Two major factors determine the profitability of a Delaware Statutory Trust (DST): the underlying property and the tenants leasing the asset. For the latter, one parameter that helps investors and sponsors assess the quality of the tenant is their credit rating. This is an objective grade that tells you about the financial strength of a company, which then informs whether or not they can earn enough to handle rent and contribute to DST portfolio stability.
In this article, Realized 1031 goes in-depth regarding tenant credit ratings to help you understand what they mean and why they matter for investors who want to make smarter decisions. Let’s take a closer look.
What Are DST Tenant Credit Ratings?
Delaware Statutory Trust tenants are often businesses, and their ability to pay lease payments is determined by their financial strength. A credit rating provides a clear idea regarding a company’s ability to meet financial obligations, especially for the long-term lease commitments involved in DST rental properties.
Third-party evaluators assign these credit ratings, taking into account factors like the following.
- Current and projected cash flow
- Total outstanding debt
- Projections of the industry
- Competitive environment
- Management stability
- Historical financial performance
Based on these considerations, the credit rating agencies assign a score to the company. For DSTs, these ratings are critical because — in order to provide steady cash flow to beneficial interest holders — these trusts must have tenants that reliably pay rent and meet contractual obligations. This dependence is acutely felt in arrangements like triple net leases, where the tenant handles all three net operating costs.
Evaluating Tenant Creditworthiness: Who Makes the Ratings?
Companies themselves cannot assign their own credit ratings. For a true objective assessment, sponsors rely on independent third-party firms that specialize in providing these ratings. These organizations evaluate corporations, financial institutions, and government entities using standardized frameworks and decades of accumulated financial data. Three names often come up in these discussions.
- Standard & Poor’s (S&P): S&P ratings are widely used in real estate investments. Their methods tend to be more conservative, so many investors and sponsors trust their ratings for tenant reliability. The ratings range from AAA (highest) to D (default).
- Moody’s: Meanwhile, Moody’s follows Aaa to C for their ratings. Moody’s is widely used for large corporate tenants such as national retailers, healthcare systems, and logistics companies.
- Fitch: Fitch follows a similar rating as S&P, except for the RD rating before D. This represents “Restricted Default,” where a company has defaulted on one financial obligation but continues to meet others.
Companies with AA to AAA ratings are considered to have high-grade credit. Those with BBB or BB ratings are upper to lower medium grade. Meanwhile, businesses with CCC or D ratings are highly speculative and carry the highest risk.
Evaluating DST 1031 Exchange Tenant Risk Through Credit Ratings
For investors, checking the credit rating of tenants before investing in a DST is a critical part of due diligence. Here’s what these grades tell you.
1. Cash Flow Predictability
The most significant impact of a financially strong tenant is the assurance of predictable cash flow. Meanwhile, those with lower ratings have a higher risk of missed payments.
2. Default Risk
Tenants with low to poor credit ratings are more likely to default, resulting in diminished or disrupted cash flow. At worst, the DST may not cover debt obligations until a new tenant comes in.
3. Property Valuation Impact
Creditworthy clients tend to lease high-quality properties. These assets become more attractive to future buyers, resulting in higher valuation once the holding period is over. Not only is there a higher chance for maximum returns, but the disposition process may also be easier.
4. Influence on Debt Terms
Apart from sponsors, lenders assess the credit rating of tenants when negotiating loan terms for the DST. The creditor may allow more favorable interest rates if the tenant has a high credit rating, and vice versa.
5. Transparency and Investor Confidence
Since the ratings come from third-party agencies, investors can gain peace of mind regarding the objectivity of the assessment. This transparency supports stronger confidence in the DST offering.
Keep in mind, though, that credit rating shouldn’t be used as the sole factor in determining the stability of a DST portfolio. A savvy investor will take this grade into account along with other factors like sponsor experience, location demand, and property condition to assess the overall investment.
Wrapping Up: Assessing DST Portfolio Stability Through Tenant Creditworthiness
During DST offering due diligence, one critical aspect to evaluate is the credit rating of the tenants. Those with higher grades tend to be financially strong, supporting the stability of the DST. However, even those with a lower rating can still deliver higher yields, albeit with higher risk. What’s important for investors is knowing how to read these ratings. Having the right interpretations informs your next investment decisions and gives you greater clarity with the investment.
