuant to Delaware Code Title 12, Section 3302, a fiduciary shall act with the care, skill, prudence, and diligence when investing, purchasing, acquiring, exchanging, retaining, selling, and managing property for the benefit of another. Any fiduciary breach of such duty shall bear civil liability for the loss of the investors. In other words, the law recognizes that any investment involves a certain degree of risks. It is an undue burden to impose certain results that must be delivered by the trustee. However, there is a minimal and reasonable duty that a trustee must not breach. For example, he or she may not intentionally or recklessly damage investors’ interests.
In sum, as a DST property passes through different hands, due diligence will be conducted at each level. It is important for an investor to utilize multiple sources to avoid the risks and assess potential growth and financial returns on investing a piece of DST property.
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