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This article is a continuation from RENT Magazine issue Q3’23. 

Built-in Financing

To conduct a complete §1031 exchange, a taxpayer must replace the entire value of his/her rental property, including the loan. A new loan can be difficult for retirees. Their current income often is lower than when they originally took out a loan to purchase their property as a residence. Obtaining an investment loan, as opposed to an owner-occupied loan, may be an underwriting challenge. Taking on new debt also may limit one’s ability to qualify for other loans (e.g., to buy a vacation property or boat).

In DST programs7, the acquisition loan typically is in place before the first investors exchange into the property. All of the loan terms are predetermined, and there are two parties to the loan agreement: the bank and the trust entity. Despite not being a named party to the loan, the individual DST investors each receive “credit” for their share of the nonrecourse loan for purposes of complying with §1031.

Here is a comparison of financing options for a §1031 investment:

Other typical terms5 of DST loans may include:

• 10-year duration
• Interest-only for 4 to 10 years
• Prepayment penalty/yield maintenance
• Initial and ongoing reserve requirements
• 30-60% LTV, with some sponsors offering “zero-coupon” programs at 75+% LTV

LIMITATIONS

Fees and Costs

Like other securitized real estate investment programs, DSTs are more expensive than buying and operating one’s own real estate. The markup on the underlying real estate (typically 8-15%) pays sponsors, affiliates and syndicators to:

• Source real estate from among thousands of listed properties around the United States and performing ongoing market research and data analysis
• Conduct intensive property-specific due diligence and preparing complicated financial models
• Secure, ideally, optimal financing terms
• Engage top property-management companies or, in some cases, utilize in-house property management
• Execute value-add strategies on a massive scale
• Provide ongoing accounting and tax reporting
• Monitor the property and the market to optimize disposition timing
• Apply years or decades of experience from firms that often are large operators of institutional-caliber real estate portfolios

And of course, there is the value to investors of barely lifting a finger to own a fractional interest in a multi-million dollar portfolio of properties.

Illiquidity Risk

Most programs illustrate a pro forma hold period of 10 years, but there is no guarantee of a liquidation date. Under a DSTUPREIT strategy, investors may ultimately acquire shares of a non-traded public REIT with quarterly redemptions. There is no public market for program interests. Once invested, there is only a very limited possibility to seek a buyer for program interests from among the other owners, and likely only at a significant discount to current value. Investors should assume their invested funds will be unavailable for the duration of the program. There is no specified time at which a program portfolio will be liquidated.

Control Risk

DST investors have no control over leasing, financing, management or disposition.

Exchange Risk

The §1031 DST industry relies on IRS guidance that dates back only to 2004. There is not a body of case law or subsequent regulations to provide additional assurances that these programs will comply fully with IRS requirements for §1031 exchanges. Investors are not guaranteed an interest in the program until all agreements are signed and the exchange proceeds are transferred to the program. A purchase may be delayed and may not satisfy the timeliness requirements of IRC §1031.

Performance Risk

DSTs are considered speculative and there is no guarantee that investors will receive any return. Investment may result in loss of entire principal. There can be no assurance that the investment objectives described in the PPM will be achieved. Past performance of other properties cannot be relied upon to assess the future performance of any program. Distributions are not guaranteed and may be sourced from non-income items and constitute a return of capital.

Sponsor Conflicts

A program sponsor and its affiliates are subject to conflicts of interest between their activities, roles and duties for other entities and the activities, roles and duties they have assumed on behalf of the program. Conflicts exist in allocating management time, services and functions between their current and future activities and the program. None of the arrangements or agreements between affiliated entities, including those relating to the purchase price of program properties or compensation, is the result of arm’s length negotiations. A program sponsor and its affiliates receive substantial compensation in the form of fees for acquisition, financing, asset management, property management and disposition. Although a sponsor may have a long track record, the entities it creates to manage individual programs typically are de novo with no operating history.

Leverage Risk

Most programs rely on leverage—an acquisition loan or similar form of indebtedness—to acquire the property. These are generally non-recourse loans, though some loans allow for “bad boy carve outs” in the event an investor commits an act such as declaring bankruptcy or committing fraud. There can be no assurance that the disposition of the property will allow for the repayment of outstanding indebtedness. Leverage has the effect of amplifying any percentage gain or loss on invested equity. If a program does not liquidate before the interest-only period ends (typically five to seven years), loan amortization likely will result in reduced distributions to investors.

Transaction Risk

If the program property or portfolio has not yet closed, there is a risk that the purchase may not be consummated. Especially in the case of new or inexperienced program sponsors, it is possible that the program could be delayed in, or fail entirely to, raise the entire equity offering amount.

Real Estate Risk

Program investors are buying real estate, with all of the risks inherent in any real estate investment, including:

• General acquisition, ownership and operational risks
• Environmental, regulatory, zoning and easement issues
• Increased competition and decreased occupancy
• Unforeseen maintenance, repairs and capital expenditures
• Macroeconomic changes, including interest and cap rates
• Tenant acquisition, retention and re-leasing costs

Although significant due diligence may be performed by sponsors, lenders, third-party consultants, appraisers, broker-dealers and registered investment professionals, this does not ensure that an investment will perform as projected. There may be issues that are not discovered through due diligence prior to or following an investor’s subscription in a passive §1031 program, which may cause an investor to incur losses up to the entire amount of the investment. The risks set forth herein are not exhaustive of all investment risks, and certain programs have greater or different risks than others.

To learn more visit http://1031capitalsolutions.com, email [email protected], or call (800) 445-5908.

Disclaimer: This is not a solicitation or an offer to sell any securities. Private placements are only available to accredited investors (typically have a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last three years) and accredited entities only. If you are unsure if you are an accredited investor and/or an accredited entity, please verify with your CPA and Attorney. Because investor situations and objectives vary, this information is not intended to indicate suitability for any particular investor.

Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services offered through Concorde Asset Management, LLC (CAM), an SEC-registered investment adviser.1031 Capital Solutions is independent of CIS and CAM.