When the Distributions Stop: What Happens if a DST Goes Wrong

Delaware Statutory Trust offerings are usually presented with a projected distribution rate, a target hold period and photographs of a well maintained building. Those projections are made in good faith, and many offerings perform close to them.

Some do not. Understanding what happens when a DST underperforms, and what you can and cannot do about it, is the part of the decision that deserves attention before you invest rather than after.

Why can distributions be cut?

Distributions come from the property's net cash flow after debt service and expenses. Anything that reduces that cash flow can reduce distributions.

• ›Vacancy. A departing tenant, or several in a multi tenant property.
• ›Rising expenses. Insurance, property taxes, utilities and maintenance can all outpace rent growth.
• ›Interest costs. Where debt is floating rate, or when a loan is refinanced at a higher rate.
• ›Capital needs. Roofs, systems and tenant improvements consume cash.
• ›Reserves being rebuilt after an unexpected cost.

Sponsors can reduce or suspend distributions when cash flow does not support them. Investors are informed, not consulted.

What can investors actually do?

Very little, and that is by design.

A DST must remain passive to keep its interests eligible as 1031 replacement property. Investors have no voting rights on operations, no ability to replace the trustee, and no right to force a sale or a refinancing.

The interests are also illiquid. There is no exchange on which to sell them, no redemption right, and no obligation on anyone to buy. Investors who want out of a struggling DST often find there is no route.

What is the springing LLC?

Because a DST is so restricted, it cannot easily respond to trouble. It generally cannot raise new capital from investors or renegotiate its loan in the way an ordinary owner could.

Most DST documents therefore include a provision allowing conversion into a limited liability company if the trust faces circumstances that threaten the property, sometimes called a springing LLC.

Conversion gives the manager flexibility to act. It also changes what investors hold. LLC interests are generally treated as partnership interests, which are not eligible for 1031 exchange treatment. An investor who later exits may find the ability to defer gain has gone.

What happens if the loan matures at a bad time?

Loan maturity is the most common pressure point. If the property's value has fallen or lending conditions have tightened, refinancing may require more equity than the trust has, or may not be available at all.

Outcomes can include an extended hold, a sale at a disappointing price, a restructuring, or in the worst case a loss of the property. Debt relief in a foreclosure can create taxable gain for investors even without cash, because relief from debt is treated as value received.

What does a poor outcome look like financially?

Investors may receive reduced or no distributions for a period, and may eventually receive less capital back than they invested. Because the original gain was deferred rather than eliminated, a loss of value does not undo the deferred tax on the earlier property in all circumstances. The interaction needs modelling with a CPA.

What reduces the risk?

• ›Diversify. Several offerings with different sponsors, asset types and locations rather than one.
• ›Check leverage. Higher leverage magnifies both outcomes.
• ›Check loan maturity against the hold period. A loan maturing mid hold introduces refinancing risk.
• ›Ask about reserves and the capital expenditure plan.
• ›Ask how prior offerings performed in 2008 and 2020, including any suspensions.
• ›Read the conversion provisions so you know what could change.

What should you ask before investing?

• ›What happens if occupancy falls by 20 percent?
• ›Under what circumstances would distributions be suspended?
• ›What triggers a conversion to an LLC, and who decides?
• ›What is the loan maturity date and the refinancing plan?
• ›Have any of your prior offerings suspended distributions or lost principal?

Does underperformance affect your ability to exchange again?

It can. When the property is eventually sold, you receive your share of whatever proceeds remain. If you want to defer the gain again, the normal rules apply, with a Qualified Intermediary engaged before the sale proceeds reach you and the usual 45 and 180 day deadlines running from that sale.

Two complications arise in poor outcomes. If the trust converted to an LLC, you may hold a partnership interest rather than real property, which cannot be exchanged. And if the proceeds are small relative to the debt that was relieved, the tax result may not match the cash you receive.

Both are reasons to ask about conversion provisions and leverage before investing rather than after.

What to do first

Read the risk factors section of the offering documents properly, not the summary. Ask the sponsor the questions above and note whether the answers are specific. Then size your investment on the assumption that the projection is optimistic rather than certain.

Nothing here is tax, legal or investment advice. DST interests are securities offered to accredited investors only through licensed broker dealers and definitive offering documents, and investing involves risk including loss of principal. Past performance does not indicate future results.