What is necessity retail?
Necessity retail is a sub-class of retail that consists of recession-resilient, creditworthy tenants in retail and healthcare industries. These tenants provide essential services which continue to be in high demand during recessionary periods and are not easily replaced by the internet. They remain open in many cities and states where other businesses have been forcibly closed due to the COVID-19 pandemic. In many instances, tenants have experienced record demand for their products and services during this challenging period.
Examples of necessity retail tenants that are found in DST offerings include Walgreens, Walmart Neighborhood Market, Tractor Supply, Family Dollar, Fresenius Dialysis Clinic, CVS Pharmacy, among others. Leases for necessity retail tenants are often guaranteed by the parent company.
Due to the relatively small value of each necessity retail asset as compared to an apartment or commercial office property, it is very common for several necessity retail properties to be grouped together as a portfolio in a single DST.
How are necessity retail properties performing?
One of the largest necessity retail DST sponsors, ExchangeRight, reported that they collected 100% of their rents in 2020 totaling approximately $129M – and that all their past necessity retail DST offerings have met or exceeded cash flow distributions to investors since their founding in 2012. Comparable portfolios of net leased properties managed by public REITs did not fare as well and reported collections during 2020 ranging from 69% to 96% underscoring that not all necessity retail was immune to the pandemic.*
What attracts investors to necessity retail DSTs?
- Steady payments with no COVID related distribution reductions in 2020
- Generally higher pre-tax income relative to other assets classes e.g., apartments
- Good track record of leading necessity retail DST sponsors
- Diversification of assets across tenants and geographies within a single DST
While these attributes contribute to the growing demand for necessity retail DSTs, there are additional considerations that investors should evaluate.
What to consider before investing in necessity retail?
- Fixed term leases
- All necessity retail properties have fixed term leases that, by definition, decline year-by-year until they are either renewed or expire. As the lease term comes to an end, there is a risk that a tenant may not renew and vacate their building or that they will demand less favorable terms in a lease renewal. Renewal risks can result in loss of equity since property values may drop if rent or occupancy is anticipated to be negatively impacted at time of renewal.
- By contrast, multi-tenant residential assets such as apartments are being perpetually leased and are not generally subject to a full loss of income as might be the case in a single tenant property if the sole tenant vacates.
- Properties with shorter term leases can have added risks
- Most of our clients who are attracted to necessity retail, seek properties with remaining lease terms greater than 10 years. Once remaining lease terms drop below 10 years, renewal risk can rise.
- Depreciation impact on after-tax cash flow
- While distributions can appear to be greater with some necessity retail DST offerings, investors should consider that retail properties are depreciated over a 39-year period versus the more favorable 27.5-year deprecation period allowed for residential properties. What at first glance may appear to be higher relative cash flow may in fact be less when depreciation deductions are considered.
- Tax reporting
- Investing in portfolios of properties can result in added tax filing obligations. Some tax advisors may require that their clients file tax returns in those tax-reporting states where each property is located. Be sure to consult with your tax advisor before investing in a DST portfolio so you will not be surprised with unexpected tax filing fees and obligations after you make the investment.
- Self-dealing and conflicts of interest at time of sale
- Some necessity retail sponsors offer their investors at the time of future sale an opportunity to invest their proceeds into an income producing Real Estate Investment Trust (REIT) that they manage. While this option may be attractive, investors need to consider the following:
- While proceeds from the sale of a DST can be invested in some REITs without triggering a tax obligation, the investor will lose the ability to defer taxes when those REIT interests are sold in the future.*
- Since the sponsor controls both the DST and the REIT, there may be conflicts of interest e.g., setting the sales price of the DST interests without seeking independent third party appraisals or obtaining competitive bids via a traditional marketing process.
Summary
Necessity retail has become a very popular DST asset class and new offerings from top sponsors often fill-up up quickly after being released due to recent and past performance. Prospective investors are urged to study the inherent risks and trade-offs prior to investing and to especially consider exit scenarios and options offered by sponsors at the time of future sale.
For more information on necessity retail DST offerings, please contact us!
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* Rent collection data provided by ExchangeRight who reported that cited data was based on press releases and public filings that have been made available as of January 2021.
* If the investor passes during the holding period, his/her heirs may be able to inherit those interests at the current market rate at the time of passing and avoid paying capital gains taxes.