The Virus Economy: It Now May Be a Good Time to Diversify Real Estate Holdings

By Chay Lapin, Senior Vice President – Kay Properties and Investments

The entire country is experiencing a national lockdown and businesses have been stopped in their tracks.  This has caused many commercial and residential tenants to struggle with the ability to pay rent resulting in a very unknown and difficult time for landlords. 

According to the U.S. Department of Labor, over 20,500,000 people are unemployed as of May 8,2020. Also, many publications have noted that over 30% of American’s and Corporations could not pay rent in full in April and May 2020. This has put tremendous stress on the owners of multifamily, commercial and single family rental properties. 

Over the years at Kay Properties and Investments, we have stressed the utmost importance of diversification where possible.  In today’s virus economy, the diversification approach has provided some risk management for our clients real estate portfolios. 

The Kay Properties team has spoken to thousands of 1031 exchange investors over the years who have decided to not diversify and to over concentrate their net worth into a single Triple Net Leased (NNN) building. Within the last two months of the pandemic, the feedback that the Kay properties team has received from those investors is that they absolutely should have diversified their real estate holdings. 

Many 1031 exchange investors decide to purchase their own real estate versus diversification due to the fact that they were able to get a higher potential distribution on the properties they purchased on their own. What many investors fail to honestly assess is the risk of chasing higher distributions and cap rates.  In many cases these properties they were purchasing were operated by franchisees or non-investment grade tenants whom now are unable to pay rent due to the pandemic. 

Typically, investment options that have potentially stronger tenants generally do not provide higher distribution scenarios that most investors are looking for. We believe this investor mentality will now change and people will be willing to explore diversification and lower distribution scenarios. It is not to say that “stronger tenants” do not come with a level of risk as we have heard of situations where very strong tenants are not paying their rent in this COVID-19 era and this is where the diversification can come into play. 

Diversification is not just splitting up your investment dollars. There are many potential categories to diversify, a few examples, geographical diversification, political diversification, asset class diversification, tenant diversification and many other factors to consider. 

In most financial crisis’s there are certain areas of the country and tenant bases that are affected greater than others and it can be different for any given reason. We saw this in the 2008 crisis and now are seeing it in the current virus crisis. Furthermore, different areas of the country will recover faster than other areas due to lockdowns ending sooner and to diversify your holdings can potentially help balance these risk factors. 

We recently had a client that was strongly considering investing into 1031 exchange Delaware Statutory Trust properties (DSTs) on the marketplace and was creating a diversified portfolio approach. They were weighing the options of purchasing a few “passive triple net properties” that they would manage themselves or invest into a 1031 exchange DST portfolio with Kay Properties. The investors considered all the options and decided they wanted to manage on their own and that they ultimately wanted higher potential distributions. 

We have had some interaction with these 1031 exchange investors since they closed on their NNN properties that they purchased on their own and from our understanding they are unfortunately having major issues with tenants not paying rent and potentially losing the tenants entirely. The problem here, and with most investors that we see buying commercial triple net buildings, is that they have never owned this kind of real estate previously or had to deal with corporate tenants.   They think that a high cap rate and long lease makes a property good but don’t understand the potential risks they are taking on.

Many clients previously only had experience running their rental homes and multifamily properties and now find themselves pursuing the dream of passive income within NNN properties that real estate brokers have placed a strong influence on. We do not believe that investing in net lease properties is a bad investment (I have owned many NNN properties in my portfolio over the years and continue to do so now) and when you have a NNN property that checks all the right boxes (boxes that many 1031 exchange investors either are unaware of or simply ignore) they can potentially be a appropriate for investors looking for passive income. 

The question for 1031 exchange investors is, “What happens when the NNN tenant does not pay rent or breaks the lease”. Are you prepared to take a large corporation to court? Pay up front for legal fees in a long drawn out battle? Are you prepared to go through the undertaking of backfilling vacant space at a commercial building and pay a broker leasing commissions and tenant improvement costs? There are many “What if’s” to consider for investors getting into the world of NNN properties that ultimately, they have zero experience in and now they are investing a large majority of their life savings. 

When investing into DST 1031 properties, you are truly a passive investor and have a DST sponsor company that manages the day to day operations and deals with all the “What if…”scenarios. Some of the sponsor company managers that our clients have access to on the platform manage billions of dollars of residential and commercial / net lease real estate. There is no guarantee that problems will be solved or guarantee of return but in most cases a large institutional sponsor company will have more potential success dealing with major corporations when issues arise than an individual investor would. For those 1031 exchange investors that thought that a NNN property was the answer to their problems of not wanting to deal with tenants, toilets and trash, COVID 19 quickly said “Think again…”  A diversified 1031 exchange portfolio across multiple DST investments can provide an investor with a way to spread his/her 1031 equity across thousands of multifamily apartment units in dozens of geographic locations throughout the country as well as across dozens of NNN properties leased to some of the strongest corporations in the United States such as FedEx, Amazon, Walgreens, CVS, Fresenius, DaVita, Dollar General and more.  

This approach does not guarantee success however when one tenant has issues from a pandemic, recession,  technology disruption, etc. it does not necessarily wipe out your entire income stream due to the extreme diversification that DST investments can provide 1031 exchange investors.