On our way to work, many of us are accustomed to sitting in standstill traffic, depending on where we are and what times we make our commute. Other than the jealousy you may feel when you’re sitting in that traffic and see a car in the carpool lane zoom by, something in you may admire those who figured out a way to make the rules of the road work for them. They put in the work to take extra people with them wherever they’re going and save valuable time in their day.
When it comes to the investment options available to you, Delaware Statutory Trusts (DSTs), which are a unique vehicle to invest in direct real estate, aren’t too different from the carpool lane! So, let’s get into how DSTs are a bastion of stability in a market where returns and low-volatility opportunities are hard to come by.
Considering the Full Range of Your Investment Options
Flashback to a few years ago. Stocks were on the rise, whether the stability-centered Dow Jones Industrial Average or the high-risk, high-reward Nasdaq Composite. Corporate and Treasury bonds were also rising in value as yields were sinking. In general, your portfolio was seeing double-digit gains over the year, inflation was low so your budget wasn’t as stressed, and interest rates were nearly at zero, so putting your money anywhere else other than the public markets might have seemed like an ill-advised decision at first glance. When it came to real estate, you might have seen the low growth rates of a real estate investment trust (REIT) index fund and subsequently turned elsewhere.
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Flash-forward to the present day. We’re seeing the decade-long bull market run – a run that seemed indefinite – come to an operatic end, record inflation rates are hitting our budgets, and the overall economy could be in the early stages of recession. Chances are that your retirement finances took a hit due to these factors. The stocks that grew the most during the bull market run are coming down the fastest, leaving your stock portfolio at risk of large declines.
But what about real estate? How are real estate markets performing relative to the overall market?
The Resilience of Real Estate
If you’ve been tuned to the real estate markets, you may have noticed that, because of the Federal Reserve’s decision to sharply raise interest rates, mortgage rates have been rising, pushing buyers out of the market, and pushing home values down. Some have coined this as the start of a housing recession, but that doesn’t tell the full story.
The Case-Shiller Home Price Index shows that, yes, in terms of percentage performance over the years, the S&P 500 outperforms the growth of average home values in the long term, but that doesn’t necessarily mean that your real estate will perform poorly for you. If you do the math, the downside risk is greater than what the percentages show. And to put the icing on the cake, the index shows that from October 2021 to July 2022, home prices went up roughly 13%, whereas the S&P 500 went down roughly 13%. That’s a 26-percentage-point difference!
The factor here is that real estate markets and stock markets simply operate differently. The stock market is highly liquid and tends to move together, while real estate is an illiquid, highly individualized asset class. Think about your own home and what goes into its value. Then think about all the other properties out there with their own unique factors and property management, ranging from cheap lots to multimillion-dollar developments, and that’s not even discussing property types, neighborhoods or geographies.
Most important, unlike stocks, there isn’t a centralized exchange where people can buy and sell real estate in seconds. That wouldn’t even make sense for real estate! With such tangible assets as property and buildings, real estate markets can be relatively more insulated from the psychological herd behavior that governs stock market prices.
For this reason, the right real estate assets can perform successfully even in difficult market conditions. However, if your only exposure to real estate is through your own home or a small allocation of your investment portfolio towards REIT stocks, you’re left with an undiversified direct real estate asset (your home) and a basket of stocks whose performance is subject to market volatility and is based on the speculative value of the real estate investment company, an indirect entity as opposed to the real estate itself. So, you must be thinking, “How do I access direct real estate more effectively?”
Enter Delaware Statutory Trusts (DSTs)
DSTs are legal entities that allow investors to passively invest in direct real estate assets. That means that you can pool your money along with other investors for a larger development that you would have otherwise had to fund on your own, all while the headaches of property management are taken care of by a separate management team. This provides you with access to your portion of the potential gains of direct property development.
In addition, you can transfer your real estate asset into a DST in exchange for a basket of diversified assets rather than one large one. This allows the investor to reduce their risk through diversification. You can also make this transfer tax-free by using a 1031 exchange, in which you defer capital gains on the sale of your original, appreciated investment. This deferral can continue, and eventually, heirs can enjoy a step-up in basis, essentially extinguishing the original gain (more on that below!).
Another benefit for you is that you can see a complete elimination of capital gains tax if the investment is held inside the DST or continues to roll into another 1031 exchange indefinitely. At your passing, the beneficiaries would receive the stepped-up basis, meaning that the asset ownership timeline would reset, and any capital gains on the sale of their inherited asset would be calculated starting when they received the asset, not when you first bought it – significantly reducing their capital gains burden.
What’s more, you can receive passive income without the responsibilities of being the landlord. However, the DST still allows you to perform tax write-offs on costs of buying and improving properties that the DST manages (a function called “depreciation”). This makes DSTs a highly tax-efficient investment vehicle while potentially producing regular cash flow.
So, back to the original analogy, the DST investors are just like those people who use the carpool lane. They found a way to use the rules and tools available to them to meet a specific need. As a DST investor, you’re using a tool built to grant you access to a potentially lucrative segment of the real estate market that was previously closed to singular investors. In the same way roads get less crowded when multiple people use one car, the real estate industry benefits from having passive investors in direct real estate to increase the amount of capital available for larger developments.
The Bottom Line
Of course, investing in DSTs involves risk as well. Like any investment, real estate through DSTs can come with an investment loss. But also, DSTs are illiquid, meaning you can’t take your money out whenever you want like you can in the stock market.
But if the DST investment vehicle is right for you, you could gain access to a previously inaccessible asset class, insulated from stock market volatility, that can potentially produce income or high gains as well.
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