Typically, when the topic of investment real estate is discussed or even thought about, the concept of leverage always seems to be part of the conversation. For example, look at many of the current real estate offerings available in the real estate investment trust (REIT) and Delaware Statutory Trust (DST) space, and it becomes crystal clear that the vast majority of those properties have substantial amounts of debt associated with them.
Surprisingly, very few real estate sponsor firms acquire properties on an unleveraged basis. However, now more than ever, investors should consider debt-free real estate investments as a prudent strategy.
Headlines Show Dangers Surrounding Leveraged Real Estate
Today’s headlines are full of examples of real estate firms that have been forced to relinquish assets because they succumbed to the lurking liabilities of leverage. In many cases, these firms were led by highly skilled executives with years of experience and files of successful transactions. However, even these world-class real estate firms are creating a case for staying debt-free. Here are just a couple of examples in the news to illustrate the point:
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- Recently, one large firm was forced to give a large office campus in the Southwest back to lenders after the private investment firm stopped making the payments on its roughly $300 million loan on the office campus.
- One of the nation’s largest real estate investment firms located in the Midwest is struggling with the bitter taste of lender foreclosure after its bank filed a roughly $100 million foreclosure lawsuit against the real estate firm over a recent investment gone awry.
- After failing to repay its loan on a Class B complex in the South, an international investment firm was forced to turn the asset over to the lender.
- One global real estate firm, recently handed back a large East Coast building to its lender after the building’s anchor tenant left the building.
- Fannie Mae recently announced it was prepping for possible losses in the multifamily housing sector as lenders anticipate loan losses from developers and private equity players who used heavy leverage within the multifamily housing sector.
- In the hotel sector, a prominent New York City hotel developer is facing foreclosure after failing to repay a mezzanine loan to a private equity group.
- An upstate New York lender recently announced it was going to move forward with foreclosure proceedings after the owner was unable to make payments on a large self-storage facility near Midtown Manhattan.
Recent Black Swan Events Expose the Dangers of Debt
Historically, debt-free DSTs have been a good fit for risk-averse 1031 exchange investors willing to forgo slightly higher potential returns for the potential asset security a debt-free investment provides. However, more and more investors are waking up to the reality that investing in leveraged offerings may not be a prudent situation for them and that taking on an extra layer of risk may not be a good choice.
For wealth advisers and investors alike, recent events such as the war in Ukraine, bank failures and, of course, the COVID-19 pandemic serve as reminders that black swan events are real and that using leverage comes with risk. The bottom line is that the risk of lender foreclosure, which is always mentioned but rarely considered a realistic possibility, has suddenly become much more of a reality.
Taking a look at debt from the opposite side of the same coin, during times of higher interest rates, like we’re experiencing now, the cost of debt increases, making debt-free deals potentially more competitive from a return standpoint.
Here are five additional reasons why debt-free DSTs should potentially be a part of a 1031 exchange investor’s portfolio today.
1. Debt-Free DST Assets Provide Investors with Zero Risk of Lender Foreclosure.
DSTs without debt are considered by many to have a much lower risk profile than those with leverage. Debt-free DSTs have zero risk of lender foreclosure, protecting investors from a complete loss of principal invested. Also, debt-free DSTs provide protection from a balloon payment associated with loan maturity, which many real estate firms are very concerned about in today’s market.
2. Debt-free DSTs Give Sponsors More Flexibility to Respond to Unforeseen Circumstances.
On a leveraged property, many asset management and leasing initiatives require lender approval before they can be executed. This limits the real estate operator in the speed at which they can operate the property and, at times, may limit the options available to them.
In a debt-free DST setting, however, there is no lender that needs to approve an asset management or leasing initiative, so the sponsor has the ability to potentially act quickly on behalf of the property and thereby investors.
3. Debt-Free DSTs Have No Monthly Debt Service to a Lender.
A leveraged DST has monthly debt-service payments that must be made first and in full each month, allowing remaining funds to be paid out to investors. In economic downturns, an asset’s revenues may be reduced. The equity investors in a leveraged DST bear the burden of this revenue reduction because debt-service payments must still be made, potentially impairing investor monthly distributions.
4. Debt-Free DSTs Provide Investors the Ability to Diversify a Portion of Their Portfolio into Unlevered Assets to Lower Potential Risk.
Many entrepreneurs who have invested heavily in the stock/bond markets turn to all-cash/debt-free Delaware statutory trust properties as a strategy to diversify away from stocks and bonds. Since these products do not contain the risks of a loan, they are especially interesting to direct cash investors.
5. Debt-Free DSTs Protect Investors From Lender Cash-Flow Sweeps Associated with Tenant Credit-Rating Fluctuations.
In the event a tenant’s credit rating decreases, under certain loan terms, the lender would have the right to sweep the cash flow until the tenant’s credit rating improves. This is a major risk found in many net lease DST offerings with leverage. In a debt-free DST, if the tenant’s credit rating gets lowered, there is no lender to effectuate a cash-flow sweep, thereby potentially protecting investors’ monthly distributions.
In summary, each of these arguments supporting the wisdom of investing in debt-free assets stands on its own. Put them all together, and it is clear that debt-free DSTs are not just a trendy flash in the pan during higher interest rate environments, but an important investment strategy for DST investors for the foreseeable and long-term future as well.
Kay Properties is a national Delaware Statutory Trust (DST) specialty firm. The www.kpi1031.com platform provides access to the marketplace of typically 20-40 DSTs from over 25 different DST sponsor companies, custom DSTs only available to Kay clients and a DST secondary market. Kay Properties team members collectively have over 400 years of real estate experience, are licensed in all 50 states, and have participated in over 30 Billion of DST 1031 investments.
Diversification does not guarantee profits or protect against losses. All real estate investments provide no guarantees for cash flow, distributions or appreciation as well as could result in a full loss of invested principal. Please read the entire Private Placement Memorandum (PPM) prior to making an investment. This case study may not be representative of the outcome of past or future offerings. Please speak with your attorney and CPA before considering an investment.
There is a risk of loss of the entire investment principal. Past performance is not a guarantee of future results. Potential distributions, potential returns and potential appreciation are not guaranteed. For an investor to qualify for any type of investment, there are both financial requirements and suitability requirements that must match specific objectives, goals, and risk tolerances. Securities offered through FNEX Capital, member FINRA, SIPC.
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