By now, you may have heard that May rent collections have been stronger than many analysts expected, at least for some real estate asset classes. For multifamily properties—the kind that is most commonly subject to master leases in DST investment programs—rent collections as of the 13th of the month nationally were 2.7 percentage points ahead of where collections were on April 13 for that month, and off 2.1 percentage points from May 13, 2019. And April didn’t turn out so bad—94.6% of renters had made at least a partial rent payment (most made a full payment) by the end of the month, compared to 97.7% during April 2019.
No doubt that professional property managers have adapted significantly over the past few weeks to become more proactive in working with tenants to maximize collections. And those April stimulus checks helped, too. But not surprisingly, as many current and prospective renters have opted to stay where they are, growth of asking rents (and rents from actual leases) are starting to plummet. Some markets, like San Francisco, have experienced asking and effective rental rates dip below where they were in April 2019.
Whether it’s from decreased collection levels or declining new lease rates, it’s probable that net revenues will fall short of projections going forward for many multifamily DST programs. And while property managers work out payment plans with tenants to keep them in the building, and asset managers defer fees to preserve cash flow, one of the most significant defensive levers that a sponsor can pull (and potentially most impactful to investors) is to cut or suspend distributions. Let’s look at when, why, and how likely a sponsor would take that action.
Sponsors are evaluating DST programs for distributions changes on a case-by-case basis. This makes sense given the disparity of performance across property markets and classes. For instance, by mid-April, monthly rent collections for distinct metro areas ranged significantly (rent collections in Salt Lake City exceeded those in New York City by 13.2 percentage points). And performance by class had also varied widely. While Class C apartments struggled with collections, lagging Class A by about 3 percentage points, Class C properties have been much more able to secure year-over-year increases in new leases in mid-April (up 8.1% for the week ending April 26) than Class A (down 7.9% during the same time period).
It’s for another blog post to reconcile these statistics. What is clear is that a one-size-fits-all outlook for multifamily is not particularly appropriate. (One wonders whether and when more policymakers will grasp analogous reasoning in other contexts.) Economic fallout from the pandemic and our reactions to it is not evenly distributed across the multifamily sector, and thus, not all multifamily programs will be impacted in the same way. And some programs may have already been better positioned to absorb the impact than others from a reserve or maintenance perspective.
In light of these various considerations, some multifamily DST sponsors have cut or reduced distributions for some of their programs, but have not changed them for others. Surely there might be pain to come for many that have been relatively unscathed so far, but it’s somewhat heartening to appreciate that generally these assets are in the hands of experienced managers, and it appears that not all investment programs will be “crushed.”
What suspending distributions is really preparing for
But for those programs that have or will experience distribution cuts, it is important to understand what they mean. In this case, we are not ordinarily referring to the suspension of the master tenant’s payment of rent to the trust, to be resumed when market conditions improve. We’re talking about the trust manager holding back rent already received from the master tenant instead of distributing it to investors.
If the master tenant is currently paying rent to the trust, why would the trustee withhold that rent from the investors? Because in situations like these, there’s a heightened likelihood that in the (perhaps near) future, the property will be unable to generate enough cash flow to the master tenant to fully support its rent obligations to the trust under the master lease.
And if funds flowing into the trust start to decrease, the trust’s prospective ability to pay debt service and avoid foreclosure, and properly maintain the property, are compromised.
In other words, a distribution cut should be understood as an action taken to preserve of the underlying real estate investment, done in anticipation of a prospective master tenant default under the master lease. It is not to preserve the tax status of the investment in a DST.
Flex, but not break
As we say around here: the DST master lease is not a credit enhancement. It does not significantly insulate the investors against market conditions. It certainly wasn’t designed with the shock of a pandemic in mind. Instead, it is a creature spawned to enable the program to comply with Revenue Ruling 2004-86, adding risk to (and/or lowering the return of) the deal in exchange for making tax deferral possible.
While it can offer limited downside protection to investors in the short term, generally a master lease is designed to generate a long-term profit to the sponsor to compensate it for bearing the risk that it will have to pay some rent to (or on behalf of) the trust even if property operations are not profitable, which is essentially a required obligation for the lease to be considered a “true lease” for federal tax purposes. The payment of master lease rent cannot be contingent on the property generating net profits.
While the master tenant will have to pay at least some rent regardless of market conditions, in these particular conditions we want the master lease to flex but not break. That’s because in most cases for multifamily programs, breaking means that the loan is thrown into technical default, putting the investors’ capital at risk.
For those programs that have not yet experienced distribution cuts—how likely is it that that their master lease will start to show signs of strain in the future? The way a particular master lease will perform under adverse conditions will depend on how it’s structured.
Different structures, potentially different outcomes
One common type of master lease obligates the master tenant to pay fixed amounts for base rent, from which the trust pays debt service, makes reserve contributions, and distributes cash to investors. The trust receives the same amount of base rent regardless of actual property performance. While in theory this kind of master lease would seem to be the least sensitive to changing economic conditions, in fact it is the most likely to experience a default during poor conditions (unless there is substantial backing to it, such as when a highly capitalized entity provides a guarantee of the master lease). That’s because the master tenant’s obligation doesn’t ease as property cash flow, from which is satisfies most of that obligation, becomes constrained. Sponsor demand notes or other sources of capitalization can provide a backstop for a time. But DST properties were not underwritten, and master leases were not structured, on the expectation that there would be a negative rent growth environment of the kind that we may now be facing.
Another type of master lease sets the amount of base rent to cover debt service and necessary capital expenditures, but nothing else. Actual cash distributions are sourced from additional levels of master lease rent, which become payable once property revenues reach a certain threshold. Thus, a significant portion of the rent can move with the market conditions that impact top line property revenues. In fact, effectively this kind of master lease could automatically result in a cut to investor distributions as property revenues decline without the sponsor having to take any special action, by virtue of decreasing amounts of rent that the master tenant must pay to the trust.
Many master leases are hybrids of these two—with some cash-on-cash yield sourced from base rent, and some coming from additional levels of rent. One feature to look for in any kind of master lease is a possible provision enabling the master tenant to defer a portion of rent payment (perhaps up to all that would constitute the investor distribution portion) if property performance does not support full payment, so long as the amount of rent that is paid covers current debt service. Any deferred rent would accrue interest and would be payable on or before the trust disposes of the property. (Whether deferred rent would be recoverable in the future largely depends on if and how well the property bounces back.)
While a deferral provision is for the direct, immediate relief of the master tenant, it’s an important safety valve for the trust, too, as is most cases, it avoids that master lease default that would trigger a loan default.
Other ways forward?
Here, we’ve discussed the relative likelihood and necessity of distribution changes under different master lease structures. Soon on this blog, we’ll look at some other options that DST sponsors may pursue to help preserve investor capital, whether working within the DST wrapper or potentially outside of it.