In our last post, we discussed how periods of rising inflation can affect commercial real estate assets and how today's rising price environment potentially impacts investment property owners. Depending on the types of properties an investor currently own, and where they are located, they may find that now is a good time to evaluate one’s holdings and determine if one should make any changes.
Broadly, investment real estate has historically performed well during inflationary environments compared to many other asset classes.1 And within the commercial real estate industry, some strategies may appeal to investors who own one or a few rental properties and are concerned about sustaining their cash flow potential as inflation climbs higher.
One of those strategies is the Delaware Statutory Trust (DST), which is becoming increasingly popular among accredited investors selling property using a 1031 exchange. This is because the DST meets "like-kind" property requirements of the 1031 exchange, affording investors the full tax-deferral benefits allowed by the IRC Code. Yet, it also has a few characteristics that may help assuage investment property owners' worries today.
Many rental property owners are worried about how our high inflation will impact their tenant's ability to pay monthly rents. And many owners dislike the task of replacing current renters with new tenants.
The DST investment structure allows investment property owners to sell their property and exchange it into the DST for ownership of a fractional interest in a portfolio of properties. Because these properties are of typically institutional quality and managed by professional management firms, tenant conditions are more favorable for tenant retention.2
If one owns an office building or small retail center, they may have experienced what the industry refers to as "concentration risk."3 Perhaps during the pandemic, they were asked by tenants to renegotiate their leases or even provide rent relief. The office and retail sectors were hit hard during lockdowns.
DST’s often hold different types of investment property in other geographical areas, so their holdings are much more diversified. For example, a DST could hold a sizable multifamily apartment in Austin, Texas, a distribution center in Boston, Massachusetts, and a data warehouse in Orlando, Florida. Owning a fractional interest in multiple properties of different types can help manage investment risk when one property type isn't performing as well as others.
If an investor has a loan on their investment property, ideally it is a fixed rate note for an extended period. That would help a borrower from rising inflation because typically, as inflation increases, so do borrowing costs. But, on the other hand, if an investor needs to secure new financing, they will likely pay more for it today than a few years ago, which could lead to rising operating expenses.
DSTs, however, generally have in-place financing on the properties within their portfolios negotiated at institutional levels. So, by exchanging an existing property into a DST, the need to secure one’s own financing is avoided. And, a DST's debt is considered non-recourse to the investors, so liability is limited.
Often overlooked when the cost of goods increases rapidly is the impact of more expensive materials and equipment on operating expenses. When prices are high, replacing a hot water heater or a new roof could be more costly today than just a year ago.
Since DST’s are managed by professional management firms, the trust and management group manage the expenses incurred to maintain and operate the portfolio's properties. Investors are not required to provide additional capital for repairs and maintenance, as is allocated within the budgets. Perhaps most importantly, investors have no responsibility in operating the properties.
DSTs, as with any investment, carry certain limitations and risks investors should be familiar with prior to investing. As we have discussed here, DSTs may provide current investment property owners additional benefits to consider during periods of rising inflation. And they may also be suitable for investors during periods when inflation is not a concern.
To learn more about how a DST 1031 exchange may help you address your current real estate portfolio concerns, contact our team to schedule a no-cost consultation.
1https://www.blackrock.com/institutions/en-us/insights/investment-actions/inflation-and-real-assets
2Institutional-grade properties generally refer to a property of sufficient size and stature to merit attention from large national or international investors, and typically have the characteristic of high-quality assets in major markets and at price points beyond the reach of individual investors and smaller partnerships.
3Concentration risk is the potential for a loss in value of an investment portfolio or a financial institution when an individual or group of exposures move together in an unfavorable direction.
Because investor situations and objectives vary this information is not intended to indicate suitability for any individual investor.
This is for informational purposes only, does not constitute as individual investment advice, and should not be relied upon as tax or legal advice. Please consult the appropriate professional regarding your individual circumstance. Fortitude Investment Group does not offer legal or tax advice.
There are material risks associated with investing in real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal.
IRC Section 1031, IRC Section 1033 and IRC Section 721 are complex tax concepts; therefore, you should consult your legal or tax professional regarding the specifics of your particular situation.