Interest in Delaware Statutory Trusts (DSTs) continues to grow with 1031 exchange investors. A chief reason for the rising popularity is the turnkey, non-recourse debt that satisfies investors’ 1031 requirements without requiring the investor to apply or sign for the loan. Though there are clear potential benefits to investors who want or need to buy passive real estate with leverage, there are risks that are common to real estate and also unique to DSTs that should be understood prior to investing.
Several key aspects of the mortgage can significantly impact the performance and returns of the investment. These include the loan amortization schedule, the timing of balloon payments, the presence of cash traps, and whether the properties are cross-collateralized. Each of these factors can influence cash flow, equity buildup, and the overall risk associated with the investment. This article explores these critical elements, providing insight into how they function and what investors should be aware of to make informed decisions.
1. Does the loan amortize; if so/when?
Loan amortization is the process of gradually repaying a loan through regular, scheduled payments over a set period. Each payment is divided into two parts: one portion goes toward paying the interest on the loan, while the other portion goes toward reducing the principal or the original amount borrowed. Often, a larger portion of each payment is allocated to interest early in the term, with smaller amounts applied to the principal. As the loan matures, this balance shifts and more of each payment goes toward reducing the principal.
In DSTs, the investor can build up equity in the property when the loan amortizes. However, paying down the principal can reduce cash flow to the investors, and there is typically no tax benefit when paying back a loan. Therefore, many DST sponsors may coordinate a mortgage with interest-only payments for the entirety of the loan or facilitate a loan where the first few years are interest-only before the loan begins to amortize after three to five years.
It is important for the investor to know when the loan amortizes, as this may create additional challenges to the property’s cash flow, but it also provides an opportunity to build up equity in the property. It is important for investors to understand the risks and potential benefits of interest-only vs amortizing loans so they can make the best decision for themselves and their families.
2. When does the balloon occur?
A balloon loan is a type of financing where the borrower makes regular payments for a predetermined period, typically with lower or interest-only installments, followed by a larger “balloon” payment due at the end of the loan term. Loan terms may also amortize as if the term is thirty years, but the entirety of the loan may be due at year ten. This final payment covers the remaining principal balance in one lump sum. Balloon loans are often attractive because of their initially low monthly payments, making them suitable for borrowers who anticipate an increase in their income or who plan to refinance or sell the financed asset before the balloon payment is due. However, they also carry significant risk, as the borrower must ensure they have the necessary funds or financing options available when the balloon payment becomes due.
A DST is not permitted to refinance. Therefore, balloon loans typically force a property to sell, even if it results in a loss. Typical balloon loans occur around year ten of the term. However, there are occasions where balloon payments could take place sooner. Investors should know when the balloon occurs to assess whether there is enough time for the property to appreciate to provide returns that meet the investor’s criteria.
3. Are there any cash traps built into the loan?
A cash trap (also called cash flow sweep) is a financial mechanism or situation where cash flows generated by an asset are retained and not distributed to investors or owners as intended. This typically occurs when certain financial covenants or conditions specified in loan agreements are not met, triggering the lender’s right to withhold cash distributions. The retained cash is often used to bolster reserves, pay down debt, or address deficiencies in the property’s financial performance.
A cash trap can be implemented by lenders to protect their interests if the property’s income falls below a specified threshold or if the property fails to meet certain performance metrics. While this practice may be intended to help the asset remain financially, it can also reduce the immediate returns for investors or owners, affecting their cash flow expectations and potentially impacting their financial planning. Below are potential triggers for cash traps:
- Property net-operating-income (NOI) drops below a certain level, often called the debt service coverage ratio (DSCR).
- A tenant in a net lease property no longer operates on the property (even if the tenant pays the lease).
- One or more tenants of a property are approaching the end of the lease term and have not indicated yet whether they will renew.
- Pre-determined cash traps are built into loan agreements that automatically take place after a certain number of years, independent of the performance of the property.
- One or more properties in a multi-property portfolio are struggling; this is called “cross-collateralization.”
4. Are the properties cross-collateralized?
Cross collateralization is a lending arrangement where a single loan or a group of loans is secured by more than one asset. A lender may use multiple assets owned by the borrower as collateral to secure a loan or a series of loans. This provides the lender with additional security, as they have multiple assets to claim if the borrower defaults on their obligations. While cross collateralization can provide benefits like improved loan terms or the ability to secure a larger loan amount, it also carries risks. If the borrower defaults, the lender can seize any or all the collateralized assets, which could lead to significant financial loss.
This is important for a DST investor looking for diversification. If the exchanger invests in a DST with multiple properties, the exchanger may not be as diversified as intended if the properties are cross-collateralized. The lender can potentially sweep the cash flow or foreclose on performing properties due to the poor performance of a few. In this case, the investor may consider splitting the investment into an additional DST instead of putting all their eggs in one basket.
5. Other concerns
Commercial loans often come with a variety of covenants and loan agreements that could compromise an investment. For example, a bank may control who is permitted to lease a building and the price at which it is allowed to rent, even when it is to the detriment of the owner. There can be various penalties and costs built-in that are difficult to determine unless you read the fine print.
In conclusion, understanding the intricacies of loan amortization, balloon payments, cash traps, cross collateralization, and other nuances of the loan agreement is essential for making informed investment decisions in a DST. Each of these factors can significantly affect the financial performance, risk profile, and overall returns of a DST investment. By thoroughly evaluating the loan terms and potential implications, investors can better anticipate challenges and opportunities, ensuring they align their investments with their financial goals and risk tolerance. Proper due diligence and awareness of these financial mechanisms will empower investors to optimize their portfolios, mitigate risks, and maximize their returns in the DST market.
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