A Comprehensive Guide and Video on Why Investors Should Consider Debt-Free Delaware Statutory Trust (DST) Properties

Learn eight specific and compelling issues 1031 exchange and Delaware Statutory Trust investors might not be aware of when it comes to risks associated with leverage.

By Dwight Kay, Founder and CEO, Kay Properties and Investments

In the world of 1031 exchanges and Delaware Statutory Trust investments, mitigating risks where possible is paramount. One strategy that has gained traction among savvy investors is the all-cash or debt-free Delaware Statutory Trust (DST). As the founder of Kay Properties and investments, I have been involved in thousands of 1031 exchange DST transactions that have often included 100% debt-free Delaware Statutory Trusts as a way to potentially avoid some of the pitfalls and risks associated with leverage. Using this deep experience and background as a point of reference, here is a comprehensive guide on why investors should consider debt-free DST properties for either a 1031 exchange or direct cash investment, including ten very specific and compelling issues that could arise with leverage that many investors may not be aware of.

Two Minute Video of Why Investors Should Consider Debt-Free DST Properties

In addition, I recently sat down to record why investors should consider debt-free Delaware Statutory Trust investment real estate to provide investors accurate and detailed answers to the theme of debt-free Delaware Statutory Trust investments. I believe in conjunction with this article, the video is a “must-see” for any potential investor.

Key Takeaways from this 2-Minute Video Include:
  1. What are some of the specific benefits of investing in debt-free Delaware Statutory Trust investments?
  2. Why do so many Delaware Statutory Trust offerings come with leverage?
  3. How did the recent COVID-19 pandemic impact real estate investors?

Compelling Reason #1:

Protection from Lender Foreclosure:

The last thing any investor wants is to lose their full principal due to lender foreclosure. A debt-free DST can potentially act as a safety net, preventing such a devastating scenario as a lender foreclosure. I have personally seen some of the largest DST sponsor companies lose properties to lender foreclosure when an unanticipated scenario arose such as a major tenant bankruptcy. If those DST properties had been debt-free there would have been no lender foreclosure and no full loss of investor principal.

For those investors wanting to sidestep entirely the possibility of a lender foreclosure my recommendation as somebody whose firm has participated in over $30 billion dollars of Delaware Statutory Trust 1031 exchange investments (as well as somebody who has personally invested in over 50 different DST investments from many different DST sponsor companies), is to stay debt free. Why take on the risk of leverage in a DST if you don’t need it? Yes, for those investors needing to replace debt in a 1031 exchange a debt free DST may need to be paired with some DSTs that have leverage in order to achieve full tax deferral. However, allocating at least a portion of you 1031 exchange proceeds to debt free DST offerings helps to lower your overall risk when investing in DSTs.

Compelling Reason #2:

Potential for Higher Projected Cash Flow:

DSTs that are purchased in an all-cash transaction (100% debt-free), often outperform their leveraged counterparts in terms of projected cash flow. For one reason, the absence of monthly debt service payments to lenders helps gives them this edge. Right now, in 2023, the majority of DSTs in the market are leveraged with debt and their corresponding investor projected cash flow is markedly lower than debt free DSTs. Investors who are looking for higher monthly income potential from their 1031 exchange investments should take note and consider debt-free DST options as a better choice. Most real estate investors are focused on their net monthly cash flow potential from any investment and in today’s market, with interest rates being much higher than just 2 years ago, debt free DSTs can potentially provide investors with a greater amount of monthly net cash flow potential. As always, it is important to remember that DSTs, whether those with debt or those that are debt free, have no guarantees for monthly cash flow and that distributions could always be lower than anticipated in DSTs and any real estate investment.

Compelling Reason #3:

Avoid Refinancing Risks:

An all-cash/debt-free DST shields you from the uncertainties that come with refinancing a mortgage. You can steer clear of fluctuating interest rates and other variables that might affect a Delaware Statutory Trust property with a loan coming due. Right now, in 2023 there are billions and billions of dollars of commercial and multifamily real estate debt that is coming due on numerous types of investors: DST sponsor companies, institutional investors such as state pension funds and sovereign wealth funds, public Real Estate Investment Trusts (REITS), real estate private equity firms, syndicators and more. Many of these are loans that were originally 5- and 10-year terms put in place in 2013 and 2018. At the time of those loans being originated, nobody anticipated that interest rates would rise to 7-8% and that refinancing would be such a huge challenge. If those ownership groups had decided to purchase these properties debt free (without a mortgage), they would not be in a situation now where they must either sell prematurely at a potentially inopportune time or be foreclosed on for a full loss of principal invested. This is a risk that could have been avoided by being debt free.

Compelling Reason #4:

Flexibility and Staying Power in Tough Times:

The flexibility of being in a debt-free DST means that you can withstand various economic adversities that may come your way over the years ahead. Whether it's market downturns, credit shortages, recessions, or even depressions, your debt free DST investment can be flexible in a way that leveraged DSTs just don’t have. Many DST investments with mortgages will be forced to spring to an LLC to refinance or to sell altogether at a distressed time in the market with so many loans coming due in 2023, 2024 and 2025. If these DST investments had been debt free the investors and DST sponsor would have had flexibility and staying power to hold through the storm.

Compelling Reason #5:

No Lender Cash Flow Sweep Provisions:

When a lender originates a loan on a DST property, the loan documents often stipulate cash flow sweep provisions. These essentially state that if a triggering event takes place (such as a major DST tenant bankruptcy, the DST properties debt service coverage ratio (DSCR) dropping below a certain threshold, the DST properties occupancy dropping below a certain threshold, a major tenants credit rating dropping below a certain threshold, etc.) that the lender has the right to sweep all excess cash flow (that amount above the monthly debt service amount) and hold in reserve. I have personally seen many Delaware Statutory Trust sponsors with leveraged DSTs (even with modest 50% leverage) and their investors suffer from these lender cash flow sweep provisions.

In fact, over 8 years ago, I personally invested into a DST offering with one of the major DST sponsor companies in the market that had a cash flow sweep provision in the loan documents stating that if the tenant moved out of the building, even if the tenant continued to make monthly rental payments, that all excess cash flow would be swept. The property has performed exactly as anticipated in that the tenant has never missed a rent payment in years however due to this lender cash flow sweep associated with the debt on this DST, investors have not received any monthly distributions for many years.

If this had been a debt free DST, even if the tenant had moved out of the location, investors would have received their monthly distributions on time for as long as the tenant continued to honor the terms of the lease. With a debt free DST, there are absolutely no risks of a lender cash flow sweep. Yes, debt free DSTs (just like leveraged DSTs) still have no guarantees for distributions and/or monthly income potential as well as they can go down in value with the general real estate market, however they do not have any lender cash flow sweep risk.

Compelling Reason #6:

Elimination of Cross-Collateralized Loan Risks:

Certain leveraged DSTs come with the hazard of cross-collateralized loans. This essentially means that even if the DST has five or ten properties in it that it likely has only one loan that covers each of the properties in the DST. If something happened at one of the properties, such as a tenant bankruptcy, this could trigger a cascade effect of defaults even though all the other properties that may being performing just fine.

Years ago, one of the major DST sponsor companies had a portfolio of single tenant net lease properties with a cross collateralized loan on the portfolio. When the major tenant in the portfolio went bankrupt, the entire portfolio was foreclosed on by the lender. The DST investors that had invested into this DST offering lost their entire principal amount invested. If this DST offering had been debt free this would never have happened. Yes, the buildings may have been vacant for a number of months or even years as the DST sponsor proceeded to backfill the vacant space however the investors would not have been foreclosed on and their equity completely wiped out. For investors that are wanting to not have the risk of cross collateralized loans as found in certain leveraged DSTs, the debt free DST option is something they should absolutely consider.

Compelling Reason #7:

No Balloon Mortgage Maturity:

Unlike most leveraged DST properties, all-cash DSTs don't have the looming threat of balloon mortgage maturities. A balloon mortgage is a type of mortgage structure that features regular payments for a set period, followed by a lump-sum payment, commonly referred to as the "balloon payment," at the end of the loan term. For those investors who purchased properties in 2014 with a 10-year balloon, that loan is now coming due to 2024. This could be very challenging as we are experiencing a time when lenders are very skittish making it incredibly difficult to refinance any type of commercial real estate and multifamily asset with rates that are much higher than just a few years ago. The balloon mortgage maturity risk of DSTs with debt is a very real thing that those investors that choose debt-free DSTs do not have to worry about.

Compelling Reason #8:

No Exit Loan Costs or Fees Owed to a Lender:

With an all-cash DST, investors can breathe easy knowing they won't be required to pay lender prepayment penalties, defeasance costs, or yield maintenance expenses. These fees can drastically reduce sales proceeds to DST investors when a DST property is sold. This can make it more difficult for the DST sponsor company to exit the property and provide a potential gain to investors. With debt free DSTs, there are no lender prepayment penalties, defeasance costs, or yield maintenance expenses thereby potentially providing greater flexibility and exit opportunities to the DST sponsor company on behalf of the DST investors.

In conclusion, I have personally invested in over 50 Delaware Statutory Trust properties, and my company has helped thousands of investors nationwide purchase DST properties for their 1031 exchange. My strong conviction and belief is that the debt-free DST investment is something that all investors should consider if they are able to. At Kay Properties and Investments and the www.kpi1031.com marketplace investors are able to access multiple debt free DSTs from numerous DST sponsor companies. For those investors needing to replace debt in a 1031 exchange we have leveraged DST offerings as well, however we always will encourage investors to consider the risks of investing in DSTs with debt.

*Diversification does not guarantee profits or protect against losses.