In part 1 How to Review a Private Placement Memorandum (PPM) for a Delaware Statutory Trust we opened up the discussion. We covered the role of the PPM in DST Investing as well as Compliance and Investor protection. We continue with Part 2 which includes reviewing Sponsor and Management, the Asset or Property and a few other disclosures.
By Al DiNicola, AIF®
1031 Tax Deferred Exchange Specialists & DST Advisor
NAMCOA® – Naples Asset Management ~Company®, LLC
Securities offered through MSC-BD, LLC, Member of FINRA/SIPC
Part Three will focus on the Use of Funds. How to Review a Private Placement Memorandum (PPM) ~ Part 1
Understanding the scope of a private placement memorandum (PPM) continues to be a requested topic. Many PPMs are over 150 pages long and some may reach 300 pages (or more) especially if the DST offering is comprised of several offerings in a portfolio. We have reviewed nearly 700 Offerings over the past number of years.
Sponsor and Management Team
The sponsor’s expertise and track record often determine DST performance. Since 2004 when DST were first acknowledged by the IRS as a permitted replacement for a §1031 exchange there have been many sponsors who have entered the space. Some of the sponsors were large real estate companies with a long-track record of investment experience. DSTs may be the same type of real estate offering with a different “wrapper” according to some opinions. Meaning rather than a Tenant in Common (TIC) or REIT, the investment was structured to be offer to a potentially expanded investor pool (those investors executing a §1031 exchange). As a DST sponsor the longest track record may be 22 years. Inland Real Estate was one of the first DST sponsors. Inland was the company who petitioned the IRS to use DSTs in a §1031 exchange. Like other sponsors, Inland was an established real estate investment company expanding their offerings. Quickly the adoption of the DST offerings became sought after and there were many more sponsors. Some with extensive track records and others with limited track records. Recently very large REITs (Real Estate Investment Trusts) are now offering DSTs. Imagine, a $25 Billion REIT is now offering a $50M DST. The strategy the REITs provide is for the DST to be moved back into the REIT after a safe harbor period (2 years). This may provide a large diversification pool of assets.
What to Review:
There are a number of items to research regarding the sponsor. The sponsor history prior to the DST offerings is one area to review. As stated previously there may be an experienced real estate investment firm who enters the DST sponsor role as a “new sponsor”, but not new company. There are also individual sponsor principals with experience from other firms who establish a new company and rely on business skills sets they bring to the new company. The success of previous programs should be noted with regards to realized returns and exit performance. The PPM should note the successful programs as well as marginal or unsuccessful programs. PPMs will also disclose any pending or former litigation that involves any of the principals (known as “bad actors”). The key elements of concern according to a third-party evaluation company may be… First this section attempts to ascertain the likelihood that an organization’s officers or key employees may commit fraudulent or risky activity and to identify whether the manner in which an organization conducts its business activities may position the organization for costly litigation. Second, this section attempts to identify disqualifying “bad actor” events under 17 C.F.R. §230.506(d) of issuers, affiliated issuers, and individuals. This review does not include registered representatives or selling group members. Third, this section attempts to identify areas of litigation-related contingent liabilities that may affect the organization’s financial position. When we meet with sponsors and third-party due diligence firms we do ask a plethora of questions. Many times, there will be co-investment by the sponsor which may demonstrate alignment of interest. This would be a favorable aspect of the offering.
Property Overview
The PPM should provide details on the property or portfolio. Single properties may be easier to review and obtain information. Portfolios of properties will have additional information. A single property may become easier to identify on the 45- Days identification list since portfolios of properties need to be identified individually even if offered as one acquisition. This becomes an extra detail to avoid any confusion in the completion of the required identification process if a 1031 exchange is being used.
Key Items to Review:
The underlying asset of the DST is real estate and as such will have the fundamentals described. This includes fundamental location such as the demographic, employment, schools (important for multifamily properties). Infrastructure needs such as transportation networks (access to rail in certain areas may be important). For certain properties the tenant analysis becomes very important. What are the lease terms, renewal risks, and credit worthiness? Triple net lease properties may have certain advantages with credit worthy tenants. The physical condition of the property becomes important and if there was deferred maintenance in the case of an older building. There may also be independent appraisals as well as engineering reports included in the PPM or available as a supplement. One element to understand is how the property was acquired. Was the acquisition through an affiliated party where the DST sponsor has an interest? Sponsors that are vertically integrated may provide some efficiencies when bringing a DST to market. There may also be occasions where there has been a mark up from the affiliated party acquisition of the property and then the ultimate sale to the DST. This would be disclosed.
One recent inclusion in supporting documents may be a cost segregation study on certain DSTs. Since the new legislation signed into law on July 4, 2025, 100% depreciation may again be utilized.
There are also the overall fundaments of the real estate investment. Let’s review a Hypothetical Property Example.The property is a Class A multifamily complex, Phoenix, AZ. The Total Acquisition price (including all cost & fees) is $80 million, 50% LTV financing. The complex has 300 apartment units and is 95% occupancy. The Strengths are a strong local market fundamentals with a Diversified tenant base. The rent assumptions (annual increases) are conservative. The Risks may be with the loan. If the loan has a balloon maturity in seven years this may cause an issue. DSTs may not refinance the loan. There may also be high acquisition fees as well as a Limited capital reserve allocation.
The investor decision may be to allocate partially to balance risk with diversification across other DSTs.
Financial Projections and Assumptions
Somewhere within the PPM will be financial projections. These may be stated in a chart or in a form very similar to an excel spreadsheet. The projections provide sponsor expectations but are not guaranteed. There may also be the reference to pretax and after-tax potential return. Many times, the after-tax implication takes into effect the highest tax bracket as well as a state income tax to arrive at a potential total rate of 40%. All investors may not fall under this category.
What to Evaluate:
Within the volumes of information contained within the PPM when it comes to financial aspects of the DST, there are specific items to review. If the property is a multifamily property, the rent growth (past and projected) is a key metric. The occupancy rate (or vacancy rate) is typically expressed as a percentage. Most markets have detailed reports on the competitive set to establish the vacancy rates. Over the past few years occupancy rates projected in the PPM have come under pressure. The (typically projected) rental growth expressed as a 5% rate of growth may not hit that level and may actually be flat (or negative) due to interest rate increases. Historically this has moved up and down over the years. Inflation may have caused expenses to escalate over the past few years. The double-edge sword of flat rent growth and increased expenses (taxes & insurance) may continue to put pressure on the property. If there is a loan on the property another key metric is the debt coverage ratio (DSCR). Years ago, a familiar term that was used was “Cap Rate Compression”. Many times, the compression factor created an opportunity for an exit. The same Net Operating Income (NOI) when acquired may create a profit as cap rates compress. If cap rates do not compress the value may not increase.
Legal Structure and Compliance
DSTs are governed by IRS Revenue Ruling 2004-86. This was the ruling that permitted DSTs to be acknowledged and permitted to satisfy the §1031 replacement requirements for completing the exchange. There are on-going requirements for the DST to adhere to comply with ruling. If sponsors violate any of the requirements (known as the Seven Deadly Sins) the §1031 exchange may be in jeopardy and investors may face immediate tax consequences.
Key Points to Confirm for investors.
One of the first questions from a CPA (who may not deal with §1031 exchanges let alone DSTs) will ask, is the DST compliant. The answer is yes. DSTs are IRS compliance for §1031 eligibility. There are key elements to understand. There are limited investor rights with passive ownership. With passive ownership comes passive management. The DST itself has restrictions on refinancing and improvements. Most PPMs will address the IRS compliance issue with statements regarding the use of §1031 exchange and how each investor should seek their own counsel on qualification.
Subscription Agreement and Investor Qualifications
Within the PPM there will be a sample of the Subscription Agreement or Investor Questionnaire. Typically, there will be a separate agreement sent for electronic signatures with the assistance of the financial advisor or broker dealer representative. Final documents govern investor responsibilities. If a QI is involved the instructions are straight forward.
Key Investor Responsibilities:
There are investor responsibilities that need to be acknowledged by the investor. Starting with the Accredited Investor certification and the Acknowledgement of risks. The PPM also contains an Agreement to restrictions on transferability.
Final thoughts on Part 2
A DST can be an effective vehicle for tax-deferred real estate investing, but it is not without risk. The PPM is the single most important disclosure document. Review of the Sponsor and Management, the Asset or Property are part of the overall review. Investors who carefully analyze the PPM, engage professional advisors, and compare offerings are better equipped to protect capital and make sound decisions. In Part 3 we will cover what many feel is the most important aspect- The Use of Proceeds.
NAMCOA® is a SEC registered investment advisory firm that provides comprehensive portfolio management, financial planning, and fiduciary decision-making services on behalf of retirement plan sponsors. Our Difference is summarized by our fiduciary approach which enables us to better meet portfolio and retirement plan objectives, resulting in stronger risk adjusted returns for investors and peace of mind for Clients. We also focus on alternative real estate investment. Many real estate investors are seeking tax deferred solutions utilizing §1031 exchanges or Opportunity Zones.
Alternative investments and DSTs are not for all investors. The acquisition of a certain alternative investments including DSTs is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your §1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC §1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email adinicola@namcoa.com.
This is not an offer to purchase or solicitation to purchase any security, as such be made only through an offering memorandum or prospectus. Investing in securities, real estate, or any investment, whether public or private, involves risk, including but not limited to the potential of losing some or all of your investment dollars when you invest in securities. You should review any planned financial transactions that may have tax or legal implications with your personal tax or legal advisor. NAMCOA, LLC is a Registered Investment Advisor, regulated by SEC (Securities and Exchange Commission). Our corporate office is located at 999 Vanderbilt Beach Road, Suite 200, Naples Florida 34108. Securities Offered through MSC-BD, LLC, Member of FINRA/SIPC. 5 Centerpointe Drive, Ste. 400 Lake Oswego, OR, 97035MSC-BD, LLC and NAMCOA are independently owned and are not affiliated.
Thank you.
References
- FINRA. (2023). Understanding private placements. Retrieved from https://www.finra.org
- Internal Revenue Service. (2004). Revenue Ruling 2004-86. Washington, D.C.
- Securities and Exchange Commission. (2022). Private placement guidance. Retrieved from https://www.sec.gov
National Real Estate Investor. (2023). Trends in Delaware Statutory Trust offerings. Retrieved from https://www.nreionline.com
