As with any investment, there are risks inherent in the investment. This is true if you are investing in direct ownership real estate, stocks, bonds, mutual funds, or alternative real estate investments such as a DST property. To provide our readers with a fair and balanced presentation, we have devoted this entire chapter to presenting these DST risks. Remember that a DST risk is not a DST disadvantage. The disadvantages including illiquidity, lack of control, and the inability to raise capital, have been discussed in earlier chapters on the DST and its structure.
While assessing risks, two additional points should be noted. Firstly, many of the risks disclosed in the PPM document are standard disclosures for a direct participation program (DPP). For example, a DST with an all-cash, no debt, triple net Walgreens store as the only asset will have some of the very same disclosures as a PPM for an oil and gas wildcat drilling offering. The two offerings could not be more divergent as far as investment risk, but both would share many of the same DPP disclosures.
Secondly, the reader should be aware that the sponsor’s counsel will disclose every conceivable risk, no matter how remote. It is often thought that the PPM is designed to make the investor drop the book and run the other direction. However, we believe that an investor equipped with these insights will be able to discern each risk disclosure on its own and in view of the total offering.
In the sections below, we present the standard risk disclosures for a PPM for a multifamily property DST. The risks are typically sectioned by risks related to the trust structure, operating risks, risks related to the master lease, real estate risks, financing risks, risks related to private offerings, and tax risks. Please note that in various places we use “XXX” in place of dollar amounts as these numbers vary from offering to offering.
Risks Related to the Trust Structure and Operating Risks
Beneficial Owners Possess Limited Control and Rights. The Trust will be operated and managed solely by the Trustee and the Manager. Purchasers, as Beneficial Owners, will have no right to participate in any aspect of the operation or management of the Trust. The Trustee and the Manager will not consult with the Beneficial Owners when making any decisions with respect to the Trust and the Property, including whether to sell the Property or effectuate a Transfer Distribution. The Beneficial Owners waive any right to file a petition in bankruptcy on behalf of the Trust or to consent to any filing of an involuntary bankruptcy proceeding involving the Trust. The Manager will collect the rents due from the Master Tenant under the Master Lease and make distributions therefrom in accordance with the terms of the Trust Agreement. The Manager will seek to sell the Property in accordance with the provisions of the Trust Agreement, which provides that the Manager has sole discretion to determine when it is appropriate to sell the Property. The Trustee may remove the Manager only for cause (fraud or gross negligence causing material damage to, or diminution in value of, the Property), but only if the Lender consents (to the extent there is an outstanding Loan) and only if 65% or more of the Interests consent in writing to such removal.
Beneficial Owners Do Not Have Legal Title. The Beneficial Owners will not have legal title to the Property. The Beneficial Owners will not have any right to seek an in-kind distribution of the Property or divide or partition the Property. The Beneficial Owners do not have the right to sell or cause the sale of the Property.
The Trustee and the Manager Have Limited Duties to Beneficial Owners. The Trustee of the Trust and the Manager will not owe any duties to the Beneficial Owners other than those duties set forth in the Trust Agreement. In performing its duties under the Trust Agreement, the Trustee will only be liable to the Beneficial Owners for its own willful misconduct, bad faith, fraud or gross negligence. Similarly, the Manager will only be liable to the Beneficial Owners for its own fraud or gross negligence.
The Trustee and the Manager Have Limited Powers, and the Trust May Therefore Face Increased Termination Risk. In order to comply with the tax law regarding investment trusts and Section 1031 Exchanges, the Trust Agreement expressly prohibits the Trustee and the Manager from taking a number of actions, including the following: (a) selling, transferring or exchanging the Property except as required or permitted under the Trust Agreement; (b) reinvesting any monies of the Trust, except to make permitted modifications or repairs to the Property or in short-term liquid assets; (c) renegotiating the terms of the Loan or entering into new financing, except in the case of the bankruptcy or insolvency of the Master Tenant or another tenant; (d) renegotiating the Master Lease or entering into new leases, except in the case of the Master Tenant’s bankruptcy or insolvency; (e) making modifications to the Property (other than minor non-structural modifications) unless required by law; (f) accepting any capital from a Beneficial Owner (other than capital from a Purchaser that will be used to fund the Supplemental Trust Reserve or repurchase the Depositor’s Class 2 Beneficial Interests and thereby reduce the Depositor’s ownership interest in the Trust); or (g) taking any other action that would, in the opinion of Tax Counsel to the Trust, cause the Trust to be treated as a business entity for federal income tax purposes.
As a result, the Trust may be required to effectuate a Transfer Distribution in order to take the actions necessary to preserve and protect the Property. See “Summary of the Trust Agreement.” While the Property will remain subject to the Loan after such conversion or transfer, the Beneficial Owners will no longer be considered to own, for federal income tax purposes, a direct ownership interest in the Property.
Management and Indemnification. The Manager will have administrative authority with respect to the Trust. The Trust Agreement will provide for indemnification by the Beneficial Owners of the Trustee against liabilities not attributable to the Trustee’s own willful misconduct, bad faith, fraud or gross negligence, and of the Manager against liabilities not attributable to the Manager’s own fraud or gross negligence. Such indemnity and limitation of liability may limit rights that Beneficial Owners would otherwise have to seek redress against the Trustee and the Manager. Beneficial Owners will have personal, recourse liability for payment of any indemnity owed to the Trustee or the Manager.
Rev. Rul. 2004-86. The utilization of a DST (like the Trust) to acquire and hold property for purposes of a Section 1031 Exchange is based primarily on Rev. Rul. 2004-86, which sets forth terms under which a trust will be treated as an “entity” that is taxable as a “trust” rather than taxable as a partnership. It is possible that the IRS could modify or revoke Rev. Rul. 2004-86 or, in the alternative, determine that the Trust does not comply with the requirements of that ruling. A determination that the Trust is not taxable as a trust (within the meaning of Treas. Reg. § 301.7701-4) could have a significant adverse impact on the Beneficial Owners.