Many 1031 Exchange investors who are selling rental properties that are free of debt express interest in investing in DSTs that have no loans.
While we typically have one or more debt-free DSTs in our inventory of approved offerings, most DSTs have loans in place that are generally in the range of 40% to 60% of the value of the property.
DSTs with loans can be attractive to investors for the following key reasons:
1. Historically low interest rates in today’s investment climate can improve the cash flow of many popular asset classes such as apartments, senior housing, storage, industrial, and healthcare.
As an example, an apartment with a 50% loan with a low interest loan might yield a 5% annual investor distribution rate whereas the same property with no loan might only yield a 3% annual distribution (or less).
2. Added depreciation and interest expense write-offs can increase after-tax cash flow to investors.
An investor who has sold a debt-free property valued at $1 million and who chooses to invest in a property with a 50% loan will be acquiring real estate valued at $2 million ($1 million of equity plus $1 million of loan). The additional acquired real estate can result in added depreciation write-offs plus interest deductions that may provide added tax shelter to the income received by the investor.
3. The DST structure requires that the DST sponsor/trustee/manager be the sole guarantor on the loan.
DST investors do not need to submit documentation to qualify for any in-place loans and do not bear liability for any loan defaults. This requirement places more motivation on the sponsor/trustee/manager to successfully manage the investment.
Potential Issues with No Loan DSTs
In our experience, all no loan DSTs are exclusively limited to properties having a single tenant with a fixed term lease such as select retail, commercial office, or health care properties. These types of properties have the following risks:
1. Declining lease term.
No loan DSTs typically consist of one of more single tenant properties that have a fixed term lease. Each year the lease for these properties declines by one-year and the investment risk increases due to the possibility that the tenant may 1) either not renew the lease, 2) default on their obligations before the lease expires, or 3) renegotiate the lease upon renewal of the lease with less favorable terms to the owner. Obviously, these risks increase during economic downturns and unanticipated events such as COVID-19.
Furthermore, once the current lease term drops below 10 years remaining, it is generally more difficult for buyers to obtain attractive financing, potentially causing buyers to generally reduce offer values.
2. Dependency on the performance of a single tenant.
Unlike asset classes with multiple tenants such as apartments, senior housing or storage, no loan DSTs typically rely on the performance of a single tenant. With changing buying trends impacting many retailers and other risks that could disproportionately impact a single-tenant- property such as recessions, weather events, and pandemics, many of our investors shy away from over-investing in single-tenant properties.
In addition to added business risks that may impact single-tenant properties, there is also relocation risk. Over our history of managing many properties, we have seen cases where even a financially strong tenant like a Walgreen’s or a Dollar Store may choose to move to a newer building in a close-by location that is performing well rather than stay at their current location.
3. Higher risk of full loss of investment.
The loss of a tenant in a single net property can have a devastating impact and potentially result in a significant loss of investment. By contrast, the loss of even a few tenants in a multi-tenant property such as an apartment can be more easily recovered and not jeopardize the entire investment.
4. Sponsor risk.
Our clients know that we place a great deal of weight on considering the prior track record of DST sponsors. We routinely caution our clients to avoid investing in DSTs where the sponsor has a limited track record, weak balance sheet, prior bad history in the industry, or who has not weathered previous economic cycles. Unfortunately, growing interest in DSTs has attracted several new sponsors who have not yet established a significant track record of consistent performance.
Some of these new entrants heavily promote no loan DSTs which are single-tenant properties. Investors need to be especially cautious when evaluating no loan DSTs from sponsors with limited/no track records since the risks may far outweigh the perceived benefits.
A new sponsor with a limited experience and finances may not be able to qualify for a loan - and therefore may only be able to offer no-loan DSTs that could be riskier investments.
To be fair, we have seen good performance from a limited number of established sponsors who offer single-tenant properties and we do not want to diminish the attractiveness of single-tenant properties – especially those that are resilient to typical risks e.g. select “necessity retail.” Necessity retail is a subset of retail properties that provide critical local services that are not easily displaced with internet competitors such as grocery stores, urgent care facilities, etc. However, the more desirable single-tenant properties with good tenants and longer leases are in relatively higher demand and therefore are more expensive to acquire and may not produce acceptable returns to investors without a loan. Those single-tenant properties that produce annual investor cash flows above 5-6% without a loan, often have underlying risks e.g., lease renewal and renegotiation risks. inability of weak sponsors to manage performance shortfalls, etc. thereby proving the adage that “The higher the return, the higher the risk.”
We are pleased to evaluate any potential real estate investment that an investor is considering and provide complimentary feedback – even if the investment is being offered by another firm. Our primary goal is to ensure that real estate investors make fully informed decisions and invest in properties that are most suitable for their personal objectives.
For more information on trade-offs in considering DSTs with and without loans, please contact us at 866 398-1031 or email us at info@FirstGuardianGroup.com. You can also schedule some time directly on Paul's calendar, here.
Disclosure: DSTs, like all real estate, have risks, including illiquidity, potential for loss of property value, costs and expenses that could offset the benefits associated with tax deferral, and reduction or elimination of monthly cash flow.
Disclaimer: There is no guarantee that any strategy will be successful or achieve investment objectives. All real estate investments have the potential to lose value during the life of the investments. This material does not constitute an offer to sell nor a solicitation of an offer to buy any security. Such offers can be made only by the confidential Private Placement Memorandum (the “Memorandum”). Please be aware that this material cannot and does not replace the Memorandum and is qualified in its entirety by the Memorandum.
This material is not intended as tax or legal advice so please do speak with your attorney and CPA prior to considering an investment. This material contains information that has been obtained from sources believed to be reliable. However, FGG1031, First Guardian Group, LightPath Capital, Inc., and their representatives do not guarantee the accuracy and validity of the information herein. Investors should perform their own investigations before considering any investment. There are material risks associated with investing in real estate, Delaware Statutory Trust (DST) and 1031 Exchange properties. These include, but are not limited to, tenant vacancies, declining market values, potential loss of entire investment principal.
Past performance is not a guarantee of future results: potential cash flow, potential returns, and potential appreciation are not guaranteed in any way and adverse tax consequences can take effect. The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. All financed real estate investments have a potential for foreclosure. Delaware Statutory Trust (DST) investments are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments. Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions. Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits.
IRC Section 1031, IRC Section 1033, and IRC Section 721 are complex tax codes; therefore, you should consult your tax and legal professional for details regarding your situation.