Individuals who are investing in real estate through a 1031 exchange – or investing after-tax dollars – will need to consider investing either in property that has a mortgage or property that has no long-term financing (debt-free).
For clients in a 1031 exchange (per the current IRS code), a property with debt may need to replace the debt obligation in order to fulfill the 1031 equal or greater purchase price requirement.
We have found through the years that investors may not actually understand the various debt structures that they are investing in and that each loan may have different terms and agreements. There are pros and cons of debt.
Often times, cash flow can potentially be higher when you use a debt within your investment strategy. High cash flow can be very attractive to investors, but high cash flow is only attractive until it is not… and this is where investors need to understand how a higher cash flow is being achieved and the risks associated with it.
We typically have seen sponsors use interest-only financing in order to get a higher potential cash flow, risking the large balloon mortgage payment that will be due. There would be no principle paydown in the loan and investors could potentially be stuck with a large loan balance that they will need to replace in their future 1031 exchange.
Cross-Collateralized Loan Obligations
Within the DST marketplace you will find that there are DSTs that have a single asset and there are DSTs that can contain upwards of 20+ properties.
It is important to understand the loan structure when considering investing in a DST with multiple properties that has a debt component. There are two types of debt structures that can be on a portfolio:
- Each property within the portfolio has its own loan, or
- All the properties are connected under one loan, otherwise known as a “cross-collateralized loan.”
A cross-collateralized loan is considered more risky, as it can potentially put a lot of restrictions on cash flow for investors and substantially limit the sponsor’s ability to sell the portfolio on behalf of investors. The DSTs might have multiple properties, providing diversification for investors, but if all the properties are under one loan this does not necessarily provide the diversification that most investors think they are getting.
For instance, there could be clauses within the loan that can significantly affect an investment, such as when a certain amount of properties stop paying rent or go bankrupt, the lender can call the loan or do a cash-flow sweep (meaning that because of one portion of the portfolio is having problems, the entire investment is at risk).
Credit-rating clauses allow a lender to sweep cash flow for a period of time should a certain tenant or a percentage of tenants’ credit ratings drop. For example, you could have a portfolio of net-lease corporate back properties that do not go out of business and do not stop paying rent, but maybe there is a recession or something else affecting the corporate level of your tenant that temporarily drops their credit rating. This gives the ability for the lender to lock all the current cash flow in the lender’s lock box, taking away an investor’s current cash flow.
We also have seen sponsors place a few properties within the portfolio that are not officially investment grade-tenants per Moody’s Standards and Poor’s ratings, and this is misleading to investors, as a non-investment-grade tenant can have a significant default risk.
Lastly, when you have a portfolio of properties under one loan it can potentially limit the ability to sell the portfolio, as in most cases you will need to sell all the properties at the same time. What if a buyer only wants to buy a portion of the properties because they do not like three of the 20 properties included? The sponsor may be forced to reduce the price to make it more attractive to that buyer.
Some sponsors have a strategy of a 721-exchange, which has its own sets of pros and cons.
If a portfolio is debt-free or not cross-collateralized, it can provide more potential exit strategies for the sponsor.
In short, investors that have the ability to stay debt-free can mitigate risks that a loan can bring on a property and its exit strategies. If investors need to take on debt or are comfortable with the risks of debt it is important to understand the pros and cons of the different debt structures available.
About Kay Properties and Investments
Kay Properties is a national Delaware Statutory Trust (DST) investment firm. The kpi1031.com platform provides access to the marketplace of DSTs from over 25 different sponsor companies, custom DSTs only available to Kay clients, independent advice on DST sponsor companies, full due diligence and vetting on each DST (typically 20-40 DSTs) and DST secondary market. Kay Properties team members collectively have over 115 years of real estate experience, are licensed in all 50 states, and have participated in over 15 Billion of DST 1031 investments.