Delaware Statutory Trust vs. 506B Syndication

[Sean Morrisey]

Could anyone tell me if a Delaware Statutory Trust is better than a 506B when setting up a real estate syndication? Pros/cons to either?

Thanks a bunch!

[Brian Burke]

I think what you are asking is whether a DST is better than an LLC. 506(b) just refers to the exemption from registration of your securities for public sale. Even a DST can utilize the 506(b) exemption.

So if my interpretation of your question is correct, it's hard to say that one is "better" than the other because they each have a use case.  

Most syndicates use an LLC structure because it allows flexibility in how you structure the offering. Most importantly you can get carried interest which in the simplest terms means that you, as the investment sponsor, can receive a percentage of the profits disproportionate to your capital contribution (even if you contribute no capital at all). You also have ultimate flexibility in how you execute the business plan. You can refinance whenever you want, you can do a value-add or heavy rehab, heck you can completely reconstruct the property if that's what is needed. But, most importantly, you can receive a share of the net profits from cash flow and appreciation.

The downside to the LLC structure is that you cannot accept 1031 funds into the LLC because units of an LLC are not like-kind property to real estate.

To solve the problem of accepting 1031 investors, sponsors started accepting money from their investors and putting them on the deed as fractional fee title owners. This was called a TIC structure because each owner was a Tenant In Common on the deed. This created all sorts of problems, mostly because there was no centralized control over the asset, and also because there was a lack of alignment of interest on the part of the sponsors--and even some corruption--so the TIC industry earned itself a very bad reputation after the market collapse a decade or so ago.

The DST concept was a response to the downsides of the TIC structure. It solved the issue of decentralized control by holding the property in a trust (the Delaware Statutory Trust, specifically) and the investment sponsor (or an affiliate) was the trustee of the trust. So now you have a structure where, similar to the LLC concept, the sponsor has control of the asset and the investors own beneficial interests in the trust, just like investors own units in an LLC. But the upside is the IRS ruled that beneficial interests in a DST were like-kind to real estate and thus qualify as replacement property in an exchange.

But just like everything else in real estate, there is no perfect solution to solve every problem and the DST is no exception--it comes with its own limitations and downsides. The primary limitations are what is called "the seven deadly sins". I'll just focus on the ones most important to you as a sponsor.

First, you cannot raise any additional capital.  Now if you raise enough in the beginning (which you always should anyways), you should be fine.  But you need to be aware of it.  Once the offering is filled, that's it.  No capital calls, no new investors.

Second, you cannot refinance the property and take out cash.  Nor can you renegotiate the terms of any existing loans. 

Third, and I think this is one of the most limiting factors--you are limited to making capital expenditures only to the extent as required for normal repair and maintenance and minor non-structural capital improvements.  So this means no heavy value-add projects and major rehabs.  

Finally, the DST structure is complex and this is not the same as an LLC syndication. You have to create multiple entities, one to be the trustee, one to be the master lease tenant and in some structures other entities as well.

And...in a DST you can't receive a promoted interest. In other words, you can't get a share of the profits in the same way as you do in an LLC structure. Instead, this is primarily a fee-based venture where you earn an acquisition fee, asset management, property management, and other fees. You can get some of the rental income via the way you structure the master lease, but you don't get a split of the property's appreciation.

So to sum it all up, it's not a matter of which is better. First you must ask yourself the question of what is the problem you are trying to solve? If it is that you have a lot of investors that want to invest in a value-add multifamily deal, LLC is your answer. But if you have a bunch of 1031 investors looking to trade into something, DST is the answer. You just have to be aware that from the lens of the sponsor these are two very different businesses.