By Al DiNicola, AIF®
November 15, 2022
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC
Structure and Function of Debt in a DST
Typically, by design Delaware Statutory Trusts (DSTs) were conceived to provide an alternative to the Tenants in Common (TIC) structure. When the IRS approved the DST structure there were noticeable differences between the DST structure and the TIC structure. One of the components was the ability for the DST to offer non-recourse debt for investors. The non-recourse debt would enable investors to satisfy the requirements of the 1031 tax deferred exchange. Any debt paid off on the property being sold must be replaced when the replacement property is acquired. Replacement of debt can be accomplished by obtaining a mortgage on the new property, having the seller hold a purchase money mortgage or bring more cash replacing the mortgage. When an investor acquires an interest in a DST there is an assignment of debt that is calculated on the amount of equity invested and based on the loan to value (LTV) of the DST. In the TIC structure each investor would be liable for the debt and typically must sign personally on the loan. In a DST the debt assignment is non-recourse and there is no application for the debt or liability for the debt by the investor.
Lending Rates Increasing
Over the past year the Federal Reserve (FED) has raised interest rates in an effort to curb the inflation rates. Borrowing rates have increased, and the effect is noticeable. On the residential side of the market the purchasing power for individual borrowers has been reduced. Last year an individual borrower may have been able to afford a $500,000 home based on borrowing rates near or under 3%. Interest rates have doubled, and the effect has reduced the ability for a new borrower to purchase a home. The $500,000 home becomes a $250,000. Housing stock is still an issue for many Americans. The increase in borrowing rates also effects the acquisition of properties that may be packaged as DSTs. While rents continue to increase in certain areas on the country the increased cost of borrowing will reduce the potential distribution that ultimately reaches the individual investors.
DST LTV Structures
Sponsors have taken action to minimize the effects of increased interest borrowing rates on distribution. When interest rates were near 3% many DST sponsors would structure the acquisition of the properties with 50% to potentially 60% loan to value. The benefits to 1031 exchange investors enabled the investors to easily satisfy the debt replacement requirements of the exchange. With the increase in interest rates DST sponsors have reduce the LTV to the 30% – 40% range. This may reflect a more conservative approach to underwriting. The effect on investor needing debt replacement can also be seen. With fewer DST structured with lower LTVs an advisor needs to be aware of all the options available. The effect on the DST cash flow may be fewer dollars needing to be allocated to debt service that may minimize the reduction in potential distributions to individual investors.
All Cash DST Increasing
Prior to COVID there were a limited number of all cash DST offerings. For example, if there were 30 DST available (through the major sponsors) there may have been one all cash DST. Because of the limited supply of an all-cash DST, the offering would subscribe (sell out) quickly. COVID had direct effect on specific asset classes. There were travel restrictions, lock downs, isolation and a total disruption of business as we knew it. The hospitality industry may have suffered the most since the restriction of travel, cancellation of meetings & conferences, and vacations virtually shut down the industry. When hospitality offerings started to emerge again (pre interest rate rise) the offerings were structured as all cash. The all cash structured eliminated the possibility of foreclosure since the was no loan on the property. Fast forward to today and the rise in borrowing interest rates may have prompted the structure of additional all cash DST offerings. In looking at the DST Landscape Overview there may be 10-12 all cash DST offerings. Many hospitality offerings are still all cash. There is now a selection (albeit limited) of other asset classes that are all cash including Industrial, Senior Housings, Healthcare, Multifamily and Retail. The assets may be single site properties or portfolio location included in one offering. There is also a notable difference in the size of the all-cash offerings. A few years ago, all cash offers (for example self-storage) were under $15M. Now there are several all-cash offerings that are well over $50M.
Appeal of All Cash DST
Investors who are not engaged in a 1031 exchange may welcome an all-cash DST structure. In addition, there are 1031 exchanges that are considered all-cash when there is no mortgage to be paid off on the sale of the relinquished property. The elimination of any debt eliminates one the risk factors associated with any real estate acquisition meaning foreclosure of the loan. All cash investors seeking the passive income also have the luxury to acquire the DST as soon as the offering is available. All cash 1031 investors still need to time the closing of the relinquished property being sold in conjunction with the DST being available. This timing may be challenging. Another advantage an all-cash offering would have for the investors who are able to invest cash is when the DST offering goes full cycle (sold). If the investor enters into another 1031 exchange, there would be no need to seek debt replacement. There are all-cash investors who are willing take on debt to increase their potential tax advantaged returns with an increase of depreciation.
Drawback of All Cash DST
The immediate drawback on an all-cash DST is the limited appeal of the offering to 1031 investors who need debt replacement. The other concern may be the effect of the carry forward basis and the tax effect. In a 1031 exchange, investors should understand the effects of depreciation and how that may affect their carry over tax basis. 1031 investors who actually are in an all-cash position (with no debt replacement requirement) may want additional basis created with a leveraged DST. The leveraged DST will have an assignment of non-recourse debt proportioned to the equity invested and based on the LTV of the DST. This may assist the investor seeking additional tax shelter and benefits from depreciation. Please consult your CPA on your specific situation and any anticipated tax benefits.
Future DST Offerings
Sponsor will continue to underwrite new DST offerings with a debt component enabling investors to satisfy the 1031 exchange requirement of debt replacement. There will also be DST offerings that will represent all-cash offerings. The all-cash offerings will appeal to direct cash investors as well as the 1031 exchange investors with no debt replacement requirement. Advisors who monitor the DST availability and perform due diligence on offerings are in the best position to assist all DST investors,
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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. 1719 NW Edgar Street, McMinnville, OR 97128 MSC-BD, LLC and NAMCOA are independently owned and are not affiliated.
Thank you.
NAMCOA® – Naples Asset Management Company®, LLC
