As Delaware Statutory Trust (DST) sponsors acquire assets to include in the DST portfolio, they will use leverage to fund the purchase. Some investors may not care about this detail as long as the DST can deliver its promised returns. However, debt structure can have a major effect on the returns of a DST investment.
Realized 1031 goes in-depth regarding Delaware Statutory Trust leverage to help you gain a better understanding of how it can affect your overall returns. Having a clear understanding of the impact can help you set expectations and make informed investment decisions. Let’s take a closer look.
DSTs are trust entities that own one or multiple income-generating assets. You enter by purchasing fractional interests. Since these beneficial interests qualify as like-kind property, you can also use the proceeds from a 1031 Exchange to participate in the DST.
The sponsor, which is the party that acquires assets and structures the DSTs, can either use all-cash or financing to purchase the properties. If your sponsor follows the latter strategy, the ratio of the debt to equity directly affects the risk and return potential of the investment.
One crucial consideration is that, under Revenue Ruling 2004-86, DSTs cannot refinance to maintain their passive nature. This means that the financing terms will not change for the entirety of the DST’s life. The feature can create stability, but it also limits flexibility if new market conditions arise.
The DST debt structure is the specific combination and layering of debt and equity in a given investment. There are three broad categories for DST investments.
There are a few ways debt structure can affect two key financial elements: cash flow and capital appreciation.
Leverage can enhance returns, especially if the DST uses the debt to purchase more productive, institutional-grade assets. However, debt also introduces interest obligations apart from the debt payments themselves. Together, these two additional expenses reduce the overall cash flow.
Another aspect that debt can influence is how much your capital can appreciate. Leverage can increase property appreciation because a smaller amount of investor equity controls a larger asset. As the asset value rises, the gain relative to the equity also increases. The inverse is true, which heightens the risk associated with highly-leveraged DSTs.
Since refinancing isn’t allowed in DSTs, the end of the loan term — the maturity — becomes a critical consideration. If the debt reaches maturity and the DST hasn’t been able to pay yet, then this might trigger a dissolution event to pay off the debt. Most sponsors will typically schedule asset disposition before or along with loan maturity. Otherwise, a mismatch could result in an untimely sale, affecting the continuity of 1031 Exchanges. You may end up with a major tax hit if early dissolution occurs.
DST returns and financing are financial elements that have a direct effect on each other. While debt is largely fixed, its structure can affect how much investors earn during the monthly distributions. Higher leverage can mean better income, but it comes with increased risk and higher interest obligations. The reverse is true for DSTs with lower leverage.
For investors, it’s important to assess the debt structure to help choose DSTs that align with your risk tolerance and income goals. Your ability to select the most suitable structure from the start can make all the difference in maximizing returns.
https://www.irs.gov/irb/2004-33_IRB
https://corporatefinanceinstitute.com/resources/commercial-lending/what-is-leveraged-finance/
https://www.investopedia.com/terms/c/capitalappreciation.asp