September  2022 DST Monthly Landscape Commentary ~ Effects of DST Offerings Reducing Loan to Value in Offerings     

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
https://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 adinicola@namcoa.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.
Thank you.
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC