Is Now A Good Time to Own Debt-Free DSTs?
Free and clear. It is the dream of every homeowner in America – to own their home free and clear of any mortgage. But is “free and clear” all it is cracked up to be in the DST space?
Recently, one of my clients inquired about exchanging from a single-tenant, net-leased property with a 50% loan-to-value (LTV). He strongly believes in the security of owning free and clear property. His initial plan was to replace the debt ($4 million) by investing a portion into a high LTV zero coupon DST and place the remainder of the equity into free and clear DSTs.
What is a Free & Clear Property?
A free and clear property is one that is unencumbered by a loan or mortgage. These property types can be beneficial or hindrances depending on your individual situation or portfolio.
I will say that in a deflationary economic environment, free and clear can often be the best plan. Should any property we invest in decline in value, leverage exacerbates these declines, which can create its own set of problems. Meanwhile, defeasance fees, or prepayment penalties on a loan, can often be an issue, especially in an interest rate environment where the 10-year bond yield is near historical lows. (10-year yields have recently reversed, thus reducing defeasance fees).
I certainly understand the sense of security that comes from investing in properties without a mortgage. Free and clear properties made up a significant portion of my own portfolio when I was investing in Denver and other counter-cyclical markets from 2002 through 2012. Even today I own some real estate investments without debt.
These are all real factors and solid rationales for exchanging into zero coupons, free and clear, or debt-free properties. There are, however, equally good reasons to consider DSTs with moderate leverage currently, and when appropriate. This is particularly true for investors who need leverage to satisfy their replacement requirements.
As I explained to my client, I understand the issues he is worried about, and I regularly run multiple scenarios to better mitigate these risks. The long-term, net-leased zero coupons will likely be held to lease maturity (20 to 25 years). Some of the recent zeros have full amortization of the loan coterminous with the lease maturing, which means the loan will be paid off when the lease term ends. Others have significantly reduced, albeit remaining balances, at the termination of the lease. Recently, I reviewed another zero coupon DST where two of the multiple loans had negative amortization, which in fact adds to the principal balance.
Ultimately, each zero coupon DST needs to be analyzed stringently and individually. Going “all in” to achieve free and clear DST ownership may not make sense right now.
The Benefits of Moderately Leveraged DST Properties
Here are some considerations for use of moderately leveraged DST properties in today’s market:
- Non-Recourse Debt: It is an asset today if you believe we will experience continued asset inflation and a devaluation of the dollar. As DST investors, we are not named as parties to the loans. The multifamily DSTs can borrow from the GSEs (Fannie and Freddie) close to our “real” inflation rate today (some would argue below our “real” rate of inflation). Even with the most recent CPI reading of 1.7% (YoY), the interest rates on multifamily properties are averaging about 100-130 basis points higher (U.S. Bureau of Labor Statistics). Therefore, the real cost of borrowing is extremely low. Given the amount of Quantitative Easing/money printing currently taking place in the U.S. and around the world and given the government’s need to inflate its way out of its monumental debt load, the U.S. dollar already has, and will likely continue to lose value. Congress, the Treasury, and the Fed are “all-in” with Modern Monetary Theory, and this should provide significant tailwinds for continued inflation of assets. As such, a loan of $10 million today will likely feel much lighter when paying it off through a sale in 7 to 10 years (outside of retail, office, and other declining value assets).
- Positive Leverage/Arbitrage: When interest rates are below cap rates, we have positive leverage – our return is higher because we are making money on the banks/CMBSs money. Whenever you can effectively use “other people’s money” to improve your return-on-investment, that is a winning strategy.
- Amortization: I recently refinanced several of my local investment properties with 30-year, fixed-rate mortgages in the mid-2% range. When I reviewed my first mortgage statements, I was taken back. I was used to paying mostly interest at the beginning of a 30-year loan. Now, almost 45% of each mortgage payment is going toward a principal reduction. The compounding effect of interest is much lower at these ultra-low rates, and this helps us – investors – to build equity through debt/principal reduction. Many of the multifamily properties have interest-only periods for three and five years; however, when amortization begins, the principal reduction is much greater than it was in the past at higher rates.
- Debt Service Coverage Ratios & Conservative Leverage: The leverage on multifamily DSTs is typically in the 50% range, and the debt-service coverage ratios (“DSCR”) generally range from 2.2x to 3.1x and higher. These high DSCRs provide a big cushion in terms of occupancy and rents. Of course, we need to stick with the plan of buying well-priced, suburban multifamily properties within high-growth markets and with high barriers to entry to make sure we are best positioned for growth. But, even in situations where rents and occupancy go down, there is a cushion to offset the risk of having moderate leverage.
- Available Properties: There are only so many free and clear DST properties available at any given time. I prefer to review all the available DST properties, both leveraged and free and clear, and then select the ones that will perform best. By limiting properties to only those that have no debt, we are likely excluding some of the best-performing properties.
- Fees & Expenses: The fees and expenses of DST structured properties are significantly greater, as a percentage, for free and clear properties because most fees and expenses are on the equity portion, not the debt portion.
- Free and Clear Properties Have Expenses: The debt service component is only one of many expenses associated with owning real-estate investments. Owning a single-tenant property free and clear still carries the risk of negative cash flow should the tenant leave early, skip rent, and/or not renew their lease. Property taxes, maintenance, capital expenses, leasing, and tenant-improvement costs are among the many expenses associated with any property, whether leveraged or free and clear. Again, for me, I will say that owning investments in well-positioned, suburban, multifamily properties in high-growth, high barrier-to-entry locations with moderate leverage, and high debt service coverage provides greater safety than owning many free and clear commercial properties.
- Close to All-Time-Low Interest Rates: If there was ever a time to consider leverage over free and clear investments, perhaps now is that moment. We are at a point in our economic history where interest rates on mortgages are close to the lowest they have ever been. And given the nascent inflation that is now bubbling, this is probably the lowest they will ever be. Such low rates bring a lower level of risk because of the lower payments on borrowed money.
- Tax Benefits/Depreciation: Properties with leverage provide a great basis to depreciate from because of higher total values achieved through the use of other people’s money/mortgage.
- Impact of Leverage on Profits: My investors and I recently sold out of a multifamily property in the Phoenix MSA. We held it for four years and received a profit of more than 65%. After factoring in the loan/defeasance fees, our return was still 37% higher than it would have been if we owned the property free and clear. Of course, leverage works both ways, and if a property declines in value, leverage makes the decline worse. If we are investing in properties that decline in value though, paying the taxes or choosing other alternatives to reduce or defer taxes might be a better option.
- Assumable Loans: Given the recent narrative and changes in long-term interest rates on U.S. bonds and mortgages, the ability to assume low-rate loans might add value to the investment, as buyers can assume these loans at lower-than-market rates. Not all loans are assumable, of course, but most Fannie Mae loans on DST multifamily properties are fully assumable. That can be very appealing to a buyer and help secure a deal.
- Ease of Financing in a DST: Investing in a DST with leverage is the easiest way to finance real estate investments. Lenders need only qualify the DST as the borrower, not each individual investor. Lenders prefer this less-complex form of lending (as opposed to underwriting each investor) and often provide better rates and terms because of this efficiency. Gathering income, expenses, tax, and property data is a big process with traditional financing and refinancing of investment properties. With a DST, these hassles are completely avoided, making ease-of-financing one of my favorite features of the DST structure – along with lack of any property or lender liability.
Conclusions
Of course, being in a perceived “safe” position with free and clear properties brings peace of mind and a better night’s sleep for many investors. However, if there was ever a time when investors might consider moderate, non-recourse leveraged DST properties now is the time.
To further discuss your DST options, contact us by clicking here.
