Let’s take this hypothetical situation.
You’ve decided to perform a 1031 exchange from direct real estate ownership into a Delaware Statutory Trust (DST). As an intelligent investor, you perform your due diligence only to find more than one type of DST. There is your traditional DST. Then, there is the Growth DST, which focuses less on cash flow and more on property appreciation. Meanwhile, the Zero Cash Flow DST uses cash flow to pay down property debt.
Then there is the Debt-Free DST.
As the designated title suggests, the properties in such a trust have no debt. Instead, they’re acquired only with cash. Depending on your particular financial goals and situation, a Debt-Free DST can be a good option if you don’t want to invest in a property with a mortgage and want to manage your risk level better.
Because the trust acquired its properties without taking out a loan, the Debt-Free DST can offer lower risk. The trust doesn’t have to pay back the debt. This means there can be less risk of default or foreclosure.
Because the DST doesn’t have to pay back debt, other potential benefits can include:
Higher potential returns. A leveraged DST can be required to pay back the lenders first. But if there is no debt, more cash can be available to distribute to investors. This can mean a steadier – and higher – cash flow for you.
Safety from tenant-rating fluctuations. If a tenant’s credit rating decreases, the lender could sweep the cash flow until that rating improves. This involves directing excess cash toward the loan. As no lender is involved in a Debt-Free DST, no cash flow sweep is necessary when a tenant’s rating declines.
Increased sponsor flexibility and responsiveness. The sponsor can act more effectively in unforeseen situations without being bound by debt requirements or lender mandates. This allows the sponsor to potentially act on your behalf.
All investments have a degree of risk. Debt-free DSTs are no exception. Here are some of the challenges involved with this type of investment.
No interest tax deductions. DST properties allow you to use mortgage interest write-offs to defray your income. That is if your properties have a mortgage. No mortgage with a Debt-Free Delaware Statutory Trust means you can’t take that interest write-off.
Higher fees. Sponsor fees in a DST are based on how much equity is involved. A leveraged DST (in which the properties carry debt) tends to have fees taken only on the equity involved. But with a Debt-Free DST, fees are generally based on 100% of the capital. This could result in more money going to the sponsor.
Additionally, Debt-Free DSTs have other risks, including market fluctuations, which can impact the value of the DST shares. Furthermore, if a tenant defaults or there is property damage, the DST could lose income.
Debt-free DSTs can provide less risk, making them a potentially good option if you’re looking for a more conservative investment.
But before moving forward on the Debt-Free DST path, understand your financial goals and desired rate of return. Also, perform your due diligence and read the fine print. Working with your financial advisor to determine if this investment makes sense is also a good idea.