There are many angles to view how Delaware Statutory Trust debt liabilities are used. We can view it from the investor’s perspective, the lender, or the DST sponsor. DST investors should be familiar with all of them to fully understand the potential benefits of DST liabilities and advantages.
DST liabilities are typically non-recourse, which means that investors are not personally liable for the debt. This can make DSTs a more attractive investment for those looking to avoid personal liability.
Debt is used in DSTs to acquire property. While investor funds can be used to acquire property, taking on debt means there are more funds for property acquisition, opening up new opportunities.
However, like all debt, DST debt comes with risks. Foreclosure is a real risk for DST investors. In the case of a foreclosure, investors lose all of their principal. Foreclosure may occur if the DST defaults on its debt.
Debt payments can also slow down the pace of returns since some cash flow must go to servicing debt.
The risk of a prepayment penalty can occur if the loan is paid early. A knowledgeable sponsor will negotiate good terms for the potential prepayment of the loan. For example, instead of a six-month window to maturity, the sponsor might be able to negotiate a three-year window, which means the loan can be paid off within three years of its maturity.
Balloon mortgages present refinancing risk. In this scenario, the DST cannot refinance the balloon mortgage, resulting in default.
DSTs are pass-through entities, which means profits and expenses flow to the investors. So, any profits that the DST generates go directly to the investors, net of expenses and debt payments.
From this, you can see that if there is no debt to pay, cash flow to investors should increase.
The loan-to-value (LTV) ratio is a value that represents the amount of loan a property has taken on compared to its value. A $10MM property that borrows $5MM has an LTV of 50%.
This is important to DST investors because it affects how their interest is invested. With a 50% LTV, 50% of an investor’s interest goes to property, while the other 50% goes to servicing debt.
A leveraged DST is the same as a DST utilizing debt. As market conditions change, DST revenues may be affected if landlords experience a decrease in cash flow. However, DST debt servicing levels probably will not change. This dynamic can result in lower revenues/cash flows for DST investors during a market downturn.
The DST sponsor might receive an offer to buy the DST properties, which would have been arranged at the beginning of the investment. However, if debt is involved, the lender will likely need to approve any transaction, which could lead to missing out on a favorable deal.
When debt is involved in a 1031 exchange, there are rules that the exchanger must adhere to. Specifically, the debt of the replacement property or properties must be equal to or greater than that of the relinquished property for the exchange to be eligible for tax deferral. This rule applies whether the replacement property is real property or a DST.
Since the relinquished property’s mortgage will have been paid off, the exchanger must take out a new mortgage for the replacement property. There is also the option to use cash instead of taking out a new mortgage. But the same rules apply to the cash amount.
Debt is an important component of understanding the potential risks and rewards presented by a DST. Investors should work with an experienced professional who can thoroughly answer their questions before investing in a DST.