By Al DiNicola, AIF®
September 15, 2022
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC
DSTs by design have Debt
Nearly 20 years ago the Delaware Statutory Trust (DST) structure became an accepted vehicle for cash investors as well as 1031 tax deferred exchange investors. The IRS ruled (Revenue Ruling 2004-86) that a DST is eligible as replacement property in a 1031 exchange. A DST qualifies as a “like-kind” investment. Prior to this ruling fractional ownership was focus on the Tenants in Common (TIC) structure. We will have a blog entry comparing the differences between the DST and the TIC. Structured debt is one of the topics of this writing. In a TIC structure the individual investors must qualify and assume liability for the property level debt. CAUTION-The individual investors may assume personal liability above the invested equity. In the DST structure the individual investors do not personally assume liability for the property level debts. In addition, the investors are limited on liability to the invested equity.
Both structures (TIC & DST) include debt for a common reason.
Using debt as leverage increases the purchasing power and enables investors to simply buy more property. From a prospective of the 1031 exchange the presence of debt enables an investor to conform to one of the key requirements of the IRS 1031 structure. This requirement is to replace the debt that is being paid off on the property sold with debt on the property being acquired. The investor always has the options to bring more cash to the closing on the new property being acquired rather than taking on debt. Failing to replace debt in a 1031 exchange may result in the investor incurring mortgage boot. The DST structure provides an allocation of debt to the investor that is referenced as non-recourse.
Leverage and Loan to Value
Leverage has long been used by individual investors as well as institutional investors to control real estate. In the residential markets initial down payments may range for zero on the Veterans loan program all the way to 20% down payment. There are many variations in between. There are FHA programs with 3% down, 5% down programs and 10% down programs. Once an investor (individual) reaches 20% down there may be the elimination of PMI (Private Mortgage Insurance). This insures the difference between what the investors is putting down as their equity and the 20% amount. PMI does not insure the entire debt. Commercial real estate has a variety of financing options. The basic leverage principles apply to other investments including DST. When the DST can leverage the acquisition of the property the results may be a larger asset being acquired. The big advantage with the DST debt is that the debt is prepackaged making it extremely easy for the investor needing debt replacement to protect their 1031 exchange.
There is always a risk of default whenever a property has a loan (mortgage). There are many real estate risks assumed by the investors. The question may come up as to what an acceptable amount of risk is as expressed in a loan to value (LTV). I was reviewing DST offerings from three years ago and noted that many of the LTVs on offerings were higher than 50% and some in the mid 60% range. What this enabled investors to do, who were selling (via 1031 exchange), was to move into those offerings and easily satisfy the replacement of debt requirements. On further review of the offerings, I also noticed the borrowing terms were somewhat different than today. Interest rates were less than today. This enabled the capital stack to be structured differently. For example, a $50 M offering three years ago with a 60% LTV needed $20 M in equity and $30M in debt. This debt would be allocated to the individual DST investors based on their equity invested.
Sponsors of DSTs today are structuring offerings with a lower LTV. This may be a result of more conservative underwriting, rising interest rates, and other factors. Locating a replacement property for investors with higher debt requirements may be more difficult. Using the same $50M example from above, a new offering may have a 35% LTV. This requires an increase in equity raise to $32.5 M and a decrease to $17.5 M in debt to be assigned.
Balancing the cash and satisfying the debt on a 1031 exchange.
Once an investor has closed on the property being sold (occasionally referenced as the “down-leg”) all the cash needs to be with the Qualified Intermediary (QI). The agreement between the investor and the QI should be set with enough time to review the procedure the QI will follow as well as the process for closing on the replacement property or properties (which is permitted). Investors who close on the down-leg with no debt to be paid off have an advantage on deciding which DST to acquire. Since no debt was paid off no debt is required to be assumed. There are all cash DST albeit in shorter numbers of opportunities than DST with structured debt. We do have cash investors who seek out opportunities to take on debt (leverage) with the potential of receiving tax favored returns utilizing the proportion of interest write offs in addition to the increased proportion of depreciation. The acquisition of replacement properties occasionally is referenced as the “up-leg”.
For investors who paid off debt on the down-leg the challenge is more entailed. The right asset or property offering need to be located to satisfy the debt replacement. This may include more than one property if the investor is seeking diversification. The difficulty is locating an exact match for the debt replacement. Let’s take a look at a few examples.
Investor A: Sells a property for $1M and satisfies a mortgage of $250,000. For ease of example $1M is the fair market replacement value that needs to be met. (In practice there may be set offs for cost of sale items). QI receives $750,000 for future replacement purchase.
• Investor A wants to purchase only one asset and through his advisor locates a multifamily property that he invests (through the QI) the $750,000 (cash equity).
• That property has a 32.79% LTV. There is an allocation of debt based on his equity investment and the 32.79% LTV.
• The debt allocation (on the $750,000 cash invested) would be $365,905 and when added to the contributed equity has a new fair market value (for 1031 exchange purposes) of $1,115,905.
• The 1031 exchange requirements are: use all the cash, meet or exceed the replacement price, and meet or exceed the debt paid off.
• This investor satisfied all financial requirements,
• Any potential distributions would be made on the equity contributed ($750,000).
Investor B: Sells a property for $1M and satisfies a mortgage of $250,000. For ease of example $1M is the fair market replacement value that needs to be met. Financials are the same as investor A.
• This investor wants to purchase more than one asset and potentially three properties.
• The advisor is successful at locating three properties.
• Property 1: 32.79% LTV; $250,000 equity invested providing a debt allocation of $121,968.
• Property 2: 38.20% LTV; $210,000 equity invested providing a debt allocation of $129,806.
• Property 3: All Cash; $290,000 equity invested
• Total debt would be $251,774 (satisfies the replacement of debt)
• This investor satisfied all financial requirements,
• Total replacement value would be $1,001,774 (Satisfies fair market replacement value).
The additional properties may provide asset diversification and or geographic diversification. We have been successful at balancing the cash, meeting or exceeding the replacement value, and also balancing the debt replacement. We designed extensive spreadsheets and calculation utilizing many of the active DST offerings. We update the offerings constantly to assist the investors.
Investors who need debt may struggle with replacement.
Recently we have answered investors questions regarding the challenges of replacing debt that is more than 50%-55%. Using the example from above this would be a $1M property that was sold with a $550,000 loan paid off. The challenges come from many of the sponsors moving down in LTV (below 50%). This may limit the options an investor may have when selecting the DST replacement properties. The advisors who are well skilled will constantly review new offerings, conduct due diligence, align investor preferences with sponsor offerings and make recommendation. There are highly leveraged DST offerings by designed (referenced as zero coupon or zero distribution offerings). These highly leveraged offerings (over 85% LTv) are not always available. As the name suggests, zero distribution means during the holding period the investor does not receive any distribution since all distributions are utilized to pay down the loan on the property. When the DST property is sold the loan payoff would potentially be less, meaning there may be a buildup of equity. We did assist an investor who used one of the zero DST offerings to satisfy all the debt replacement of her down leg and then was able to purchase two regular real estate rental homes. The three properties combined satisfied all the IRS requirements. Interesting strategy for those looking for alternatives in solving debt replacement.
Using the Debt Component
If you are contemplating selling your property in the future, now may be the time for a call with your real estate broker/agent as to how viable the prospects of selling your property would be at this time. Real estate brokers who understand the benefits of the DST alternative add value to their breath and depth of knowledge. The DST is a securitize offerings and advisors need to be properly licensed to assist the investor. The DST replacement opportunity offers a new dynamic to providing a solution for investors. DST provide passive tax advantages returns with non-recourse debt.
Keep up with other topics on DSTNews.org
DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email email@example.com.
This is not an offer to purchase or solicitation to purchase any security, as such be made only through an offering memorandum or prospectus. Investing in securities, real estate, or any investment, whether public or private, involves risk, including but not limited to the potential of losing some or all of your investment dollars when you invest in securities. You should review any planned financial transactions that may have tax or legal implications with your personal tax or legal advisor. NAMCOA, LLC is a Registered Investment Advisor, regulated by SEC (Securities and Exchange Commission). Our corporate office is located at 999 Vanderbilt Beach Road, Suite 200, Naples Florida 34108. Securities Offered through MSC-BD, LLC, Member of FINRA/SIPC. 410 Peachtree Parkway Suite 4245, Cumming, GA 30041. MSC-BD, LLC and NAMCOA are independently owned and are not affiliated.
NAMCOA® – Naples Asset Management Company®, LLC