These days, we’re seeing increasing innovation in anticipated exit strategies for DST programs. With real estate values currently hovering near or at record highs, and the expectations that rising interest rates will someday take capitalization rates with them, it’s easy to see why sponsors are focusing on exit strategies—today’s products need to be designed to return investor capital in an uncertain tomorrow (while enabling future tax deferral).
Let’s take a look at some key considerations in evaluating a DST program’s exit strategy and factors that will affect net sales proceeds to investors.
The breakeven prospects
The main objectives of a DST investment programs are typically tax deferral and current income, but full return of capital is not far behind. Breakeven analysis is one of the more critical operations we undertake when FactRight reviews a DST program. Breakeven risk is exacerbated by the DST fee and expense structure—of total investor equity, perhaps only 85% will actually be used to purchase the real estate, which means that the property must appreciate a certain amount by the time of sale to be able to return 100% of investor capital.
Of course, other factors may affect net sales proceeds, including costs of sale and the amount of loan amortization during the hold period. But with offerings utilizing interest-only financing more frequently to optimize the attractiveness of current yields, and cap rates expected to rise over the next few years, net operating income (NOI) growth is perhaps the most likely path to the property appreciation needed to overcome the load.
Assets with relatively short-term lease cycles that are poised to capture market rent growth in real time, like apartment complexes and self-storage facilities, may be expected to experience respectable NOI growth over the hold period—as long as rent continues to increase. Because these are management-intensive assets, NOI growth may also depend on the sponsor realizing operating efficiencies. And while the capitalization rate environment at sale will still have critical bearing on breakeven for these assets, most often the cap rate needed to fully return equity to investors for them—assuming the sponsor’s projected terminal NOI is not overly-aggressive—is higher than the rate at which the trust acquired the property.
However, assets that are encumbered by long-term net leases (like industrial, office, or retail) are often a different story. Now, these kinds of leases can offer many pluses, but typically they do not provide sufficient rental increases during their terms to result in enough property appreciation (all other things being equal) to enable full return of capital. Thus, most of the net lease offerings we review are dependent on unlikely cap rate compression to return 100% of equity to investors.
So, what can the sponsor do, for net leased assets especially, to mitigate breakeven risk and enhance investor returns at exit?
Fee subordination can only go so far
First, we’re seeing more DST sponsors subordinating their disposition fees to full return of investor capital. Of course, that’s a welcome, investor-friendly innovation that better aligns the sponsor with investors. However, note that often subordination won’t make enough of a difference, and the sponsor will earn substantial compensation during the life of the program regardless of what it takes on the back-end. Still, it’s a best practice to look for.
Attempt to capture a portfolio premium
Many programs’ investment objectives and potential exit strategies now include some type of portfolio aggregation. For instance, the sponsor may be a serial syndicator of similar types of assets, and intends to effectuate exits for several of its programs at the same time through sale of a combined portfolio. The idea is that because the sponsor has assembled a portfolio of assets that are perhaps diversified by geography or tenant, or which may allow for operational or managerial efficiencies, the portfolio will command a premium over the summed values of the individual properties. This premium will then make the difference to overcome the load.
This makes a good amount of sense and there often appears to be reasonable prospects for realizing a portfolio premium down the road (although note that in some cases prospective buyers might actually require a portfolio discount). But of course, the sponsor’s ability to execute on this strategy is speculative, given that future market fundamentals are currently unknown. Factors to look for are whether the sponsor has experience managing and disposing of real estate over multiple cycles, whether the sponsor is on its way to amassing a sufficient portfolio (or already has done so), and who the potential buyers of such a portfolio may be (and in the case of prospective public REIT buyers, whether the assets would be accretive to their efforts to maintain dividends to investors).
And even if aggregation makes sense on the sponsor’s portfolio level, it theoretically may not be in the best interest of any individual DST program, although if it enables the full return of capital for all programs involved, it’s likely a success for everyone.
Can sponsors offer other benefits at exit?
Not only may a sponsor aggregate its management portfolio for sale to a third party, but it may also organize a new investment entity in the future to acquire the portfolio. This strategy, too, may provide for a portfolio premium. Or else, a sponsor may already manage a diversified investment program like a non-traded REIT that has a future purchase option on the asset being syndicated through the DST. In either case, the DST investors will likely be given the ability to acquire interests in the entity through a tax-deferred section 721 exchange.
The sponsor will market this strategy as a future opportunity to invest in a diversified investment program. A key consideration should be whether the DST investor may be suitable for the program that could eventually acquire the property, especially given that an interest received through a 721 exchange cannot subsequently be exchanged in a tax-deferred transaction when that diversified investment program has its own liquidity event.
However, most often, DST investors will be given the option to take cash for their trust interests, which could be used for a subsequent 1031 exchange, in lieu of receiving an interest in the diversified program. Obviously, a key thing to keep in mind is that either way, the sponsor is facilitating an affiliated transaction. As such, the transactional mechanics must be assessed for fairness.
Do trust documents require that the sales price—paid either in cash or interests in the investment program—be supported by an independent appraisal? How current must that appraisal be? How will fair market value of the investment program’s interest be determined for purposes of a 721? Often, the sponsor will have discretion in determining these values, but remember it is serving two masters—the DST investor group, and the shareholders of the acquiring entity.
The mechanics of the DST investors’ election must also be considered. In many programs we review, the DST investors are deemed to have consented to receive interests in the acquiring entity unless they provide a written dissenting notice to the trustee/manager within a relatively short time frame. And they may not receive their cash until some time after the consenting investors have been closed into the investment entity.
Other factors will impact return of capital to investors
Of course, total sales proceeds and disposition timing will depend on other factors, including return of reserves and loan terms. In fact, we’ll do a blog post soon on the various prepayment lockout terms and penalties we see in current DST financings, as well as other items to look out for in assessing back-end prospects. Even though it’s hard to predict just how well DST investors will fare at an exit years down the road, it’s still important to address the variables that will determine the outcome.