Top Considerations for Analyzing Master Lease Structures in DST Programs

The Delaware statutory trust (DST) structure for real estate syndications qualifying for section 1031 tax exchanges effectively requires the use of master leases for certain kinds of asset classes. Given that fact, and because IRS guidance limits how they can be structured so as to avoid classification as a partnership, it may be tempting to view master lease structures as fungible. But a master lease should be analyzed as more than just a necessary accommodation.

Subtle but significant differences exist across the spectrum of master leases that FactRight assesses in its DST offering reviews.

Who is standing behind the master lease?

Perhaps the most important consideration in a master lease structure is who or what is backing the master lease. This is especially important when financing terms define a monetary default of the master lease as a default under the loan agreement.

Analysts and sponsors may debate whether master leases provide credit enhancement to the deal, but most master lease entities are thinly capitalized, perhaps only through a demand note from the sponsoring entity. Sponsor financial due diligence comes into play here; what is the amount of aggregate contingent demand obligations the sponsor has (or may have in the future), and what liquidity can it access to meet any demand?

The spread between net operating income and what the master tenant owes to the trust as rent under the master lease is something to pay attention to, although it’s true that usually the sponsor has no obligation to retain any such net revenues in the master lease entity. But nearly all master lease structures are designed to make the sponsor money, and usually an operational hiccup at the property will eat into the master tenant profit before it threatens to cause the master tenant to default on its rental obligations to the trust.

In the end, while we do look to see master tenant spread to provide some cushion, the question is whether the sponsor’s share in the cash flows leaves a reasonable return to investors for the risk they are taking on. Cash-on-cash yields across the DST multifamily space should not be considered fungible either—a newly developed Class A multifamily property in an urban core will have a different risk profile (and appropriate yield) than a Class B value-add opportunity in a secondary market.

Different rent levels, explained

Typically, master leases provide for rent at different levels or components. Base rent always covers debt service and any lender-required reserve contribution, and also often (not always) provides a certain cash return on invested equity. Stated base rent figures in the master lease represent an absolute obligation for the master tenant—the amount cannot be reduced or deferred. And for good reason, because base rent’s primary purpose is to keep the trust compliant with the loan.

Sometimes, base rent will cover most of the projected cash-on-cash return to investors. In other sponsors’ structures, much of the cash-on-cash returns will come from additional levels of rent—sometimes called additional or percentage rent. The amount due to the trust under these levels will be dependent on property revenues, not property net operating income, because tax considerations preclude investor return under the master lease to directly depend on property profitability.

The amount of cash flow to the trust under these additional levels of rent is determined by excess revenues over a threshold. A sufficient threshold amount will enable the master tenant to provide for expense and other obligations under the master lease. Amounts over the threshold are often split between the investors and the master tenant. Sometimes, excess amounts are subject to another breakpoint or threshold, after which the split between the investors and master tenant is modified.

Because additional rent is based on property revenues, and not NOI, the master tenant is incentivized to control expenses. One may imagine a scenario in which revenue amounts are realized as expected (and thus additional rent is due as projected), but expenses are higher than anticipated. In this case, the master tenant is put under financial strain and may not be able to pay the full amount of additional rent due to the trust with other capitalization. In most DST deals that FactRight reviews, any default under the master lease would constitute a technical default under the loan. Thus, to avoid this, it is important to confirm there is a provision in the master lease that allows the master tenant to defer payment of additional rent if property cash flow can’t support payment of it, which would be a much better result to investors than having the loan go into default. 

When does the master tenant begin to profit?

With the master tenant on the hook for master lease rent and generally, property expenses, the master lease may serve to align the sponsor’s interests with those of the investors. For the offerings in FactRight’s database, a typical master tenant is projected to earn annual profit equal to 0.60% of investor equity. You should compare the expected master tenant spread with this metric, and consider it within the larger context of the amount of upfront and management fees sponsor affiliates will earn (which are more or less not directly related to ultimate success of the investment).

However, an additional question to ask while assessing the different levels of master lease rent is when the master tenant will start to participate in property revenues. Many master lease structures provide an anticipated amount of cash-on-cash returns to investors before the master tenant gets anything. However, we’ve seen some master leases that enable the sponsor to participate in operational profit once debt service and reserve contributions are provided for, but before the investors see any return on equity. Thus, it’s important to determine how much of the master tenant profit is subordinated to investor return, if any at all.

Still more considerations

Additional complexities of master lease structures abound:

• Although the master tenant is generally responsible for expenses, in some structures, the trust is responsible for taxes, insurance, and utility costs—the so-called uncontrollable expenses. In other structures, the master tenant will cover uncontrollable expenses up to the amounts in the sponsor’s projections, and the trust is responsible for any excess.
• Who is responsible for capital expenditures? Usually, the trust, paid through reserve funds. However, can the master tenant access reserves to meet its own obligations under the master lease? Will that be treated as a loan to the master tenant?
• How does the master lease structure affect investor returns when changes in debt service payments (for instance, when an amortization period begins) or reserve obligations occur during the hold period? (Although typically outside of the master lease structure, pay attention to how asset management fees may change, too.)
• Will the master lease automatically terminate without penalty upon sale of the property, or will the master lease survive, adding economic complexity to sales analysis?

The ultimate consideration in assessing a master lease is whether it provides a fair return while not creating any additional undue risk. Does the master lease primarily enable a DST interest to qualify for a 1031 exchange, or does it unnecessarily distort the risk/return proposition for your investors?