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Guest Contributor: Yield-Enhancement Strategies for DSTs – My Top 10 List

By: Tim Witt, Chief Investment Officer at DAI Securities LLC

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By: Tim Witt, Chief Investment Officer at DAI Securities LLC

Generating attractive year-one cash-on-cash returns has never been more challenging for Delaware statutory trust sponsors. Not many years ago, a five handle was considered the minimum expected by investors and their financial representatives. Four became the new five, and now three has become the new four. Once the mid-pandemic economy stabilized, helped by unprecedented government stimulus along with aggressive Fed actions to reduce interest rates, cap rates on popular DST asset classes – multifamily, necessity net lease, and self-storage—experienced further compression.

Investors, both domestic and foreign, have increasingly pursued these asset classes as they performed well over the past decade and appear to have longer-term tailwinds. Unfortunately, the moves to stimulate the economy, coupled with supply chain disruptions and supply/demand imbalances, are creating the highest inflation in four decades.

With the Fed behind the curve, they are now taking and messaging aggressive actions to increase interest rates. Borrowing costs have jumped in a short timeframe. It seems like yesterday DSTs were being syndicated with interest rates on 10-year fixed rate debt of ~2.75 percent. Now, that same debt is closer to 5 percent. However, cap rates have been slow to follow interest rates higher.

With cap rates in the three’s for many high-quality assets, current mortgage interest rates can result in negative leverage (meaning, placing debt on the property reduces cash flow). A DST with reasonable leverage – 45 percent to 50 percent on total capitalization – may have starting cash flows below 3 percent at market interest rates. This situation leads sponsors to a few potential strategies to navigate this environment: (1) lower loan-to-values (LTVs), (2) debt-free DSTs, and/or (3) utilizing a number of yield-enhancing methods. The first two are expected and reasonable responses; the third can be problematic.

Below is my top 10 list of methods I have observed. These are in no particular order although I have saved the worst for last. In conclusion, I will discuss the potential challenges and conflicts of these strategies.

  1. Prepaying or reserving for normal expenses: Examples include property taxes, insurance, mortgage interest, and ongoing lender reserves. These are pretty easy to catch in a sponsor’s pro forma. Look at each year-one expense category to check for amounts that are zero or dramatically less than later years. Using reserves to offset expenses is effectively returning investor capital.
  2. Waiving or deferring asset management fees: Often, sponsors are giving up asset management fees in the first year or two. This is one of the more acceptable methods as these fees are separate from the normal operations and the net operating income of a property. Check the fine print to see if the fees are waived or just deferred. Some are deferred to sale of the property. Waived is best for investors. (Some are beginning to waive property management fees also. This needs to be taken into consideration when calculating the purchase cap rate using “normalized” NOI.)
  3. Purchasing assets that are of poor quality and/or located in unattractive markets: Usually, higher cap rates indicate higher risk, issues with asset quality, or a market considered less desirable by institutional investors. Examples of market conditions include out of balance supply/demand, low household incomes, and/or a lack of population and job growth. These higher cap rate properties may produce higher initial yields, but driving rent and NOI increases over the holding period could be challenging, leading to a less than optimal exit. In certain cases, the cap rate premium may justify the additional potential risk.
  4. Underfunding upfront reserves: One lesson from the great recession is that syndicated 1031 offerings need a meaningful rainy-day fund. Forecasting robust economic growth every year for the next 10 years is not a reasonable assumption. In addition to expected repairs detailed in the property condition assessment, a property may need upgrades to finishes and amenities to remain competitive. This is especially true of new apartments with trendy finishes.
  5. Purchasing a property with a tax abatement or other tax benefit: Benefits to NOI from taxing authorities typically result in a higher purchase cap rate. Conceptually, the purchase price in this situation has two components: (1) the value of the property assuming unabated (full) taxes and (2) the net present value (NPV) of the tax benefit. Usually, the discount rate used for the NVP calculation is higher than the market cap rate, resulting in an overall higher blended cap rate. However, a tax abatement has a finite life which likely will have less or no benefit to the next buyer. For a breakeven exit for the DST, the property must overcome not only the syndication load but also the additional purchase price paid for the tax abatement benefit.
  6. Interest rate buy down: Obviously, this works to decrease the interest rate, but usually at a high cost which increases the overall load and raises the hurdle for a successful exit.
  7. Loan structures other than 10-year, fixed-rate debt: A lower interest rate can be obtained by decreasing the loan term or utilizing variable-rate debt. However, this can significantly increase the risk to the DST investor. With shorter-term debt, there is less time to grow NOI to overcome the load. A recession occurring sometime during the next five years should not be ruled out. Properties may need time to go through an economic downturn and recover. In a rising interest rate environment, variable rate debt may not be a good bet. Until recently, the U.S. was in a declining interest rate environment since the 1980s. However, it is unknown if we are seeing a trend reversal or if we will just bounce along the bottom for years. It is impossible to remove the risk of owning real estate for the DST investor, but interest rate risk can be controlled through long-term, fixed rate debt.
  8. Net lease strategy shifts: There are a few key strategies to finding higher cap rates on net lease assets. One is to pursue properties with less lease term. However, this reduces the period of expected consistent cash flows during the initial lease term while little remaining lease term upon disposition results in a higher cap rate (lower sales price). Another strategy is accepting a lower credit quality tenant – poor revenue growth, minimal to no profitability, low cash position, high debt, and/or poor industry outlook. This increases the probability that the tenant will default during the lease term. A tenant default on a leveraged, single-tenant DST will likely result in foreclosure.
  9. Aggressive assumptions: This applies mostly to multi-tenant, multi-expenses-category asset classes such as multifamily, self-storage, senior living, hospitality, etc. (Net lease asset assumptions are typically a reflection of the contractual lease terms.) With strong recent rent growth, more than a decade since a real recession, and the need to increase returns, there is a temptation to use aggressive revenue growth assumptions. There is also a temptation to use historical inflation rates to project increases in expenses. If you expect a strong inflationary environment for an extended period, that should apply not only to revenues but also expenses.
  10. Using reserves to supplement cash flow: This method has no benefit other than enabling the sponsor to show higher cash flows to more quickly raise equity. There is no economic substance to returning the investors own funds – loaded money – back. Further, there is practically no limit to the amount of yield enhancement that can be generated. A sponsor can buy a property with little current cash flow and use reserves to produce year-one returns in line with or higher than competing offerings. This may create a significant disparity in the actual performance of an asset compared to the return being forecasted. Sponsors utilizing this approach never mention its use in their marketing brochures, effectively admitting most investors would be turned off if they knew.

Two problems arise from engaging in the above. First, investors buying a DST with meaningful yield-enhancements may not fully understand and appreciate how the sponsor has structured the offering. When a certain cash-on-cash return is forecasted, investors often assume the return is being generated by the property’s own operations, not by the aforementioned strategies. Investors should be able to clearly understand a property’s true NOI and the relationship of NOI to forecasted cash returns.  This understanding enables an investor to make a fully informed buying decision and better make an apples-to-apples comparison among competing DSTs.

Second, when a sponsor enhances a DST’s yield, this is in some measure based on the belief, maybe hope, that the property will be able to grow into the forecasted distribution a few years down the road. Should the property not grow into the distribution as hoped, due to a recession, new competition, or other unforeseen circumstances, the distribution will need to be reduced. That is when many investors will first learn that the property was not producing the forecasted distribution on its own two feet from the start. This may lead to dissatisfied investors.

The DST market has never been healthier. According to Mountain Dell Consulting, the industry raised over $8 billion last year, a new high-water mark and more than double the prior year. DSTs have become widely recognized as viable replacement-property options for 1031 investors wanting to transition from active to passive real estate ownership. The market shift from the tenant-in-common (TIC) to the DST structure has significantly reduced the risk of a rogue investor voting contrary to the super majority. The most popular DST asset class – multifamily – has a good risk profile for the DST investor and has performed well. Furthermore, a significant number of DSTs have gone fully cycle with positive returns.

All participants in the DST ecosystem can and should work together to keep the DST market healthy and attractive for 1031 investors for decades to come. Financial engineering increases the risk that the forecasted cash-on-cash returns will not be achieved, leading to unhappy investors and reputational risk for the entire DST market.

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The views and opinions expressed in the preceding article are those of the author and do not necessarily reflect the views of The DI Wire.