Investing in real estate through Delaware Statutory Trusts (DSTs) has become an increasingly popular strategy, particularly for those looking to defer taxes via a 1031 exchange. Debt-free DSTs offer a unique set of benefits that can make them an attractive alternative. However, it is important to take a close look at the structure, asset characteristics, and fees involved to assess the best option for each exchanger’s unique situation. This article offers a critical review of debt-free DSTs. We will start off with the benefits.
No Risk of Balloon Loans
Debt-free Delaware Statutory Trusts (DSTs) offer the significant advantage of eliminating the risks associated with balloon loans. Balloon loans typically require smaller periodic payments with a large lump sum, or “balloon payment,” due at the end of the term, which can pose substantial risks if the borrower is unable to refinance or sell the property before the due date. In a debt-free DST, there is no such looming balloon payment, as the investment is not burdened by any debt obligations. This absence of balloon loans removes the pressure of securing refinancing under potentially unfavorable terms or selling the property in a down market, thus providing a more stable and predictable investment environment. Investors in debt-free DSTs can enjoy peace of mind knowing that their investment is shielded from the financial strain and potential default risks that balloon loans can impose.
No Risk of Cash Flow Sweeps
Debt-free Delaware Statutory Trusts (DSTs) mitigate the risk of cash traps, a scenario where all excess cash flow generated by the property is directed toward paying down debt rather than being distributed to investors. In leveraged investments, lenders often impose cash traps if the property’s financial performance falls below certain thresholds, such as a low debt service coverage ratio (DSCR). This can significantly limit the cash flow available to investors, impacting their income and financial stability. However, in a debt-free DST, there are no debt obligations or lender-imposed restrictions to divert cash flow. As a result, all rental income generated by the property is available for distribution to investors, ensuring a more consistent and predictable income stream. This elimination of cash trap risks enhances the financial security and attractiveness of debt-free DSTs, making them an appealing option for investors seeking steady returns without the constraints of debt servicing.
No Risk of Cross Collateralization
Cross-collateralization is a practice where multiple properties are used as collateral for a single loan. This means that the financial performance and stability of one property are directly tied to the others in the portfolio. While this can sometimes provide better loan terms, it also increases risk. If one property underperforms or faces financial difficulties, it can jeopardize the entire portfolio. This interconnected risk can lead to a domino effect, where issues with one property trigger financial instability across all the properties, potentially leading to widespread losses for investors. However, in a debt-free DST, there are no loans and, thus, no lenders imposing these restrictive measures. If one property fails to perform, it will not impact the income generated by the other properties. A portfolio of properties in a DST can then be truly diversified.
No Need for New Debt In Future Exchanges
Debt-free Delaware Statutory Trusts (DSTs) provide a significant advantage when it comes to future 1031 exchanges, as they eliminate the need to secure debt for subsequent transactions. In a typical 1031 exchange involving leveraged properties, investors must replace not only the value of the relinquished property but also match the debt amount to fully defer capital gains taxes. This can complicate the exchange process, requiring investors to take on new loans and potentially increasing their exposure to interest rate fluctuations and credit risks. However, with a debt-free DST, the need to replace debt is removed. Investors can focus solely on finding a suitable replacement property of equal or greater value without the additional burden of securing financing. This simplification of the 1031 exchange process reduces stress and complexity, providing a more straightforward path to tax deferral and continued real estate investment growth.
Easier Exit Strategy
Selling a debt-free property can be more straightforward compared to a leveraged property. The absence of debt eliminates the need to negotiate with lenders or deal with prepayment penalties, making the sale process simpler and potentially quicker. This can be particularly advantageous in a market where timing is critical.
Difficulty Overcoming DST Fees
Investing in a debt-free Delaware Statutory Trust (DST) can present challenges in overcoming DST fees, which can be substantial and impact overall returns. These fees typically include acquisition fees, management fees, and administrative costs, which are incurred regardless of the property’s performance. These fees typically range from 9-20%. There is then a disposition fee of 4-7% on average when the property sells. Without the leverage of debt to amplify returns, the income generated by the property must be sufficient to cover these fees and still provide a desirable return to investors. This can be particularly challenging in markets with lower rental yields or when unexpected expenses arise, reducing the net income available for distribution. The asset type is also important to consider
For a single tenant net-lease or “NNN” DST, the fees may be insurmountable in a typical market. If the tenant goes out of business or does not renew the lease, it could take well beyond a decade to recover. The value of a net lease property directly correlates with the strength of the tenant and the duration of the lease. So, as the lease burns off, so does the potential market price of the property. If the property goes vacant, not only is the potential price of the building a fraction of what it was bought for, but the cost to re-tenant can be potentially 20-40% of the market price. The property appreciation may also have to cover the disposition fee. Consequently, the burden of DST fees can weigh heavily on the profitability of a debt-free DST investment, requiring careful consideration and thorough due diligence to ensure that the potential returns justify the costs involved.
Turn-key Mortgage May Be Advantageous in Competitive Market
Many investors pursue DSTs as a 1031 exchange solution because of the turn-key nature of the loans they need to complete their 1031 exchange. Investors can take on debt in order to purchase property of equal or greater value without applying or signing for it. In an environment where banks are extremely conservative and favorable debt is difficult to acquire, access to this easy financing can be a great advantage in a competitive market.
Non-recourse Debt May Be A Unique Strategic Benefit
Non-recourse debt is a type of loan secured by collateral, usually real estate, where the lender’s only remedy in the case of borrower default is to seize the collateral securing the loan. In other words, the lender cannot pursue the borrower’s other assets or personal wealth if the collateral does not fully cover the loan balance. This contrasts with recourse loans, where the lender can go after the borrower’s other assets if there is a shortfall after liquidating the collateral. Passing up on the ability to acquire investment properties with non-recourse mortgages may be huge opportunity costs for investors to acquire wealth in a competitive market.
Debt May Create Significant Tax Efficiencies
DSTs can provide investors with notable tax advantages, particularly in the context of 1031 exchanges. Many DST investors have depreciated much or all of their bases. Taking on additional debt allows the investor to purchase more property therefore they expand their basis. Investors can then potentially depreciate their new basis and garner additional tax benefits, sheltering some or all their revenue from income tax. Interest payments on the debt can be deductible, also potentially lowering the taxable income generated by the investment. These potential tax advantages may make debt in a DST an appealing strategy for investors seeking to optimize their returns while minimizing their tax burden, especially investors in high income tax states like California.
No Refinancing Ability
The lack of ability to refinance in a DST is a compelling argument to stay debt free. However, other structures that can refinance, such as a Tenant-In-Common (TIC) may provide investors opportunities that a debt free DST cannot. The most notable factor is to refinance when interest rates are declining. Real estate owners that refinanced with lower interest rates in previous years increased their property net operating income significantly. There is no guarantee that interest rates will drop again. However, many analysts believe they will. If those analysts are correct, DST investors may miss out on significant income potential.
Conclusion
Debt-free DSTs offer a compelling investment option for those seeking reduced risk, steady cash flow, and a simpler, more stable investment experience. However, investors should look critically at what upside potential is sacrificed to mitigate the downside risk. When the tax benefits, upside potential, and DST fees are all considered, the upside of taking on debt in certain asset classes may dwarf the risk involved, or may even turn out to be less risky depending on the exchangers investment criteria.
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