Four Lender “Cash Traps” Scenarios Investors Should be Aware of When Considering Using Leverage for a 1031 Exchange and DST Transaction

By Dwight Kay, Founder & CEO of Kay Properties & Investments

Key Takaways:

  • 1031 Exchange real estate investors must replace debt as a condition of their exchange. However, in some cases if the property has been held long enough, there is no debt to replace. That’s why Kay Properties encourages investors to consider debt-free DST real estate offerings.
  • If an investor must take on debt, it would be wise to consider minimal leverage in order to avoid lender foreclosure and total loss of capital.
  • However, for closure is the only concern when taking on debt. Lenders can sometimes initiate a number of “cash flow sweeps” where monthly cash flow can be diverted to pay off a greater percentage of the principal.
  • This article covers four very specific cash flow sweep mechanisms that investors should be aware of.

Understanding the fundamental risk versus reward balance can be one of the biggest keys to investment success, especially in the worlds of the 1031 Exchange and Delaware Statutory Trust real estate investing. 

Kay Properties & Investments believes that avoiding leverage whenever possible is a prudent strategy to help mitigate risk, especially in today's world filled with geopolitical and economic challenges. While it is true that using leverage can be a good thing, it is also true that using leverage can be fraught with risk. 

Just scan the headlines of any business publication, and you will read about large real estate firms that are walking away from real estate assets because they highly leveraged their investment positions during a low-interest rate environment. Almost overnight, interest rates suddenly shot up, catching many investors off guard with no way to refinance. It is not only smaller investors experiencing this situation, but also large firms led by highly skilled real estate executives with decades of experience in successful transactions. 

Leveraged real estate and DST properties (whether they contain a 1031 exchange or 721 exchange exit strategy) are full of potential hazards beyond the interest rate environment; they can also be susceptible to market fluctuations. For example, if you have a property and the market value goes down by 20%, and you're at a 50% loan to value, you just lost 40% of your equity. 

However, in addition to the normal risks associated with real estate, using leverage can also have many risks that many investors (especially DST, 1031 and 721 exchange investors) are unaware of. For example, here are four common lender cash trap provisions that investors should understand when using leverage for a 1031 exchange Delaware Statutory Trust investment. A cash trap occurs when certain conditions occur, and the lender can come in and "sweep" or divert a percentage of excess income created through the asset to pay down the commercial loan. 

First Cash Trap Scenario:

Debt Service Coverage Ratio (DSCR) Violation
Many investors must realize lenders can hide this cash trap in their loan documents and DST investors should carefully search the leveraged DSTs Private Placement Memorandum (PPM) for this provision. This type of cash trap is triggered when an investment property's Net Operating Income (NOI) falls below a specific Debt Service Coverage Ratio (DSCR) measurement. To lenders, this could indicate that the asset is dangerously approaching the point of not generating enough net operating income to cover the debt service payment each month. When this happens, many lenders will trigger a cash trap and divert any excess cash generated, above the monthly mortgage amount, to fulfill the debt obligations until the DSCR improves. An investor's cash flow could be halted for months and even years if a scenario like this were to occur at their DST property as well as at various 721 UPREIT offerings.

Second Cash Trap Scenario:

Risk Management during Economic Downturns:
It also surprises many investors who need to be aware of this inclusive loan document provision when borrowing money for a piece of real estate investment. In this scenario, if there is an economic downturn or widespread market instability, lenders may initiate a cash allocation sweep to protect themselves from any losses caused by adverse economic conditions. By capturing additional income, the lender hopes to reduce their default risk. This may be a smart move for the lender but the DST investors that 1031 exchanged into that particular DST offering may be out of cash flow for months or even years in this type of situation.

Third Cash Trap Scenario:

Cash Flow Sweep Exercised by Lender if a Tenant Vacates an Asset Even if They Continue to Pay Rent and Fulfill Their Lease Obligations:
One of the fastest ways lenders can invoke the cash flow trap clause of the loan documents is when a tenant leaves the asset but continues to pay their monthly rent. In real estate, this is referred to as a tenant "going dark," which almost always initiates a cash flow sweep to ensure the debt payment continues on time. This unique cash trap was prevalent during COVID-19 when tenants left buildings but continued to pay their rent as well as is very common when investors purchase Triple Net Lease – NNN properties with debt as each year many of the major NNN tenants shut down locations across America. If you were invested in a DST offering via a 1031 exchange that had a loan on the DST property (or maybe it was a DST portfolio of properties with dozens of NNN properties inside of it), a “go dark” clause should be examined in the loan documents to see what, if any, the lenders rights and remedies in this scenario would be.

Fourth Cash Trap Scenario:

Tenant Credit Rating Downgrades:

Many DST offerings that have debt associated with them (even when there may be conservative amounts of debt such as a 30-50% Loan to Value) have a provision in the lenders loan documents whereby if a tenants credit rating is dropped below a certain level that the lender has the right to sweep excess cash flow.  This immediately halts distributions to investors and could be something that continues for months if not years until the tenant were to have their credit rating increased above the lender's designated rating threshold.

All real estate investors - especially those considering a 1031 exchange, DST investments and 721 exchange UPREITs - must know these and other cash flow sweep provisions and carefully review their loan documents to be aware of any potential for a cash sweep. Again, these examples illustrate why staying debt-free whenever possible can be very important for those investors that are keenly focused on reducing the possibility of an impairment to their monthly cash flow distribution potential.  All real estate has risks of tenants not paying rent however when you add on top of that the very real risk of lender cash trap provisions in loan documents it is a potential recipe for decreased cash flow to investors for months and possibly even years.  For those investors not wanting the risk of lender cash flow sweeps, lender foreclosure and lender balloon maturity, Cove Capital Investments specializes in debt free DSTs available for 1031 exchange as well as 721 exchange vehicles.