DST 1031 Property Due Diligence

By Dwight Kay, Founder and CEO, Kay Properties & Investments

Key Takeaways:

  • Why is Due Diligence important for Delaware Statutory Trust 1031 Exchanges?
  • What are the seven steps of due diligence Kay Properties performs?
  • Why rejecting exotic and high-risk property categories should be the first step of any due diligence process?

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At Kay Properties and Investments, we’re different than others—not just different in that our DST 1031 volume was $610 million in 2021, our Kay Properties team has 150 years of cumulative real estate experience, and that we have participated in more than $30 billion since our founding; not just different in that we have offices in Los Angeles, New York, and Washington DC, San Diego, San Francisco and Seattle; not just different in that we have access to all DSTs in the marketplace from all sponsors as well as client exclusive, off-market DSTs that are only available to clients of Kay Properties—but different in that we place a high priority on seeking to perform comprehensive DST due diligence. The Kay Properties Due Diligence Team is made-up of seasoned industry veterans who have performed due diligence, research, and analysis for regional and national commercial banks, private real estate companies, large real estate developers and international commercial real estate research firms.

Why is due diligence so important? Delaware Statutory Trusts (DSTs) can be an outstanding solution for 1031 Exchange investors, offering the potential for passive income and diversification among professionally managed, institutional-caliber real estate assets. But when viewed as individual securities, their quality can vary dramatically from project-to-project and sponsor-to-sponsor

Kay Properties Performs These Seven Steps of Due Diligence

Asset Class Rejection Mystery Shopping Assets Sensitivity Analysis Cash Flow Assumptions Stress Tests Lease Audits 3rd Party Reports and Market Analysis
Due diligence is an important part of the investment process, however, investors need to be aware that properties with careful due diligence conducted on them could still end up underperforming projections as well as result in a complete loss of investment capital. This is due to a number of items that potentially cannot be foreseen such as economic difficulties, tenant bankruptcies and other greater forces outside of any investor’s control. Real Estate investments and DST properties contain absolutely no guarantees and we encourage all potential investors to carefully read the Private Placement Memorandum (PPM) paying careful attention to the risk section, prior to considering an investment. As we are unable to provide you with any tax or legal advice, we ask that you please speak with your CPA and attorney for all tax and legal advice prior to considering an investment or exchange.

On top of that, DSTs are complex real estate securities, which is why they are only reserved for accredited investors. Each portfolio has a different real estate risk profile as diverse as the many ways real estate projects may be conceived. But when evaluating DSTs, it’s not just about the inherent complexity of determining the quality of specific investment properties, their different geographic markets, or sub-sectors. There are also ongoing business operations and different industries that can swing radically from one year to the next that need to be evaluated.

That’s why DST 1031 advisory specialist firms like Kay Properties & Investments encourages all of its investors to be cognizant of the fact that properties with careful due diligence conducted on them could still end up underperforming projections as well as result in a complete loss of invested capital. This is due to a number of items that potentially cannot be foreseen such as economic difficulties, tenant bankruptcies and other greater forces outside of any investor’s control.

Kay Properties emphasizes due diligence almost above any other priority for our clients. Due diligence helps investors and companies understand the nature of a deal, the risks involved, and whether the deal fits with their portfolio. Essentially, undergoing due diligence is like doing ‘homework’ on a potential deal and is essential to informed investment decisions.

Real estate investments and DST properties contain absolutely no guarantees and it is highly prudent for all potential investors to carefully read the Private Placement Memorandum(PPM) paying careful attention to the risk section, prior to considering an investment.

That’s why investors need to listen to the careful advice and guidance of professional DST experts to help them perform due diligence. Also, not all due diligence efforts are the same. As a leading 1031 Exchange specialty firm, Kay Properties makes it a point to set the highest standards for its due diligence efforts, and as such, it could be used as a litmus test for investors who are entering the DST 1031 exchange market.

What is the Best Due Diligence Processes to Follow?

  • Asset Class Rejection
  • Mystery Shopping Properties
  • 3rd Party Reports and Market Analysis
  • Sensitivity Analysis and Stress Tests
  • Cash Flow Assumptions
  • Lease Audits

Asset Class Rejection

No matter how much you “crunch the numbers” on high-risk assets it doesn’t change the fact that they are high-risk assets!

At Kay Properties, although our competition often continues to offer these high-risk asset classes like oil and gas operations, senior care facilities, and hotels (often because they have higher commissions than the lower risk asset classes), Kay Properties has from the very beginning drawn a line in the sand that no matter how high the projected cash flow is, no matter how great the story of the asset class is, they WILL NOT use their clients as guinea pigs on investments that may be more likely to have large losses in the future.

Over the years, we have spoken with many investors who have lost tens of millions of dollars investing in senior care facilities,regional shopping malls, hotels, and oil and gas investments.

Kay Properties rejects the previously mentioned asset classes outright. Period!

Mystery Shop Every Property

Kay Properties and Investments does something not not many DST advisory firms do, they mystery shop virtually every DST property that we have clients invest in.

A refreshing piece of due diligence, right?

This level of boots on the ground review of the property and its neighborhood practically is unheard of in the DST industry. Few if any other broker- dealers and other registered representatives place the time, money, and energy into seeing virtually each and every DST like Kay Properties does.

Reading spreadsheets and crunching the numbers is fine (which Kay Properties analysts love doing) but without visiting the property, the “due” has not been “done” and the “diligence” has not been “diligent.”

Even as I write this article, Kay Properties team as well as commissioned independent property inspectors (often the same inspectors that Fannie Mae, Freddie Mac, CMBS Lenders, and other institutional investors commission) are performing property tours on DST properties throughout the country, regardless of the number of properties in the portfolio..

Investors should be advised that other wealth advisory firms and even CPA’s might say they visit each property. However, what they fail to mention to potential clients is that what they mean by “visiting the property” actually means they are invited once or twice a year by product sponsors to fly out, tour a property and have a nice 1031 exchange educational dinner as a marketing tool by the sponsor. Essentially they will see only one to three percent of the properties they work with per year. Hardly impressive.

One of the main areas that differentiates Kay Properties as a DST specialty firm is they take the time, effort and energy to see virtually all of the DST properties they represent.

Sensitivity Analysis and Stress Tests

Kay Properties also has proprietary algorithmic models that have been custom designed to take the sponsors’ assumptions about a property and apply pressure to them in an effort to help better understand how certain circumstances will affect their investors. Items like physical occupancy, concessions, rental rates, vacancy rates, etc. are inputted into proprietary models which we are able to run baseline tests on, and from there apply negative or positive pressure on them.

This allows the Kay Properties firm to ascertain what the worst case scenario for a property is, and from there to understand how likely that scenario is to potentially happen or not. These stress tests provide a sophisticated level of analysis helping the firm further understand potential risks that various scenarios can cause.

Lease Audits

When analyzing a retail, office or industrial DST property, one of the incredibly important steps to focus on is the property’s lease(s). Afterall, the lease on a property can greatly affect that property’s value now and in the future.

To completely understand the property’s lease includes carefully examing what the tenants’ obligations are and what the landlord’s obligations are when it comes to the maintenance, taxes and insurance of the property.

Things like is it an Absolute Triple Net (NNN) lease – where the tenant is responsible for ALL maintenance, taxes and insurance, a Triple Net (NNN) lease – where the tenant is not responsible for all of the previously mentioned items, but is responsible for a majority of them; a Double Net (NN) lease – whereby the landlord is typically responsible for the roof and structure of the building or a Gross lease whereby the landlord is responsible for all maintenance, taxes and insurance costs?

Does the tenant have any early termination clauses built into the lease? Are there any co-tenancy clauses built into the lease that could give the tenant an early out if a neighboring tenant were to vacate the building?

Does the lease provide for annual rental increases,increases tied to the Consumer Price Index (CPI) or is it a flat lease for the entire term of the lease?

Seeking to understand how the property’s lease will potentially affect the property’s value throughout the hold period and upon the eventual exit (sale) of the asset is a critical part of performing due diligence.

Third Party Reports and Market Analysis

When performing due diligence on a DST1031 property, it is important to conduct a thorough review of the property’s third-party reports (the property appraisal, environmental report and property condition report—the inspection)

These reports can be reports the lender or sponsor ordered on the property as well as reports provided by commercial real estate research firms such as Costar, REIS, Real Capital Analytics, Axiometrics, etc. and large commercial real estate brokerage research departments.

These reports are critical to providing detailed insight into the building and market.

Also, items such as comparable sales, comparable lease rates, comparable occupancy rates, market and submarket development and employment trends and data, physical condition of the asset, projected repairs and improvements needed on an immediate and ongoing basis throughout the projected hold period, property environmental history and concerns, etc. are key ingredients to a thorough due diligence review.

In summary:

As noted earlier, you can do due diligence on bad deals all day long, but in the end they are still bad deals.

It is of utmost importance to be very selective and reject the exotic and high-risk property categories from a top down approach when it comes to beginning the due diligence process. Once all of the junk has been rejected, Then it is time to dig in and deconstruct a property from a bottom-up approach utilizing mystery shopping, sensitivity analysis and stress tests, lease audits, third-party report reviews and market analysis, etc.

Comprehensive DST due diligence is the most critical aspect of property selection, and what separates DST specialists like Kay Properties & Investments from other DST advisors.