How To Guard Against The Pitfalls Of Financing Used In DSTs Investors should be cautious about taking on any additional debt when investing in DSTs.
By Dwight Kay, CEO of Kay Properties and Investments and the Kay Properties Team
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nvestors going into a DST investment are often laser focused on the property they are buying. Where is their money going – perhaps it’s an apartment complex in Dallas or a portfolio of dollar stores in the Midwest? Investors often “kick the tires” so to speak looking at factors such as the location, occupancy, rental income and credit quality of the tenants. One question that often gets pushed lower on that checklist is what type of financing the property has in place. Debt on the real estate is an important part of the deal, and unlike a home mortgage, financing is not always structured the same. Kay Properties typically cautions clients to avoid taking on any additional burden of debt when investing in DSTs. Taking on an asset with debt is inherently more risky than acquiring a property with no leverage or debt obligation. Yet it is common
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1031 DST Digest
for DST properties to have 10-year financing in place which can potentially help to mitigate 1031 exchange closing risk for investors. In addition, for investors conducting a 1031 Exchange who need to replace debt in the exchange, DSTs are an ideal solution. You don’t have to buy too much debt, and you don’t have to go to a bank to take out a loan or sign personally for that loan. Financing options for commercial real estate properties can span a variety of different structures and terms. When assessing DST investment opportunities, it is important to know whether or not the DST has financing in place, and if so, are there any potential “red flags” associated with that financing. Part of the job of Kay Properties team members when working with investors is making sure that clients are aware that a DST has financing in place, and if so, are there any potential pitfalls that could impact investment performance.
Potential Financing Pitfalls Pre-payment penalties or defeasance costs: A loan might be defeased or paid off prior to the end of the term, such as is the case with a sale. However, some lenders have onerous pre-payment penalties or “yield maintenance” clauses in the loan agreement that protects their financial interests even if the borrower decides to exit the loan early. Foreclosure: If a property underperforms or loses a tenant and is unable to generate enough income to pay its debt service, the lender could foreclose on the property. If that were to occur, investors could lose part or all of their equity investment. For those investors not wanting to face a potential foreclosure and loss of capital the Kay Properties team would advise them to consider debt free DSTs which are also called all cash DSTs. These debt free DSTs don’t have a long-
