After taking a back seat to tenant-in-common (“TIC”) structures prior to the financial market meltdown of 2008-2011, the Delaware Statutory Trust (“DST”) structure has become the vehicle of choice for real estate investment programs structured to qualify as replacement property under Section 1031. DSTs present unique issues and challenges to lenders, which Seyfarth Shaw, as a firm that regularly counsels both program sponsors and lenders, is particularly well positioned to resolve.
This article briefly describes the rules applicable to DSTs and the landscape faced by lenders seeking to make loans to such entities.
The DST Structure
The DST as a vehicle for Section 1031 exchanges was blessed by the IRS in Revenue Ruling 2004-86. In this ruling, the IRS held that a beneficial interest in a DST that owns real estate will be treated as a direct interest in real estate, and thus “like kind property” with other real estate for purposes of Section 1031, if certain conditions are met.
From the lender’s perspective, the DST structure varies from the TIC structure in two important ways:
- Management and control of property ownership: The TIC structure requires unanimity of multiple investors for certain critical decisions. In contrast, all decision-making authority for a DST is held by one person: a sponsoraffiliated trustee. As a result, DSTs are much more agile decision makers than TICs.
- Structural simplicity: The TIC structure requires a Tenancy in Common Agreement to which the investors are parties, deeds to each investor, a management agreement or master lease, and the execution of loan documents by the investors. By contrast, in a DST structure, the real estate is owned by one party and there is only one borrower on the loan documents -- the DST. As a result, it is much more efficient to close and manage a loan to which a DST is a borrower.
Nevertheless, there are meaningful restrictions on DSTs. Specifically, in order to qualify as replacement property for purposes of Section 1031, DSTs must be designed in a way that prevents the DST and its trustees from violating the “seven deadly sins.” This means:
- A DST cannot raise new capital after the initial offering closes.
- A DST cannot renegotiate or enter into new financing unless there is a tenant bankruptcy or insolvency.
- A DST cannot renegotiate any of its leases or enter into new leases unless there is a tenant bankruptcy or insolvency. Note that this restriction can be circumvented for multifamily, self-storage and other high-turnover, multi-tenant properties through the use of a master lease structure. In a DST master lease, the master lease is a long term triple net lease between the DST and a sponsor- affiliated master tenant. The master lease is designed so that the master tenant can enter into subleases with space tenants at the property.
- A DST cannot reinvest the proceeds from the sale of its property.
- A DST cannot redevelop property and is limited to preforming only normal maintenance and minor nonstructural repairs unless required to do more by law.
- A DST must hold its reserves in short-term debt obligations.
- A DST must distribute all cash, other than normal reserves, on a current basis.
If an issue arises that a DST cannot address without violating these “seven deadly sins,” the trust agreement for the DST requires it to convert into an LLC, which can then undertake actions the DST itself is not allowed to do. To avoid the risk of a “comatose” DST, the loan documents and the DST’s trust agreement can allow the lender to cause the conversion of a DST into an LLC.
Due to the limitations imposed by the “seven deadly sins,” DSTs are not appropriate investment vehicles for all property types. They are best suited for properties with long-term, triple-net leases to creditworthy tenants. They can also be used for properties with more frequent leasing cycles through the use of the master lease structure described above, including student, multi-family and senior housing, hospitality and self-storage facilities.
Although DST structures are now accepted by many lenders, including several CMBS lenders, for Section 1031 investment programs, they do present certain challenges to lenders. Among those challenges:
- Limited ability to address emergencies: The inability of the DST to raise additional capital, refinance, renegotiate existing financing or enter into new leases (except in the limited circumstances described above), limits the DST in responding to emergency situations. Nevertheless, in the experience of the authors of this article, because most property problems are the product of tenant cash flow difficulties that signal a tenant insolvency, most property problems can be dealt with within the DST structure. To address those situations where a DST cannot address those problems, the DST would convert to an LLC, as described above. As a result, heading into transactions, lenders should understand the conversion process and pre-approve the LLC Agreement, which is typically attached to the DST’s trust agreement. One point of interest is that, under Delaware law, the conversion of a DST to an LLC is a “single entity” reorganization that does not cause an actual or deemed transfer of the DST’s property.
It is important to note that the conversion does not result in a change of control of the property; rather, it is merely a change in the form of ownership. The sponsor-affiliated trustee of the DST becomes the manager of the LLC with the same scope of authority as it held in its capacity as trustee. Even though a DST to LLC conversion does not technically result in the transfer of the underlying property for Delaware state law purposes, lenders typically require a date-down of their title insurance policies and an acknowledgement of the LLC’s position as borrower under the loan documents.
Once lenders understand the conversion process, including the fact that the borrower essentially remains unchanged other than its entity form, they are typically able to get comfortable with the DST structure.
- High sensitivity to partnership characterization: DSTs, like all investments intended to qualify as replacement property for purposes of Section 1031, must constitute direct interests in real estate and not interests in a tax law partnership. As a result, loan arrangements and documentation must be sensitive to issues that give rise to a risk of partnership characterization for the DST investment, including the issues described below:
- Who is the borrower?: In non-DST structures involving long term “triple net” master leases, lenders may require the master tenant to execute the note, and may obtain a leasehold mortgage from the master tenant in respect of its leasehold interest. However, such arrangements cannot be used in a Section 1031 investment because they make the master tenant a co-borrower with the DST, and thus raise significant risks of loss sharing as between the investors and the master tenant. Lender concerns are often satisfied, however, through an assignment of leases and rents by the master tenant and a subordination agreement from the master tenant, and by other vehicles that place cash flow from an investment under the effective control of the lender in a default situation.
- Limits on bridge financing: For a DST to qualify as replacement property in a Section 1031 exchange, only the DST can be the borrower on the permanent financing. In addition, the DST cannot borrow additional funds if bridge financing is needed to acquire the property. This is because such financing would be treated (on the look-through basis applicable to DSTs) as undertaken by DST investors themselves, which could raise potential tax problems for the investors. To resolve this issue, the sponsor-affiliated entity that is the initial owner of the unsold beneficial interests in the DST can obtain short term financing and pledge the unsold DST interests as collateral for such financing. Under this arrangement, the bridge financing would be paid down with proceeds from the sale of DST interests to investors.
Although DSTs present certain challenges to sponsors and lenders, those challenges generally can be addressed without jeopardizing the Section 1031 treatment desired by investors. Furthermore, in the aftermath of the financial market crisis of 2008-2011, it is now commonly understood by the investment and finance communities that work with Section 1031 investment programs that the burdens of the DST structure are counterbalanced, to a significant extent, by the unified management and structural simplicity that DSTs present over TIC ownership structures. As a result, DST structures are growing in popularity as a Section n 1031 investment vehicle for sponsors, lenders and investors.