Various arrangements can occur in a Delaware Statutory Trust (DST), but the passive income and tax-deferral benefits remain the same. One of these structures is the single-tenant DST, which is when the trust owns an asset with a single financially strong tenant. While this arrangement offers stable income and requires less burdensome oversight, tenant default remains a risk that could result in cash flow interruption if it occurs.
In this article, Realized 1031 goes in-depth about tenant default and the associated challenges. We will also talk about protections and remedies that sponsors can employ to help protect investors.
What Happens During a DST Tenant Default
A tenant default happens when the tenant fails to fulfill their end of the lease. Most people associate defaults with missed rental payments, but this issue also includes abandonment of premises and even property damage. Common causes include the following.
- Financial difficulties and bankruptcies
- Operational issues
- Legal issues, such as failure to comply with new regulations
- Market changes that diminish demand
A single-tenant DST has only one tenant, which means that there’s only one source of cash flow. Tenant default will result in immediate cash flow disruption. This issue puts your investment in trouble, especially for those who entered through a 1031 exchange.
Cash Flow Interruption and Its Impact on Investors
When the tenant defaults, cash distribution will likely be halted. At first, your sponsor may tap into the reserves to temporarily maintain distributions and cover net operating expenses. However, these funds will run out unless a new tenant enters.
If the property remains vacant, then investors may face suspended cash distributions. There’s also the possibility of declining property value as maintenance is deferred due to the lack of funds. In the worst-case scenario, liquidating the asset may be necessary. Not only does this erase the investment, but you may also become liable for the deferred capital gains taxes.
Lease Remedies and Sponsor Actions
Tenant default, especially in single-tenant DSTs, is possibly the worst scenario that could happen to the investment. As such, experienced sponsors and master tenants already have strategies and protocols to prevent such an event from happening in the first place. When a tenant default does happen, there are certain contractual remedies put in place to minimize the effects and return to regular operations.
- Drawing on cash reserves provides resources for net operating expenses.
- Working out a payment agreement with the tenant as they recover can provide limited flexibility to master tenants.
- Pursuing legal action if the tenant abandons the lease can help recover unpaid rent.
- Reletting or subleasing the property to a new tenant once the lease has been terminated can generate new income.
What Single-Tenant DST Investors Can Do
Given the passive nature of DSTs, investors cannot intervene when tenant default occurs. Investor protections are in place to help provide confidence and assurance. For example, master tenants only work with creditworthy tenants. The existence of reserves and insurance coverage also helps mitigate the risk.
On the investor’s side, the most proactive step you can take is to select DSTs that have experience in single-tenant properties and the strategies to avoid tenant default. Make sure that you evaluate the private placement memorandum (PPM) and look for lease terms, renewal statements, and the tenant’s financial statements. Check the exit strategies as well, especially when a default occurs.
Wrapping Up: DST Tenant Default Effects and Remedies
When investing in a single-tenant DST, tenant default is always a looming risk. This event could lead to cash flow disruption and other unwanted consequences. Thankfully, a competitive and experienced DST sponsor has strategies in place to minimize this risk and mitigate the effects if default occurs. On your end, it pays to be a proactive investor who conducts due diligence and analyzes DSTs before committing to one.
Sources:
https://www.businessinsider.com/how-a-dst-1031-exchange-works-defer-capital-gains-tax-2024-11
https://www.cobrief.app/resources/legal-glossary/tenants-default-overview-definition-and-example/
