By Dwight Kay, CEO of Kay Properties and Investments and the Kay Properties Team
Investors going into a DST investment are often laser focused on the property they are buying. Where is their money going – perhaps it’s an apartment complex in Dallas or a portfolio of dollar stores in the Midwest? Investors often “kick the tires” so to speak looking at factors such as the location, occupancy, rental income and credit quality of the tenants. One question that often gets pushed lower on that checklist is what type of financing the property has in place.
Debt on the real estate is an important part of the deal, and unlike a home mortgage, financing is not always structured the same. Kay Properties typically cautions clients to avoid taking on any additional burden of debt when investing in DSTs. Taking on an asset with debt is inherently more risky than acquiring a property with no leverage or debt obligation. Yet it is common for DST properties to have 10-year financing in place which can potentially help to mitigate 1031 exchange closing risk for investors. In addition, for investors conducting a 1031 Exchange who need to replace debt in the exchange, DSTs are an ideal solution. You don’t have to buy too much debt, and you don’t have to go to a bank to take out a loan or sign personally for that loan.
Financing options for commercial real estate properties can span a variety of different structures and terms. When assessing DST investment opportunities, it is important to know whether or not the DST has financing in place, and if so, are there any potential “red flags” associated with that financing. Part of the job of Kay Properties team members when working with investors is making sure that clients are aware that a DST has financing in place, and if so, are there any potential pitfalls that could impact investment performance.
Potential Financing Pitfalls
Pre-payment penalties or defeasance costs. A loan might be defeased or paid off prior to the end of the term, such as is the case with a sale. However, some lenders have onerous pre-payment penalties or “yield maintenance” clauses in the loan agreement that protects their financial interests even if the borrower decides to exit the loan early.
Foreclosure: If a property underperforms or loses a tenant and is unable to generate enough income to pay its debt service, the lender could foreclose on the property. If that were to occur, investors could lose part or all of their equity investment. For those investors not wanting to face a potential foreclosure and loss of capital the Kay Properties team would advise them to consider debt free DSTs which are also called all cash DSTs. These debt free DSTs don’t have a long-term loan and as such don’t have the risk of foreclosure from a lender making them a lower risk alternative to the typical leveraged DST investments. At any given time approximately 80-95% of the DST inventory is leveraged with debt so working with Kay Properties provides investors oftentimes with a much larger selection of debt free DST options than is usually available in the marketplace due to the Kay exclusive all cash DSTs that we have curated for our clients.
Cross-collateralized debt. Some DST portfolios have financing that is cross-collateralized. Say you buy into a DST investment that includes 15 different net lease properties with different tenants. If one of those properties struggles and the tenant can’t make its monthly rent payment, the lender may have all sorts of clauses and conditions that affect the other 14 properties that are performing due to the one that is not performing. If the loan is cross-collateralized, or effectively tied to the financing on the other 14 properties, one bad property could potentially drag down the whole portfolio and result in major issues for investors on their entire investment. For example, a lender might exercise their right to call for a “cash flow sweep”, holding rent from all of the properties until the situation with the problem property is resolved. Investors do need to be aware of DSTs that are structured with cross-collateralized debt and what that could mean for potential problems if a property or properties underperform. One way to protect yourself is if you are considering a diversified net lease DST portfolio that does have cross collateralized debt it is wise to consider it as a piece to an overall diversified portfolio of completely separate DST offerings so that if something were to happen as in the examples above you only had a smaller portion of your 1031 investment in that one DST portfolio. Oftentimes, investors will seek to place all of their 1031 equity into a single diversified net lease portfolio with debt thinking that this provides them plenty of diversification. However, if things don’t work out as planned that investor will have wished they had utilized a diversified DST offering approach whereby their 1031 equity was placed into multiple completely separate DST offerings.
Balloon Payments: Some loans are structured with a large balloon payment at the end of the loan term. In most cases, the strategy at the end of the loan term is to sell the property and pay off the loan. What happens if the property is not able to be sold by the end of the loan term? The DST sponsor would have to spring into an LLC and refinance the asset. This poses a problem as it could cause potential tax implications for investors as well as what if there is a credit crunch like there was in 2009 and financing is not readily available? This would mean the property would be potentially foreclosed on by the lender and investors would likely lose their entire amount invested. As a way to avoid this catastrophe investors should when at all possible look to invest in DST investment opportunities that are debt free and have no long-term mortgages encumbering the assets. This debt free strategy is one that those not comfortable with the risk of lender foreclosure would be wise to seek out and employ for their 1031 exchange into DST investments.
Debt financing is common in the broader universe of real estate investments. Likewise, an investor may be perfectly comfortable investing in a property that has cross-collateralized debt or pre-payment penalties on a loan. What is important for investors is to know what financing exists on a DST investment in order to avoid any unpleasant surprises. For investors wanting to view available leveraged DST investments as well as all-cash/debt-free DST investments please register at www.kpi1031.com.