Delaware Statutory Trusts (DSTs) can be promising investments, especially for 1031 exchange investors who want tax deferral, passive income, and enhanced diversification. However, like any other type of real estate investment, DSTs are not immune to changing economic conditions.
One of the factors that has a direct effect on DSTs is fluctuating interest rates. Rising or falling numbers have unique effects on DST investment returns, cash flow, and property valuation. In this article, Realized 1031 shares DST 1031 exchange interest rate impact, so you’ll gain an in-depth understanding and see how to implement better strategies. Let’s take a closer look.
The Impact of Rising Interest Rates
In general, rising interest rates do not create favorable conditions for real estate investments. DSTs are no exception during these cycles. The higher borrowing costs, shifting cap rates, and tighter budgets all affect the performance of the underlying assets and, by extension, the DST itself.
Higher Borrowing Costs
The most immediate effect of rising interest rates is more expensive debt services. This is most apparent for DSTs that are just being formed. Sponsors will face higher acquisition and financing costs, which will reduce projected distributions.
For DSTs that don’t follow 1031 exchange eligibility rules and have floating-rate debt, the rising rates have an even more pronounced effect. DSTs that follow Revenue Ruling 2004-86 rules follow fixed-rate debts and aren’t as directly affected once the initial offering is closed.
When the holding period is over, and property disposition begins, higher interest rates may affect DSTs that go the refinancing route. The result is lower sales proceeds for the investors.
Expanding Cap Rates
Cap rate is the ratio of the net operating income over the property’s value. Lower rates suggest stability, and higher rates mean higher risk. When interest rates rise, cap rates also expand. This may result in lower property values since investors see the asset as a riskier investment.
Reduced Buyer Demand Overall
Rising rates at the end of a DST’s life cycle have another effect: slower property disposition due to reduced buyer demand. More investors are hesitant because of the high borrowing costs, leading to delayed sales and concessions from the sponsor. The overall effect is lower distributions for beneficial interest holders.
The Impact of Falling Interest Rates
Declining interest rates are generally more favorable, allowing the DST to perform better and increasing the value of the investment. This environment creates inverse effects compared to increasing rates.
Lower Borrowing Costs
Sponsors can provide more attractive financial projections since the cost of financing is more manageable. These attractive debt terms also incentivise the formation of more DSTs, giving you more options based on your diversification needs.
Dropping Cap Rates
Lower cap rates tend to increase DST values. Investors see compressing cap rates as a signal for stability, making them more likely to invest in a property even though the income stream remains the same. This can be especially beneficial during the property disposition phase of the DST.
More Eager Investors
Declining interest rates make investors more eager to seek real estate assets. This results in stronger market demand for DST assets, leading to higher valuations and driving up sales.
Best Practices for Delaware Statutory Trust Performance
Due to the restrictions in 1031 exchanges, investors aren’t allowed to take any active role during the DST’s life cycle. Instead, you must be proactive before choosing a DST investment to ensure that interest rate fluctuations work in your favor. Here are some signals to keep monitoring as part of your due diligence.
- Monitor the Federal Reserve policy, as rate hikes or cuts often trigger a shift in financing costs and investor sentiment.
- Check lender appetite, as their willingness to extend credit affects DST financing options and projected returns by the end of the holding period.
- Observe inflation levels, which can also affect interest rates. Inflationary environments drive up interest rates.
If you understand these trends and their effects on interest rates, then you can make a more in-depth evaluation of DST offerings and anticipate potential shifts in value. This helps you prepare for the full-cycle event and lowers the chances of unwanted surprises to your overall financial plan.
Wrapping Up: Fluctuating Interest Rates and DST Values
Interest rates are one of the key economic trends affecting DSTs. As the numbers rise, DST valuations lower because of higher borrowing costs, expanding cap rates, and more hesitant investors in property disposition. The inverse is true when the interest rates decline. For investors, having a keen understanding of this cause-and-effect helps set expectations and implement strategies that serve as a cushion to the more adverse impacts.
