downsides or risks investors might overlook? Q:
That all sounds straight forward. What are some of the potential
A: This is precisely why the book was necessary. The benefits are often highlighted, but the complexities and dangers are frequently buried in fine print or not fully appreciated. Let’s unpack a few key areas: 1. Tax Advantages & The Crucial Role of Tax Protection Agreements (TPAs): While the exchange itself is tax-deferred, the long-term tax protection is not automatic. A critical due diligence item is whether the DST’s Private Placement Memorandum includes a robust Tax Protection Agreement. A TPA is a contractual safeguard that protects investors from future tax liability if the REIT later sells the contributed property without completing a subsequent, internal 1031 exchange. Without a strong TPA—ideally with a duration of 20 years or more—investors could face an unexpected capital gains tax bill years down the line, triggered by a decision of the REIT sponsor over which they have no control. 2. Diversification & Systemic REIT Risk: Yes, moving from one property to a portfolio offers potential diversification**. However, it also exchanges property-specific risk for sponsor-level or systemic REIT risk. A single REIT, even with diverse assets, can be exposed to portfolio-wide risks. These include blanket loans or credit facilities, often with adjustable rates, where rising interest costs can pressure cash flows across every asset simultaneously. Furthermore, poor strategic decisions at the REIT level, such as overpaying for acquisitions, taking on excessive leverage, or mismanaging properties, can impair value regardless of the quality of the original DST asset. Investors also must consider the "perpetual life" nature of many REITs where they can be sold to new sponsors with different strategies and risk profiles, fundamentally altering the investment an investor originally entered. 3. Income Potential & Sustainability of Distributions: The promise of ongoing income is attractive, but investors must scrutinize the source of the distributions. Is the REIT paying dividends from genuine property operating cash flow, or is it subsidizing payouts through borrowings, new investor capital, or even a return of capital? Some perpetual life REITs may promote attractive yields by drawing on credit lines, a practice that can mask underlying weakness and jeopardize long-term stability. The key metric to analyze is the dividend coverage ratio, specifically as measured by Adjusted Funds From Operations (AFFO). A distribution not fully covered by AFFO may not be sustainable.
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