Paid With the Next Investor's Money

A century ago, paying today’s investors with money raised from tomorrow’s was a crime that sent its architect to prison. With the right disclosures, it is now a fully compliant product — sold by household-name firms, and built to be nearly impossible to leave.

A NOTE FROM THE AUTHOR

I help investors navigate the 1031 exchange process and the Delaware Statutory Trusts (“DSTs”) that often come with it, and I am writing this as a warning about a corner of my own industry. There is a mechanic — paying today’s investors with money raised from tomorrow’s — that once landed its practitioners in federal prison. Wrapped in a modern Private Placement Memorandum (“PPM”) and its risk factors, that same mechanic is now legal, disclosed, and widely sold. This paper focuses on what matters. The cash “yield” these funds pay is often funded by the equity raise rather than the real estate — something you can only see by measuring the distribution against funds from operations (FFO). The funds are structurally flawed in how they buy, sell, and honor redemptions. And they are sold so heavily by household-name firms precisely because they are nearly impossible to leave without a large tax bill. The DST structure is legitimate and, for the right investor, genuinely valuable — I recommend them. This is not an attack on an honest industry. It is one advisor’s attempt to give investors the questions that disclosure was supposed to make unnecessary.

Michael Deutsch   ·   1031 DST Solutions

Investor & Advisor Education Series  ·  August 2026

1   The mechanic that used to be a crime

Open almost any non-traded REIT or DST private placement memorandum and, buried in the risk factors, you will find a version of this sentence: “Distributions may be funded from sources other than operating cash flow, including, without limitation, offering proceeds, borrowings, and return of capital.” Three phrases, each describing money the underlying real estate did not earn.

Return of capital is the sponsor handing you back your own principal and calling it a “distribution.” Borrowings means paying your income with debt. And offering proceeds — the one that should stop a reader cold — means paying today’s distributions out of the capital raised from newer investors. A century ago, paying existing investors with new investors’ money and calling it a return was the essence of a scheme famous enough that its architect went to federal prison. Disclosure does not make the economics sound. Full transparency can reveal questionable economics, and therefore the company protects itself from lawsuits and regulatory penalties. The felony and the “fully compliant” product now share the same mechanic; only the paperwork is different.”

Disclosure is not ”transfer of risk.” A disclosure reveals new or hidden information to ensure transparency, while a disclaimer denies responsibility or limits legal liability.

2   The most startling part: the yield is often the raise, not the real estate

This is the point I most want investors to sit with. While these perpetual, open-ended funds are still raising capital, a meaningful share of the cash mailed out as “income” is not income at all. It is fresh equity — the investors’ own money, and the money of those who invested after them — recycled back out the door and labeled a distribution. A fund can advertise a 6% “yield,” collect new equity every month, and use part of it to keep that 6% flowing to everyone already in — for exactly as long as new money keeps arriving. When the raise slows, the distribution falls to what the buildings actually earn, and the investor who bought the headline yield discovers they were really buying the raise.

FOLLOW THE MONEY — YOU MAY BE PAYING TAX ON YOUR OWN CAPITAL

Trace what actually happens when a fund funds distributions from the raise. You sell a property and 1031-exchange into the fund with your own capital, deferring your gain. The fund, still raising, pays part of your “distributions” out of that same pool of raised equity. So, it takes in your money and, after fees, mails a portion of it right back to you and calls it income. You are being handed your own principal — minus a fee for the privilege — and because the entity generates taxable income, you can owe ordinary income tax on the very money they just returned to you. You put in a dollar, paid a load on it, received part of it back, and were taxed on the return of your own capital. That is not yield. It is a slow, taxable liquidation of your own money dressed up as a distribution.

FFO — the number that tells you whether the yield is real

Funds from operations (FFO) is the single most important cash-flow metric for evaluating a REIT. Real estate carries a large non-cash charge — depreciation — that drags reported net income well below the cash the properties actually produce. FFO corrects for this: it takes net income, adds back real-estate depreciation and amortization, and removes one-time gains or losses on property sales. What remains is the recurring cash the portfolio genuinely earns from operating its buildings. Set FFO next to the distribution and you get coverage. If the payout is no greater than FFO, the yield is real and self-sustaining. If the distribution exceeds FFO, the shortfall is coming from somewhere the PPM already named — offering proceeds, borrowings, or return of capital.

What a “conservative” FFO looks like

Sponsors rarely quote plain FFO. They quote “FFO as adjusted” or “Core FFO,” and the adjustments almost always run one way — they make coverage look better, by adding back acquisition costs, stock compensation, non-cash “straight-line” rent, and items labeled non-recurring. A conservative FFO does the opposite: it strips those add-backs out and then subtracts the cost of keeping the real estate leased and competitive — recurring capital expenditures, tenant improvements, and leasing commissions — while normalizing rent down to the cash actually collected. This is essentially adjusted FFO (AFFO), and it is the honest floor. If the distribution is covered by a conservative FFO, the yield is durable. If it is only “covered” by an adjusted-upward number, the coverage is an accounting posture, not cash. Ask for both, and ask what was added back and why. Even at the most respected end of the market, it is entirely legal — and common — for a fully audited fund to pay much of its distribution from borrowing or reinvested capital in a given year.¹

Here is a benchmark worth committing to memory: an AFFO coverage ratio of 1.25× or greater is conservative. It means the properties are generating at least $1.25 of real, recurring cash for every $1.00 the fund pays out — a 25% cushion that can absorb a vacancy, a rate increase, or a soft year without dipping into investor capital. For example, a REIT that distributes $1.00 per share a year while producing $1.25 of AFFO per share covers its payout 1.25× — earned, durable, and self-funding. By contrast, a fund paying that same $1.00 while generating only $0.80 of AFFO has 0.80× coverage: a fifth of the “yield” is not coming from the real estate at all, but from offering proceeds, borrowings, or a return of your own capital. When you ask for the coverage number, this is the ratio to ask for — and 1.25× is the line I want investors to hold as the mark of a conservatively run fund.

When the raise is paying the yield, the property is not funding your income — the next investor is, and so are you.

3   Structurally flawed: how these funds buy, sell, and gate

Set aside any single sponsor’s honesty. Perpetual, open-ended funds are built on a schedule that works against the investor at both ends of a cycle, simply because of how they raise and return capital.

When money pours in, they must put it to work — and overpay. Capital chases performance, so cash floods these funds exactly when markets are hot and prices are high. A manager sitting on a mountain of new money has to deploy it, which makes the fund a motivated buyer at the top of the market, paying up precisely when assets are most expensive.

When investors want out, the fund becomes a forced seller at the wrong time. In a downturn, redemption requests surge. To raise the cash to meet them, the fund has to sell — not because the timing is good, but because it has no choice. A forced seller into a weak market does not get a fair price. Buy high, sell low, on a schedule the professionals on the other side of the table can see and exploit.

And you may not be able to get your money at all. Because a perpetual fund can only promise so much liquidity, most reserve the right to impose “gates” — caps that let them halt or ration redemptions. The result is cruel in its timing: the moment you most want your money out — when everyone is heading for the exit at once — is exactly the moment the fund is most likely to lock the door.

4   Why the biggest names sell these — and why you can’t easily leave

These products are increasingly distributed through household-name broker-dealers and wirehouses, and it is worth asking, plainly, why those firms are so enthusiastic. Part of the answer is that the assets are extraordinarily “sticky.” Once a client’s exchange proceeds are locked into a DST that will convert into a REIT, the money is very difficult to move — and difficult-to-move money is the most valuable kind of assets under management a firm can hold.

EXHIBIT A — THE UPREIT PATH: FROM REAL ESTATE TO SECURITY

1 · Sell property Sell appreciated real estate; defer the gain via a 1031 exchange.

2 · Into the DST Buy a DST interest. You own real estate: depreciation shelters income, and you can 1031 again later.

3 · 721 → OP units DST converts into REIT operating-partnership units. The door closes.

4 · Now a security You hold a security: income is ordinary, the depreciation shelter is gone, and no more 1031.

Timing and conversion mechanics vary by offering. Confirm the specific structure and tax treatment with your CPA and attorney.

Many DSTs are designed to end in an UPREIT — a Section 721 conversion of your DST interest into REIT operating-partnership units. It is marketed as the elegant finish to a 1031 exchange, and it quietly ends the tax advantages that brought most investors to real estate. Your income becomes ordinary and loses the depreciation shelter that lets much of your cash flow arrive with little current tax. You can never do a 1031 exchange again, because securities are not “like-kind” real estate — the chain of deferral you may have rolled forward for decades ends permanently at the conversion. And the only way to reach your money is to sell, which finally triggers all the gain you spent years deferring.

This is why the structure of the DST you buy matters at the very outset. Insist on a DST that makes the UPREIT optional, not mandatory. Many well-designed offerings give you a choice at the sponsor’s exit: convert into the REIT’s operating-partnership units, or take your proceeds and complete another 1031 exchange into a new property or DST. A DST that preserves that right lets you keep the deferral chain alive, stay in real estate, and hold on to your depreciation shelter; one that forces the 721 conversion quietly takes that choice away for good. All else equal, the optional structure is the one to prefer — you want to retain your right to do another 1031.

Sticky AUM: the exit toll that keeps your money in place

Put those pieces together and you see why the money doesn’t leave. To get out, an investor has to sell and pay the capital-gains tax they had been deferring — and between federal capital gains, the 3.8% net investment income tax, state tax, and depreciation recapture taxed as high as 25%, the total bill can easily reach 30% to 40% of the position.² That is not a fee; it is a toll gate on the only exit. The practical effect is that the assets stay put, and the firm keeps earning on them — potentially for the rest of the investor’s life. Ask yourself a simple question: would you ever hire a financial advisor if the act of one day leaving them cost you 35% to 40% of your money? Of course not. Yet that is precisely the switching cost these structures build in — and a responsible advisor should be naming that conflict out loud, not quietly benefiting from it.

A menu of one: when every client owns the same fund

Here is a question every investor should ask their advisor directly. Many of the largest broker-dealer platforms carry only a single non-traded REIT — one fund, from one sponsor, that effectively every eligible client is steered into. Stop and consider how that can possibly square with a best-interest standard. How is it that thousands of different investors — different ages, goals, time horizons, and risk tolerances — all belong in the exact same fund? A menu of one is not a menu; it is a default dressed up as a recommendation. When a firm’s entire client base is funneled into one product, the investor is entitled to ask whose interest the shelf was really built to serve.

You would never hire an advisor if leaving cost you a third of your money. These products build that toll in by design.

5   Most sponsors are good — read for these

Let me be clear, because I work in this market and believe in it: non-traded REITs and DSTs are not scams. The great majority of sponsors are legitimate and competent, and a well-chosen DST solves real problems — completing a 1031 on a deadline, accessing institutional real estate at reasonable minimums, diversifying, and stepping out of active land lording, all while deferring tax. The concern is narrower: the same disclosure regime that lets a good sponsor operate transparently also lets a bad one operate defensibly. The losses live in the tail, and the paperwork looks nearly identical on the way in. A sound DST usually announces itself in the same documents a weak one uses to hide — read for these.

GREEN FLAGS — SIGNS OF A WELL-STRUCTURED DST

✓   Distributions covered by FFO, conservatively measured — funded by the property’s in-place cash flow, not borrowings, reserves, or offering proceeds. Ask for the coverage ratio and the first-year source of distributions.

✓   A real, verifiable track record — ask directly about the performance of the fund and the sponsor’s prior deals: full-cycle, realized investor returns on offerings that have already been sold, not projections or an internal “NAV” the sponsor sets itself.

✓   A creditworthy, diversified, or proven tenant base with audited financials and staggered lease expirations — not a single unproven tenant carrying the deal.

✓   Conservative, fixed-rate leverage with a comfortable cushion and no near-term maturity forcing a sale into a bad market.

✓   An honest, third-party valuation in line with recent comparable sales — not a large step-up over what the sponsor just paid.

✓   Insist on audited financial statements. Independently audited financials for the offering — and, where possible, for the tenant — not compiled, reviewed, or unaudited numbers the sponsor prepared itself. Unaudited financials are a recurring feature of the deals that go wrong.

✓   An optional — not mandatory — UPREIT. The offering lets you choose at exit between converting into REIT units and completing another 1031 exchange, so you keep your right to defer, stay in real estate, and preserve your depreciation shelter. Optional is strongly preferred.

✓   A long-tenured sponsor with a clean regulatory history and a clearly itemized, reasonable fee load.

6   Reading a PPM like a skeptic — and what to do now

None of the features below are illegal by itself, and several appear in sound offerings. But when they cluster, they describe a structure whose “yield” may be manufactured rather than earned.

WARNING SIGNS A DISTRIBUTION MAY NOT BE “EARNED”

›     Distributions are not covered by FFO — check coverage against a conservative FFO, not the headline yield.

›     The sponsor quotes only an “as adjusted” or “core” FFO with heavy add-backs and won’t show a conservative number.

›     The PPM permits distributions from offering proceeds or borrowings, especially during a “ramp-up.”

›     An affiliated master tenant or joint-venture partner is funding or reimbursing the rent.

›     A single, unproven tenant, or a lease described as at or above market propping up the valuation.

›     A large valuation step-up from a recent purchase price, or an appraisal prepared for the lender.

›     The sponsor can’t or won’t show full-cycle, realized performance on prior offerings.

What to do: treat “return of capital” as a warning label, not a feature. Ask three blunt questions of every income product, and insist on real answers: Where does this distribution come from, and what percentage was covered by FFO last year? What is the actual, full-cycle performance of your prior funds? And what will it cost me — in tax and in gates — to get out? Read the master-tenant and joint-venture sections to see who is really funding the rent. Understand the UPREIT door — ordinary income, no depreciation, no more 1031 — before you walk through it. And if your advisor’s platform offers exactly one fund, ask why. Most of this market clears a high bar, and a well-chosen DST remains a powerful tool. My aim is only to insist on the one thing disclosure was supposed to guarantee and no longer does: that the yield is real, that FFO conservatively covers the distribution, and that the money is being earned by the real estate — not by the person who invested after you.

About the author

Michael Deutsch is the principal of 1031 DST Solutions, where he advises real-estate investors on 1031 exchanges, Delaware Statutory Trusts, and 721 UPREIT transactions. He writes on investor protection and due diligence in the non-traded alternatives market.

Notes & sources

1.   Distribution-coverage practices at large non-traded REITs — including instances in which a majority of a fund’s distribution was funded by borrowing or reinvested distributions rather than operations in a given period — are drawn from independent reviews of public SEC filings and sponsor disclosures (2024–2026). These practices are lawful and disclosed; verify coverage against each issuer’s current fact sheets and latest Form 10-Q, and against a conservative (adjusted) FFO rather than an “as adjusted” figure.

2.   Illustrative exit-tax ranges (30%–40%) combine federal capital-gains tax, the 3.8% net investment income tax, applicable state income tax, and depreciation recapture (taxed up to 25%). Actual amounts vary widely by investor, holding period, state of residence, and prior depreciation taken, and should be confirmed with a qualified CPA.

Disclosure. This white paper is opinion and commentary offered for educational purposes. It does not allege that any specific REIT, sponsor, tenant, or broker-dealer has operated a fraudulent scheme or engaged in criminal conduct. References to industry distribution and platform practices describe lawful, publicly disclosed conduct offered as illustration; references to matters “alleged” or “under investigation” describe unproven claims and are not statements of fact regarding wrongdoing. Coverage, tax, and performance figures are period- and investor-specific, may be rounded, and should be verified against primary sources. Nothing herein is investment, legal, or tax advice, or a recommendation to buy, sell, or hold any security; tax treatment of DSTs, UPREITs, depreciation, ordinary income, and return-of-capital distributions varies by investor and should be confirmed with a qualified CPA and attorney. © 2026 1031 DST Solutions.