As the DST market has grown over the past several years, the nuances of available programs have proliferated. Given the structural requirements of Revenue Ruling 2004-86, these programs do not behave like traditional real estate investments in certain respects. In our experience working with wealth advisory firms seeking 1031 solutions for their clients, understanding the differences among master lease structures in the market can be a common hurdle. Closely related is how a particular structure may behave differently in various performance scenarios, and how the property underwriting interacts with that structure.

This post will serve as the first of two articles on DST proforma analysis. This first piece will examine DST master leases: why they are implemented, how they impact investor cashflows, and a few considerations of their importance in DST program due diligence.

Master lease mechanics 101

Given the general restriction for DSTs to enter new leases or renegotiate existing leases during the hold period, many DSTs will enter into a master lease at the time of acquisition with a master tenant, which is generally a newly formed entity and affiliate of the sponsor. The implementation of a master lease is common, and often necessary, across all real estate asset classes in which the end-tenant lease terms are shorter in duration than the term of the debt obtained by the DST or the maximum term of the DST: multifamily, multi-tenant retail/office, and self-storage, for instance. Under such arrangements, the master tenant will sublease the property to the end tenants, such as residents of an apartment complex or retail tenants of a strip mall, as illustrated below:

While we will not attempt to analyze the full terms or suitability of master leases (the relevant documents and tax opinions are generally available for review), we will examine certain master lease clauses that typically have significant implications on DST cashflows.

The key to modeling cashflows

The key to modeling cashflows under a master lease is being able to segregate the master tenant’s cashflow and the DST’s cashflow. In other words, it’s critical to understand how every dollar of property revenue flows through the cashflow structure created by the master lease. Programs with multiple master leases may create some additional complexities, but we’ll illustrate a simple example to gain a foundational understanding of how to accomplish this. Generally, the master tenant’s cashflows will consist of gross income from the property, rent paid to the landlord (i.e., the DST), and expense obligations (i.e., property operating expenses) as shown below:

The DST’s cashflows will frequently consist of rent from the master tenant, lender obligations (if applicable), reserve contributions (if applicable), and trust obligations (e.g., certain property operating expenses, trustee fees, and asset management fees) as shown below:

The constitution of these cashflows is dictated by the master lease, and understanding the relevant terms is critical for modeling up- and downside sensitivity scenarios for proforma analysis.

Parsing the various levels of master lease rent

The relevant types or divisions of rent in a master lease may be numerous, identified with words like “base,” “additional,” “bonus,” “supplemental,” or “percentage.” Such rents are usually defined in annual increments starting on the effective date of the lease agreement, but stub periods are common as well.

Despite the vocabulary that often varies from program to program, there are essentially only two types of master lease rent:

• Amounts that are fixed ahead of time by the master lease, and
• Amounts that are variable (i.e., not fixed ahead of time), based on the actual gross revenues of the property, and calculated by a formula in the master lease

“Base rent” or “stated rent” is a fixed dollar amount dictated by a schedule in an exhibit to the master lease and may even be tied directly to payment obligations under the loan. Oftentimes, base rent includes an amount in excess of debt service that supports a certain level of cash distributions to investors after payment of trust expenses. Some master leases only include base or stated rent: a fixed amount that covers debt service and the entire projected cash distribution to investors.

However, many master leases include at least one additional level of variable master lease rent. Variable rent amounts are generally set via “breakpoints,” “hurdles,” and “caps” based on gross income from the property set out in an exhibit to the master lease. The rent calculation typically utilizes a percentage factor that prescribes that the rent for a particular bucket may only include a percentage of gross income in excess of a breakpoint or hurdle.

For example, consider the following rent schedule for a given lease year in which the master lease states that additional rent is 100% of gross income in excess of the “additional rent breakpoint” but below the “additional rent cap,” and bonus rent is equal to 50% of gross income in excess of the “bonus rent breakpoint”:

If the gross income from the property for the year is $1,600,000, the total rent owed by the master tenant would be $600,000 ($500,000 base rent + $100,000 additional rent). If gross income is instead $2,200,000, the total rent owed would be $1,100,000 ($500,000 base rent + $500,000 additional rent + $100,000 bonus rent).

Can the DST rent amount be adjusted?

An additional nuance in master leases is the adjustment of rent based on “uncontrollable costs.” Oftentimes, the master tenant will be obligated to cover all operating expenses at the property; however, the master tenant may only be responsible for certain operating expenses up to a budgeted amount (generally, uncontrollable costs consisting of property tax, insurance, and utility expenses). If the actual uncontrollable costs exceed the budget for a given year, the master tenant may be entitled to reimbursement in the form of less rent owed to the DST. Conversely, if the actual uncontrollable costs are less than the budget for a given year, the master tenant may be required to pay additional rent to the DST for the difference.

This uncontrollable cost provision is taking on increasing importance in the era of elevating insurance costs, in many cases exceeding initial underwriting. When present, it is important to carefully assess how insurance costs and other uncontrollable costs are projected as amounts in excess of projection will reduce cash available to investors.

The master tenant’s “rent”

While investment in a DST program can be powerful from the standpoint of tax deferral, diversification, and passive income, especially in comparison to active ownership of a 1031 replacement property, those benefits should be considered alongside costs that can be unique to the DST structure. One such cost is the spread that the master tenant will retain between the net operating income and the master lease rent, which would ordinarily go to the real estate owner in the absence of a master lease.

You may have noticed in our example that the trust is not entitled to all of the gross revenues generated by the property in excess of the bonus rent breakpoint—one common feature of master leases designed to allow profit to the master tenant entity. Another way a master tenant can profit under the master lease structure is if the additional rent breakpoint is set at a level that exceeds the sum of the master lease base rent and projected operating expense obligations, which can also provide some cushion to the master tenant in case the property underperforms. We note that tax counsel often favors some level of reasonably anticipated profit to aid in its “true lease” analysis under the program’s Section 1031 tax opinion.

While DST programs typically anticipate some level of master tenant profit, if underperformance at a property is heavily weighted toward increasing operating expenses, the master tenant may incur a loss in a given year, essentially subsidizing the trust’s cashflow by covering operating expenses that would otherwise be covered by the real estate owner in a different structure. Such potential, however, should be measured against the capitalization of the master tenant as master tenant insolvency is often a material consideration for DST programs.

In its due diligence reviews, FactRight expresses the projected master lease profit as a percentage of investor equity, in order to illustrate the projected cost of the DST/master lease structure in terms of the investor’s cash-on-cash return. Projected annual master lease profits can be up to 50 basis points of investor equity or more, depending on the asset type master lease structure.

Not all NOI is created equal

Understanding how gross revenues flow though the master lease structure to determine rent amounts also requires a grasp of the relative expense obligations of the master tenant and trust. This will include ascertaining which party will bear capital expenditures, leasing commissions and tenant improvement costs, and even certain ordinary property expenses.

Unlike many other real estate-oriented investment programs, the same property-level NOI could produce materially different returns to investors in the DST structure. A critical practice when reviewing a master lease is to determine which factors of underlying property cashflow will impact investor distributions. Will master lease rent be based solely on gross income? Or will certain property operating expenses also have an impact?

Consider the rent schedule previously described, which detailed bonus rent as 50% of gross income in excess of $2,000,000 for the lease year with an added assumption that the master tenant is only responsible for projected uncontrollable costs.

And assume the sponsor underwrote an NOI projection for the lease year of $1,150,000 (shown below) resulting in master lease rent projection of $1,050,000 ($500,000 base rent + $500,000 additional rent + $50,000 bonus rent). In this case, the projected master tenant profit would be the difference between the two figures, or $100,000.

If actual NOI at the property for the lease year in question is $200,000 below the sponsor’s initial proforma projection, the composition of that shortfall will determine its impact on overall DST cashflows. The following $200,000 NOI shortfall scenarios will illustrate the concept:

Scenario 1: The $200,000 shortfall in NOI is entirely attributable to gross income, resulting in a decrease (relative to projections) of $50,000 in bonus rent and $100,000 in additional rent. Total annual master lease rent to the DST would be $900,000 (instead of the projected $1,050,000).

Scenario 2: The $200,000 shortfall in NOI consists of a $50,000 shortfall in gross income, a $50,000 overage in uncontrollable costs, and a $100,000 overage in other operating expenses resulting in a decrease (relative to projections) of $25,000 in bonus rent and $50,000 in other rent amounts to account for the overage in uncontrollable costs. Total annual master lease rent to the DST would be $975,000 (instead of the projected $1,050,000).

As shown above, while both scenarios included a $200,000 shortfall in NOI relative to projections, the second scenario resulted in a much lower impact to the DST cashflows and much higher impact to the master tenant’s cashflows as dictated by the terms of the master lease.

Why should investors care about the impact to the master tenant?

Master tenant entities are newly formed entities and often thinly capitalized. Upfront capitalization generally includes a demand note from the sponsor and sometimes additional amounts from offering proceeds. Important questions to ask may include: How much profit is the master tenant anticipated to have? At what level do expenses exceed the master tenant’s ability to pay them? At what point do such overages, if sustained, exhaust the full capitalization of the master tenant and trigger insolvency, and potentially a default under the loan covenants?

Utilizing the same lease year example, so long as gross income exceeds $1,500,000, the master tenant will have $1,000,000 to satisfy its expense obligations in addition to its master lease rent obligations. If gross income exceeds $2,000,000, it will also retain 50% of all amounts in excess of that breakpoint.

Assuming property operating expense obligations are projected to be $950,000 as previously shown, and gross income does not exceed $2,000,000, actual property operating expenses only need to be about 5.26% above proforma for the master tenant to sustain a net cash loss for the lease year (assuming these overages are not attributable to uncontrollable costs).

Armed with an understanding of how property revenues flow through the master lease structure, you are now ready to undertake sensitivity analysis to identify master tenant breaking points—both in terms of decreased revenue as well as increased expenses—and then assess how probable such scenarios are to occur.

When outperformance does and does not benefit DST investors

If the master lease rent amounts are capped, are the caps high enough to allow the DST to benefit from gross income overperformance? DST programs often include an anticipated hold period of 7 to 10 years. In such time, gross income may greatly outperform initial projections; however, if master lease rents are capped or fixed, the master tenant may be retaining most of the gross income overperformance, which can lead to conflicts of interest in disposition timing between the DST manager and investors if the master tenant is an affiliate.

Importantly, while caps on total rent may be limit DST cashflows during the hold period, the investors would still benefit from property overperformance with an increased value at disposition. At such time, investors will receive their pro rata allocation of net sales proceeds based on their percentage ownership in the DST.

What’s the risk/reward under the master lease?

DSTs are potent investment structures that can provide tax deferral, diversification, and passive income opportunities for investors seeking a Section 1031 exchange while avoiding the complexities of identifying, structuring, and managing their own replacement properties. The implementation of master leases allows for DSTs to acquire more than solely long-term, net-leased assets to accommodate the various needs of investors. While these structures can be complex, the understanding provided in this article can lead to more sophisticated modeling practices and a more accurate determination of risk-adjusted returns as wealth advisors and investors parse the myriad DST opportunities available.

The upcoming companion blog post to this will focus on strategies for analyzing year 1 NOI underwriting in DST programs.

Houston Hyde is an Analyst at Mountain Dell Consulting. Brandon Raatikka is the Chief Operating Officer & Principal at FactRight.