The 3Q Test

With so many DSTs to choose from, making the right investment decision comes down to the experience of your 1031 DST investment specialist and their ability to align real estate investment fundamentals with your risk tolerance. The two-fold mandate of a successful 1031 DST is simple: Preserve capital and Protect dividends.

To help evaluate alternative 1031 investment programs, investors should consider the 3Q test to allocate investment capital and manage risk. The performance of investments generally depends upon three key components:

• Quality of the Assets
• Quality of the Income
• Quality of the Sponsor

Quality of assets

A 1031 exchange generally represents a large portion of an investors net worth. At its core, a 1031 exchange is a store of capital and a tax-efficient vehicle for income and generational wealth preservation. As the downturn of 2008 and 2009 revealed, not all income-producing real estate is created equal.

Property investments and portfolio construction must be weatherproofed to withstand any economic cycle. Purpose-built properties that offer essential services like food, shelter, distribution, and healthcare are among the most popular DST offerings. Ideally, these properties are located in high-traffic locations with strong demographics, growing markets, and potential for future capital appreciation.

Some key attributes to look for when assessing asset quality:

• Strength of the sector
• Stability of occupancy rates
• Credit quality of tenants
• Business format and sector resilience
• Development cost relative to replacement value
• Comparable leasing rates in the market
• Stress-tested underwriting assumptions
• Projected rental growth over the hold period
• Feasibility of the exit strategy
• Threat of future competition and potential impact on rent growth

Quality of income

Just as all real estate investments are not created equal, property-level cash flow widely varies depending on the underlying real estate economics. Income is the plumb line for most 1031 investors. Income from 1031 properties is generally used to fund lifestyle expenses as well as ongoing financial liabilities. Financial advisors call this Liability Driven Income (LDI): income you need today to fund liabilities for tomorrow.

A well-underwritten and risk-averse DST should be generating proven monthly cash flow that is stable, durable, and repeatable. Investors should not be tempted to chase higher yields at the expense of higher risk and potential capital loss.

When assessing the quality of income, consider:

• Lease terms and length
• Realistic assumptions for revenue and expense growth
• Stress-tested cash flow projections
• Structure and terms of the debt
• Breakeven occupancy analysis

Quality of sponsor

As Warren Buffett says, it is great to learn from experience, but preferably someone elses experience. There is no substitute for experience when it comes to investing. You want an investment manager and program sponsor that has a combination of integrity and expertise.

The track record of a trustworthy DST sponsor provides a history of proven performance demonstrated over an extended period through both good markets and bad. It shows whether a sponsor has delivered on their promise to generate a return of, and a return on, the original capital invested.

Always consider these attributes when evaluating a sponsor:

• Years of experience in real estate and DST management
• Defined investment strategy and consistent execution
• Prior performance track record across market cycles
• Defined exit strategies for completed programs
• Succession plan and organizational depth

Petra applies the 3Q framework to every DST strategy it evaluates. The result is a more disciplined and defensible portfolio design process for every client.