Zero-Coupon DST Commercial Real Estate Property Investment Maturity Risk

zero-coupon DST investing for commercial real estate
Zero-Coupon DST, Constant-Coupon DST or Alternatives? It’s about the money…

Capital markets demand for zero-coupon DST commercial real estate private placement offerings has rebounded from the COVID pandemic market paralysis due to the potential tax advantages that attend the Delaware Statutory Trust investment structure and pipeline shortages in the CRE vertical. The question for investors is what are you really after? Investing is about the net funds your receive (i.e.: obtaining more capital). The DST structure is just one of the alternatives out there and may not be the panacea you think it could be. The question is for investors seeking tax-advantaged investing opportunities in the new capital markets, what are your goals?

Rule 241 Funding Proposal Advance Release for CRE Project Financing
Current Funding Plan Proposal for CRE High-Yield Investing Opportunities.

Having said, not all zero-coupon opportunities are the same. Careful attention to the long-term market risk exposure and potential for tax recapture requires strong due diligence when it comes to investment screening. Changing tax code provisions, the changes to Regulation CF offerings, the changes to Regulation A offerings and Rule 506(c) have created an entirely new class of investment vehicles that offer potentially superior risk controls and capital gain opportunities that may in fact displace DST investing as a market preference.

Zero-Coupon, Constant Coupon DST & Alternative Investment Comparisons

The zero-coupon DST represents the greatest level of risk – it’s like holding a U.S. savings bond in the old days. What it is worth in real dollars ten years from now is not known. The principle attraction is the deferment of capital gains taxes and the corresponding loss of capital. This may be a potential losing battle, so comparisons are warranted.

zero-coupon DST yield comparison for risk-adjusted tax-equivalent IRR yield expectations
The Zero-Coupon DST may not be the panacea the market expected it to be.

Zero-Coupon DST

The zero-coupon DST represents the lowest potential tier of investment return opportunities in the CRE capital markets the investing-public routinely sees. This would suggest a zero-coupon DST investment would be a “riskless investment”, but is it? We used a simple example of a multifamily DST investment comparison and found some interesting things. First, should capitalization rates increase by more than 200 basis points over the ensuing 10-year period, the investor is going to experience a loss – not even break even. How likely is it that cap rates will go down or stay the same? Second, how likely is tax policy to remain unchanged? Third, how likely is that asset obsolescence will not occur and reduce the income of the property over that 10 year period? These questions make zero-coupon DSTs potential risks that must be clearly understood before you make the investment.

The Constant Coupon DST

The constant coupon DST, unlike the zero-coupon DST, pays a constant dividend over the term (usually an annual distribution). This offsets many of the concerns, but the exposure to capital market changes cannot be overlooked, nor can the asset obsolescence issue. Having said, the constant coupon DST appears on the face to be a potentially better alternative, as half a loaf is still better than none at all.

DST Investment Alternatives

Shouldn’t the end result of your investing reflect the goal of getting more capital and not just avoiding more taxation?

The changes in capital market regulations and tax code issues create the opportunity for a combination of capital gain tax deferment that can be coupled with allocations of bonus deprecation expense, thus potentially offsetting the tax issues and gain issues associated with DST investing. When these additions are combined with opportunities for roll-over investment programs pursuant to the new securities regulations, the DST approach appears to pale by comparison. Whatever the future is for Delaware Statutory Trust investing in commercial real estate income-producing properties, it may stand to reason, the game is going to have to change in the coming year as these revelations become known on a wider basis.