Delaware Statutory Trust
There are five ownership structures used to co-own real estate [Limited Partnership, Limited Liability Co., Joint Tenant, Tenant-In-Common and Trust (DST/REIT)]. Only two (TICs and DSTs) qualify as “like-kind” for 1031 purposes.
The majority of 1031 sponsors use the DST investment structure primarily because it solves the financing issue inherent in a TIC. In a DST every investor is a co-beneficiary of the trust and the trust is considered one borrowing entity by the lender. There is virtually no limit to the number of co-borrowers. This means a DST sponsor can offer very low minimum investment amounts and purchase much higher valued property and portfolios. At these high values, the quality of the property, location, tenant profile, length of lease and the rate of return can improve. It also means each investor need not gather and provide his or her detailed financial and tax information for the lender. Since the DST is the sole borrower, each investor’s potential personal liability is greatly reduced and, with less complexity in the lending process, lenders may be able to offer more favorable loan terms and rates than for a comparable TIC offering. Additionally, while investors in a DST are not entitled to vote on management of the DST, the threat of a holdout or a rogue investor is eliminated. This stability of management may also have the effect of reducing lender concerns as the lender can anticipate that the trustee will continue operating or managing the Project throughout the holding period. The business plan for most DSTs is to buy and hold for 5-10 years and sell when there is an opportunity.
The Internal Revenue Ruling 2004-86 names seven deadly sins that limit the Delaware Statutory Trust (“DST”) trustee’s power. These regulations provide additional protection and benefit to the beneficiaries by ensuring the trustee distributes funds properly to beneficiaries and does not take unnecessary risks with the DST’s assets:
1. Once the offering is closed, there can be no future equity contribution to the DST by either current or new co-investors or beneficiaries.
2.The Trustee of the DST cannot renegotiate the terms of the existing loans, nor can it borrow any new funds from any other lender or party.
3. The Trustee cannot reinvest the proceeds from the sale of its investment real estate.
4. The Trustee is limited to making capital expenditures with respect to the property to those for a) normal repair and maintenance, (b) minor non-structural capital improvements, and (c) those required by law.
5. Any liquid cash held in the DST between distribution dates can only be invested in short-term debt obligations.
6. All cash, other than necessary reserves, must be distributed to the co-investors or beneficiaries on a current basis.
7. The Trustee cannot enter into new leases or renegotiate the current leases.
The Master Lease
While the DST has several benefits, its potential scope of utilization is much narrower than that of the TIC structure. Traditionally, the DST structure has been only utilized for limited types of properties such as a single-tenant, triple-net leases or, as the use of DSTs is beginning to expand, multi-tenant properties under a long-term master lease.
In a master lease, a master tenant (usually the sponsor or affiliate of) will lease the property from the trust, and pay rent (master lease payment) to the trust. The master tenant, then sublets the property to the tenants, and in effect can legally circumvent the operational restrictions mentioned above (deadly sin #7).
In the master lease structure, the master tenant (effectively the sponsor) pays a pre-determined “rent” to the trust, covering the debt plus a specified return. The master tenant is entitled to keep all the property level net income that is above the debt service and master lease payment. This structure provides aligned interests, because the master tenant is incentivized to maximize rents and avoid income shortfalls.
It is also important to note because there is no real ability to negotiate changes in the master lease terms and rent payments with the DST trustee, the sponsor typically reserves more capital upfront for any unanticipated repairs and expenses. These reserves are in addition to the typical lender required reserves.