Episode 50: DSTs and Tax Strategies for Landowners | Guests Joe Michaletz, Mike O'Toole and Cameron Rafati with Discipline Advisors
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Welcome to the REALTORS® Land Institute Podcast, the Voice of land, the industry's leading land real estate organization.
Justin Osborn: Welcome to the REALTORS® Land Institute podcast, the Voice of Land, the industry's leading land real estate organization. This is Justin Osborn Accredited Land Consultant with the Wells Group in Durango, Colorado.
On today's episode of the Voices of Land podcast, we're talking to the team at Discipline Advisors, Joe Michaletz, Mike O'Toole, and Cameron Rafati. Welcome to the podcast, guys. Tell us who is Discipline Advisors and what is your land story.
Joe Michaletz: Well, I'll be happy to share that story. This is Joe Michaletz. We've been in business 40 years, but it kind of goes back to very humble beginnings. I was one of those guys that was pretty motivated, real young, went through high school in three years so I could take my senior year off and commercially trapped turtles and fur. And in that process, I had established multiple trap lines of 250 miles in length and got to know a lot of farmers and ranchers in southern Minnesota. When I started my college career finance major, minors in investment analysis and real estate, I also went through college in three years and really got started in this business. I kind of knew what I wanted to do, and I had great relationships with a lot of farmers.
JM: And so I started doing farm estate planning seminars and did that for about six years, and they were very, very successful. We got to a point where we had an 80% appointment ratio, and we're booked up for six months, including Saturdays without an opening in my schedule. And life got crazy with young kids and something had to give, so I took a break, and the business just kind of kept growing from there. But that's kind of how we got started working with farmers and ranchers.
JM: And then DSTs came along and back in 2004, and a lot of my farm and ranch clients were looking to do 1031 exchanges. And so we were looking for good solutions. And when DSTs came along, they were a great solution for a lot of our clients. And so we've pretty much built our firm around that business and it just, it keeps growing and we like to work with a lot of realtors. We like to work with RLI people because they're a cut above everybody else. They're professionals and they know their clients. And we've partnered with a lot of RLI realtors over the years.
JO: Man, that's great. Definitely sound like an overachiever here, Joe, finishing high school in three years so you could go trapping. I love that. I didn't finish high school in three years, but growing up in Rockwall, Texas, back in the '90s, me and one of my buddies, we'd go out in the mornings and go duck hunting and then drive into high school with waders, shotguns. I mean, it's crazy that we didn't get expelled, but looking back now, it's all that where we used to hunt has turned over. I mean, there's hospitals, there's schools, there's all kind of commercial properties where we used to hunt. And I heard a stat from the American Farmland Trust that they estimate approximately 40% of the US ag land is projected to change hands by 2035. So we've got what? 10 years here before all that happens. So talk to me a little bit about the market trends and what you're seeing with these DSTs and tell our listeners exactly what is a DST.
Mike O'Toole: Yeah, well, this is Mike O'Toole. Thanks for having me on, Justin. It's a pleasure getting to know you. It's an interesting stat. I heard the same thing. And I really think that's just the opportunity in the land business over the next 10, 15, 20 years is you have the baby boomer generation that's slowing down, retiring, whatever you want to call it, and ultimately will be passing on. And this land is going to change hands whether it's sold or passed through an estate. I think the big opportunity for all of us in this business, which the business of helping landowners achieve their goals is education, helping educate them on what are their options, what do we do.
MO: Something that a couple other stats I'd heard, I think these are from USDA, 50% of farmers and ranchers don't have an estate plan, and it's like 70 or 71% don't have a succession plan. So there's a lot more than, I think, just selling the land. When we go and sit down and work with an RLI member, we're unpacking a lot of things, the life's work, and really trying to help them navigate this transition because most people only do it once in life.
MO: So I think the big trend we're seeing is the baby boomers. And it's really more just this opportunity of how can we help them in our professional businesses. And every day that goes by, it doesn't seem to matter whether the markets are strong in your area or soft in your area, time is fighting or working against these folks, and it's creating opportunity to, like I said, to educate and help folks out. So, the phone rings almost every day with someone wanting to learn more about these DSTs. So maybe I'll let Cameron jump in here and just explain to the listeners what is a DST.
Cameron Rafati: So everyone basically, and Justin, of course, thanks for having me on as well. A DST is a type of trust, it's called a Delaware Statutory Trust that holds title to real estate that basically lets your clients use their money from a 1031 exchange to defer paying taxes by exchanging their property into a fractional interest of one or more new stabilized large kind of institutional investment properties. So say you have a farm and ranch. The farm and ranch, farm or ranch sells, you 1031 exchange that into multiple properties. Geographically, it's going to be diversified across the country. It's going to be diversified based on real estate type as well and by DST companies as well. So we're basically diversifying your cash flow from exchanging your property as a client into these properties for mailbox money, essentially. That's in a nutshell, that's what a DST is.
JO: Mailbox money, man, I like the sound of that. So I mean, stupid question here, but I'm in Durango, I'm not in Delaware. So is this something that's possible for my clients in Colorado or talk to us a little bit for those people that are hung up on that word, Delaware Statutory Trust?
JM: Yeah, I'll be happy to answer that question, Justin. So yeah, so the Delaware Statutory Trust is... Delaware is just one of those states that has a lot of trusts for a lot of reasons because of asset protection, banks like to lend to them and just different spendthrift provisions. So it was just pretty much Delaware Statutory Trust. They've been around a while. They've been used for other applications other than just owning different types of institutional quality assets for people to exchange into. But my wife and I started investing in these things back in 2006 and we really, sounds corny, but we kind of fell in love with them because we really got sick of managing properties. We got sick of tenants. You probably heard of the four T's before tenants, trash, toilets and taxes.
JM: And so when DSTs came along, we really liked them for a lot of reasons. And some of these reasons a lot of people don't think about, but I think they're very important. And one is the fact that you do have a trust that owns the assets. And when a DST is structured and put together, there's a big real estate company, we call them the sponsor. And they actually take more risk than we do as the investor because they've got to spend a quarter million dollars or so just to put the trust in place and cover all the tax and legal. If they're going to buy a hundred million dollar, 300-unit class A apartment building in Dallas, Texas, they've got to seed that trust with $100 million of their own money. And all the parameters of that asset in that trust have to look pretty attractive to firms like ours.
JM: We own our own broker dealer, so we underwrite, do the due diligence on all these DSTs. And if we like it, great, we'll help raise capital. If we don't like it, we won't. And if a lot of firms like ours don't like it, then they're stuck holding the bag. So, they take a lot more risk than we do. So they tend to cherry pick quality assets. Now, some of the characteristics of the DST that make it really, I think, conservative, and again, it's a great investment for the right people, it's not for everybody, but if you're looking for something that is somewhat protected from a lot of other risks that are traditionally involved in real estate, the DST has these attributes.
JM: One I mentioned. It is a trust. Every trust has to have a trustee. Every trustee is held to a fiduciary standard and they are bonded and insured. So the trustee in DSTs is typically a law firm in Delaware. And we would have recourse against them if they ever breach their fiduciary responsibility to us. And so that's kind of a big deal. It helps protect us from the Bernie Madoffs of the world, for people old enough to remember all of that chaos. And that's important because it's all about people, quality people. And if you're giving up control, you want to make sure you're giving up control to a very well-established regulated industry to protect us from crazy people.
JO: All right, so I've got a client, he's selling his farm out in southwest Colorado. Let's say that's getting one and a half, 2% return right now from the tenant farmer. We've talked about rolling that money from a 1031 exchange into investment properties where his family is, down around Phoenix. And best-case scenario, we're looking at like 6 to 7% return on that. I'm sure it fluctuates but can one of you guys give me an example of, what are some realistic returns that your investors are going to be looking at with these DSTs for mailbox money and maybe talk about who they're a great fit for and who they're not so much a great fit for?
MO: Yeah, good question, Justin. I mean, I think, the disclaimer here is no returns are guaranteed. Right? So we can talk hypotheticals here and, but what we're seeing in the marketplace today is it really depends on the quality of the property, the quality of the DST, and the level of risk you're willing to take. If you're looking to invest in an office DST, it should have a higher return right now just because of the dislocation in the office markets versus say, maybe a multifamily apartment, a class A property. So, kind of the range is probably like 4 to 6% initial cash flow, estimated initial distribution with the potential for appreciation just like any other real estate. No guarantee of that. Values can go up, values can go down.
MO: But over the long term, on average, we've seen DST price appreciation, much like we've seen in other real estate sectors. As far as who they're a good fit for, that can really vary. It's kind of a loaded question. But I think who they're a good fit for is someone that is looking to be more passive with their real estate, whether they're 40 years old and raising a family and no longer able to manage a farm or duplex, whatever, or if they're 80 years old and they're looking to slow down and can no longer maybe physically manage their property.
MO: So we kind of see all walks, but typically it's someone that's older, looking to slow down, values someone else managing and taking care of the property for them, but ultimately has a tax problem and wants to solve for it. Right? There's nothing wrong with paying taxes if someone wants to take their money that wants a little liquidity, has another need for it, but if they, most of our clients will say, you know, Mike, I don't need this principle. I want to keep it working for me, but I don't want to go and buy another farm or another ranch. Why would I sell the ranch I have today if I'm going to do that? But I'm stuck. I have a tax problem. And I think that getting back to the opportunity, that's the opportunity out there is it's really education. There's so many people that just don't know that these exist.
JO: Yeah. And is it something that you've got to roll cash into or can you structure this with debt as well?
JM: That's a really good question, Justin. So yes, DSTs are not solely for 1031 replacement proceeds. You can add cash, you can invest cash. My wife and I, honestly we own over 60 DSTs personally and a lot of them, we just purchased with cash or added cash to the exchange as these DSTs have liquidated, and we just re-exchange into another DST or two, we often will add cash. But you kind of hit on something about debt. So a very unique aspect of the DST is that if it utilizes debt to acquire an asset, which is often the case especially with multifamily because the sponsor can borrow money from Fannie Mae or Freddie Mac and they get discounted loans for those types of purchases for residential investments. And whenever debt's utilized, it must be non-recourse debt. And a lot of people have never had the privilege of non-recourse debt. We get all the benefits of the debt but we're not liable for it.
JM: And that's kind of a big deal because lots of reasons. Right. It reduces risk. But also it really does help us with the underwriting too because if a big insurance company or Fannie Mae is going to underwrite the loan on a multifamily apartment DST acquisition, oftentimes, the only collateral they have was the asset. There's no personal guarantees, there can never be a capital call. So we're really protected as investors from any issues with the debt. But oftentimes if that property, has a 5% cash on cash distribution right out of the gate, net of servicing the debt, it says a lot about the quality of the property.
JM: And we look at debt service coverage ratios, we look at all kinds of little details. I won't get into the weeds today, but things that are important to us when we're doing our due diligence and underwriting and trying to figure out which DSTs really are the best options in the market. There's a lot of things that go into it. But debt is, it's a big privilege to have non-recourse debt especially if you need to replace debt in a 1031 exchange because there's two tasks, right? If somebody's selling an asset and debt's being relinquished, not only does the property value need to be replaced, but the debt needs to be replaced as well in the replacement property. Otherwise you've got taxable boot. So it's kind of nice when you can replace recourse debt with non-recourse debt inside of DSTs.
JO: Can you guys give me an example of kind of some real world scenarios where you've worked with other RLI members on this?
MO: Oh man, we could tell stories for a long time. We'll try to keep it short here. I can think of one that this one always sticks out in my mind when we speak of debt. An RLA broker out of Texas referred me to his clients who were selling a ranch in eastern New Mexico and he said, Mike, I really think you could help these guys out. They need to sell. There's no water, they're struggling. But the bank's basically kind of breathing down their neck saying you guys need to sell and retire and move on. And it was unfortunate situation, but luckily we got involved. Luckily this agent was aware of DSTs and brought us in because what was going to happen is they were selling two ranches and what they wanted the ranchers in New Mexico to sell the first ranch and pay off all their debt, which would have left them with a big tax bill but zero cash. And then the second ranch was a tougher sell and they didn't know if they were going to get it sold. And they were really kind of in a tough situation.
MO: So we came in and we educated everyone involved, including the bank, and were able to, through some lengthy conversations with the bank and their executives, get them to release only half of the collateral on the first sale. And then luckily they ended up selling the second property a couple months later. But they went from a situation where they were going to basically give up their ranch and walk away with very little money after taxes to being able to do a tax deferred exchange, defer 100% of their taxes, pay off 100% of the debt and still be left with a decent nest egg that they're generating income off. So they couldn't be happier. And those situations come up almost weekly, wouldn't you say, Joe?
JM: Oh yeah.
MO: Especially right now with interest rates going up and lenders tightening their belts a little bit. It's just, it's the debt conversation is rearing its head more and more, even in the land markets. I don't know what you're seeing out there on your side, but.
JO: Yeah, on my side I'm finding it's tough to find replacement properties. So, we've got so many off-market deals that we're doing because it's still a strong seller's market where I'm at. But then the problem is trying to then turn around and find, all right, where are they going to put that cash? And they're looking all over the place. It's not just here in my hometown or my southwest Colorado area. I gave you the example of the guy looking in Phoenix. I've got another guy right now that's looking down in Texas and he's looking to invest in any kind of long-term triple net leases, tractor supplies, Starbucks, Dutch brothers, all those. And what's tough is, we can't find him anything. And maybe their expectations are just too high, because they're looking for like that six and a half, 7% return triple net lease mailbox money.
JO: And I've got a buyer ready to buy his three and a half million dollar ranch in Durango on the Animas River, but we've got a clause in the contract that he has to find his replacement property before he closes. So, we're seeing a lot of that right now where we've really got to get creative on helping our clients, putting all these different tools in our toolbox of where are we going to move that money to. Is it a DST? Is it... We did a 1031 exchange podcast on rolling into mineral rights. That was educational for a lot of people. It's just so many different places to park the money that I think our listeners are not aware of that the more we can continue to educate them and do podcasts like this, the better they're going to be in representing their client's best interest.
MO: Well, yeah, absolutely. A lot of people come to us and say, oh, you sell DSTs? Well, no, they're just one option out there but there's not a lot of passive options. You hit on the others. Right? Net lease can be passive, minerals can be passive, and DSTs, maybe tenants in common structure too is out there from time to time, but there's not a lot of passive options if you're looking to defer your tax but get out of active management.
MO: So we find a lot of our clients were stuck until they happened, happened upon it. Right. They met a good RLA agent who was thinking outside the box and really thinking about the client's needs and laying all these solutions out there. And you go down that decision tree and it really, it's about what's a good fit for you. And we're the first ones to say DSTs aren't for everybody, but they're a strong candidate if you're looking to be passive. And I think the important thing is just to know that they exist and there's resources through the RLI network to educate yourself and your clients a little further.
JO: Can one of you guys quickly educate me on exit strategy? So we move forward, we sell the farm, we roll the money into a DST. I know you mentioned long term hold is usually best. 10 years, 15 years go down the road, how are we getting that money out?
JM: Sure, I'll be happy to explain that. So honestly, the average holding period, Justin, isn't as long as what is kind of forecasted. We always say that the DSTs are viewed as a five to 10-year hold. We've had over 100 DSTs go full cycle and the average holding period was actually just under five years, 4.9 years. There's no set in stone date of when they sell but the sponsors, when they buy the real estate for the trust, they have a business model to create value and once they capture that value, they're going to sell. And we always look at rent growth as number one. That's your best trump card against cap rates decompressing, best defense, but it's also the easy money when cap rates are flatter or going down.
JM: So rent growth is key. So that's what we're looking for. But most of these real estate sponsors will, they'll sell that asset when they can capture 20, 30, 40% capital appreciation. And if that's in one year or if it's in 10 years, that's kind of what they want to accomplish. And so when you factor in what's the average returns then you've got this 4 to 6% of cash on cash distributions. But we hope to add another 4 to 6% in capital appreciation. So now you're averaging 8 to 12% a year on these things over a long period of time.
JM: And then, the other thing I just want to clarify is that we really believe in diversification and there are certain asset classes that we really like today where we feel the potential to grow rents is the strongest. And that's like multifamily. Everybody needs a place to live. There's going to be a shortage of housing in this country. There is today. It's going to get worse in the next few years. We love industrial real estate. When you think about Amazon and anything we own, it all comes out of warehouses and there's still huge demand for warehouse space and also self storage. When people are moving around and renters, as people downsize and they rent, which a lot of baby boomers are doing, people love their stuff. And so there's always consistent demand for that as well.
JO: Man, I totally agree with that. I mean it seems like it's the American way. Let's go buy more stuff so we can then just turn around and pay somebody to put it in storage. So yeah, and the multifamily, I mean where I'm at seems like every small mountain town out in the west is having problems with trying to build enough product to meet the demand that's out there. So man, that all sounds good to me. I'm all for, 8 to 12% long-term appreciation by the time, or, excuse me, 8 to 12% return by the time you factor in long-term appreciation. That sounds good. Well, Cameron, question for you. How can our listeners learn more about DSTs?
CR: Yeah, so we do something interesting. Our crew, we put on these CE presentations for brokers. It's really important to know as you know, as a land broker, it's really important to understand DSTs, but they're complicated. And sometimes things that are complicated are the difference between you making a million dollars or getting a million dollar listing and you getting a 20, $30 million listing. So what we've kind of done is we want to work shoulder to shoulder with a lot of the brokers that are our ally and others, not necessarily beat our ally. But we basically hold these CE calls. Me, Mike and Joe get on there and teach people about DSTs. And we pretty much have CE for almost every state in the country, especially in the inner part of the country.
CR: So yeah, you basically reach out to us, we'll get you on a call and we'll teach you a little bit more about DSTs. And if it works out we'll jump on a call with you and your client, educate them as well, and you'll be able to learn the process by jumping on with us all. So we're always here to offer that educational resource. You can reach out to us.
JO: Man, that's great. So is that a one-hour class or three-hour class or what do those CE classes look like?
CR: Yes, sir, it's a one-hour class. And sometimes folks just keep... Answering questions, we've had them go up to two hours before because people keep asking questions about their clients and we love that. We appreciate that. Again, it's a hard concept to understand, but once you get it, you start firing away a lot more. You can start taking down bigger bulls out there once you really are armed with these kind of resources.
JO: Well, guys, thank you for joining us today and helping our listeners understand how DSTs work and how they can benefit their clients. Any last minute topics here as we're wrapping up?
MO: No, I just, I'd say we're gonna, we're looking forward to joining, hopefully a lot of you at the RLI National Conference down in Tucson in March. So if you're going to be there, please stop by our booth, say hello, we'd love to shake your hand and get to know you better and see if we can help your clients.
JO: Yeah, I'm getting excited about that, man. That's just right around the corner. So I'll definitely see you guys there. Well, listeners, for more expertise on land real estate topics, be sure to check out the RLI blog, follow us on social media and of course, tune in for upcoming episodes of the Voices of Land podcast.
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