Home Alts News Sponsored: Why the Trend Toward Debt-Free DSTs is Not Going Away Anytime...

Sponsored: Why the Trend Toward Debt-Free DSTs is Not Going Away Anytime Soon

By: Corey Nolen, Vice President, Wholesale Distribution, Cove Capital Investments

image_pdf

By: Corey Nolen, Vice President, Wholesale Distribution, Cove Capital Investments

Summary:

  • Debt-free DSTs eliminate the potential for lender foreclosure resulting in complete loss of principal
  • Debt-free DSTs provide the sponsor more speed and flexibility to generate potential returns for investors because there are no lender prepayment penalties or defeasance costs
  • Debt-free DSTs eliminate the refinancing risk of balloon mortgages

Debt-free Delaware statutory trusts (DSTs) have been on the market for years. Historically, debt-free DSTs have been a good fit for risk-averse 1031 exchange investors willing to forego slightly higher potential returns for the potential asset security a debt-free investment provides. In times of higher interest rates, like we’re experiencing now, the cost of debt increases, often making debt-free deals more competitive from a return standpoint. Take a look at the total supply of debt-free DSTs now compared to 6 months ago, and you will see the trend is not hard to miss.

The Coronavirus pandemic served as a wake-up call to wealth advisors and investors alike. In many cases, it resulted in reduced or suspended distributions to DST investors because primary lenders swept cash flow to cover debt service payments, because tenants requested rent relief as well as the federal eviction moratorium and its impact on multifamily DST sponsors. The risk of lender foreclosure, which is always mentioned but rarely considered a realistic possibility, suddenly became a much more viable risk. In this piece, we’ll discuss six reasons why debt-free DSTs should be a consistent part of a DST investor’s portfolio.

Reason One: Debt-free DST Assets Provide Investors with Zero Risk of Lender Foreclosure

DSTs without debt are considered a much lower risk profile than those with leverage. Debt-free DSTs have zero risk of lender foreclosure protecting investors from a complete loss of principal invested. Also, debt-free DSTs provide protection from a balloon payment associated with loan maturity.

Reason Two: Debt-free DSTs Give Sponsors More Flexibility to Potentially Work in the Best Interest of Investors

On a leveraged property, many transactions require lender approval before they can be executed. This limits the real estate operator in the speed at which they can operate the property, and at time limits the options available to them.

For example, a DST may be created with the intent of being sold to an UPREIT in a 721 transaction in year 4. It could potentially bump investor cash flows up in years 1-3, with the intent of slashing cash flow in year 4 when it is acquired by the UPREIT.

However, if there’s debt on the property, the lender may reject the UPREIT acquisition in year 4. In this scenario, DST investors will receive the reduced distributions because the property sale is on hold until terms can be met that the lender approves.

In a debt-free DST, there is no lender that needs to approve a transaction, so the sponsor has the ability to potentially act in their investors’ best interest quickly.

Reason Three: Debt-free DSTs Can Deliver Better Cash Flow Potential.

A leveraged DST has monthly debt-service payments which must be made first and in full each month, allowing remaining funds to be paid out to investors. In economic downturns, or even in cyclical high inflationary periods, an assets’ revenues may be reduced. The equity investors in a leveraged DST bear the burden of this revenue reduction because debt-service payments must still be made.

In a debt-free DST, with no debt-service payments to be made, investors are less likely to have their distributions affected. Instead, if an asset’s revenues are reduced, investors may not have their cash flow impacted at the same level as a leveraged asset.

Reason Four: Debt-free DSTs Provide Investors the Ability to Diversify a Portion of Their Portfolio into Unlevered Assets to Lower Potential Risk

Many entrepreneurs who have invested heavily in the stock/bond markets turn to all-cash/debt-free Delaware statutory trust properties as a strategy to diversify away from stocks and bonds. Since these products do not require the risks of a loan, they are more approachable for cash investors.

Reason Five: Debt-free DSTs Eliminate the Need to Take on Greater Debt in Future 1031 Exchanges

Since all DSTs should eventually run full-cycle, investors who have invested in a DST that is debt free will not be faced with the need to replace that debt with a 1031 exchange (per the IRs 1031 exchange rule of purchasing equal or greater value in replacement property).

Debt-free DSTs can also be good supplements for exchangers who want to may want to split an exchange between one higher-leveraged DST and one debt-free DST to meet the blended loan-to-value needed. This is an effective way to diversify and lower risk potential while maintaining the overall leverage required.

Reason Six: Debt-free DSTs Protect Investors from Lender Recourse Associated with Tenant Credit Rating Fluctuations

In the event a tenant’s credit rating decreases, under certain loan terms, the lender would have the right to sweep the cash flow until the tenant’s credit rating improves. This is a major risk found in many commercial net lease DST offerings with leverage. In a debt-free DST if the tenant’s credit rating gets lowered, there is no lender to effectuate a cash flow sweep, thereby protecting investors’ monthly distributions.

In Summary, each one of these arguments supporting the wisdom of investing in debt-free assets stands on it own. Put them all together, and it is clear that debt-free DSTs are not just a trendy flash in the pan during higher interest rate environments but an important investment strategy for DST investors for foreseeable future as well.

About Cove Capital Investments

Cove Capital Investments is a private equity real estate firm providing accredited investors access to 1031 exchange eligible Delaware Statutory Trust properties as well as other real estate investment offerings. The Cove Capital team consists of Acquisitions, Asset Management, Accounting, Due Diligence, In-House Counsel, Investor Relations, Marketing and Capital Markets. Cove Capital maintains a robust current inventory of DST and private equity real estate offerings potentially available to investors. Cove Capital Investments has sponsored the syndication of over 1.5 million square feet of 1031 DST and real estate offerings in the multifamily, net lease, industrial and office sectors. The Principals of Cove Capital Investments seek to invest alongside investors in each of their offerings.

For further information, please visit www.covecapitalinvestments.com or contact Cove Capital at (877) 899-1315 and via email at info@covecapitalinvestments.com.

* Past performance is not a guarantee of future results. This material does not constitute an offer to sell nor a solicitation of an offer to buy any security. Investors should perform their own investigations before considering any investment. IRC Section 1031, IRC Section 1033 and IRC Section 721 are complex tax codes therefore you should consult your tax or legal professional for details regarding your situation. This material is not intended as tax or legal advice. There are material risks associated with investing in real estate, Limited Liability Company owned (LLC) properties, LLC interests, Delaware Statutory Trust (DST) properties, and real estate securities including illiquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and net lease properties, short term leases associated with net lease properties, financing risks, potential adverse tax consequences, general economic risks, development risks and long hold periods. There is a risk of loss of the entire investment principal. Nothing contained in this material, including in this disclosure or in any other disclosure in this message, constitutes tax, legal, insurance or investment advice, nor does it constitute a solicitation or an offer to buy or sell any security or other financial instrument. Securities offered through FNEX Capital, member FINRA, SIPC.

For more Cove Capital news, please visit their directory page.

Cove Capital is a sponsor of The DI Wire, and the article was published as part of their standard directory sponsorship package. The views and opinions expressed are those of the author and do not necessarily reflect the views of The DI Wire.