Extremely low interest rates coupled with the dramatic return of multi-family lending have brought hoards of investors back to the Los Angeles and Orange County apartment markets. According to local multi-family owner/broker William R. Gorman, “the sales and investment activity has intensified over the last 3-4 months at a considerable pace.” Mr. Gorman also stated that “many investors that have been sitting on vast amounts of idle cash have recently shown an increased penchant to return to the investing world and the local apartment markets have been the benefactors of that pent up demand.”
While many of the management firms operating some of the largest apartment complexes have been eagerly pushing rents at their properties, many of the smaller property owners (2-10 units) have been less involved in the run up in rents. There are a variety of factors that may have played into this divergence amongst the owner/managers of large versus small apartment complexes; it is my feeling that emotion is the key contributor.
When you benefit from the diversification that comes with an investment property that has 20+ units, each individual apartment unit contributes a smaller percentage of your overall revenue. Increase rents when one of the unit’s leases rolls over and you run the risk of losing that tenant and any revenue for that particular unit until the apartment is re-rented. In addition to the lost revenue are all of the turnover costs to prepare the unit for a new tenant (paint, carpet cleaning, repairs/upgrades, ect). If you own a duplex and lose one of those tenants due to a disagreement over a rent increase you have lost 50% of your revenue for the period of time that the unit sits unoccupied. If the unit is down long enough, you run the risk of depleting a large portion if not all of the budgeted profits from the investment property for the year.
The owner/managers of larger complexes are more apt to seek rent increases in attractive markets like Los Angeles and Orange County because the rent that may be lost from a single down unit contributes a much smaller percentage of their overall revenues. If a tenant is lost due to a the manager’s desire to push rents higher, the economies of scale provided by the larger number of units in the property works to lessen the blow of losing that particular tenant. Obviously managers of apartments, both large and small, need to maintain awareness of the leasing activity in their local markets to ensure that any rent increase is in line with levels acceptable given the supply and demand factors in that area.
I discuss the role that emotion plays in the investment property sector because, in the end, the majority of investors that have stepped into the apartment ownership game have done so to generate cash flow. If you allow the negative emotions that surround the potential loss of a tenant and the fears of dealing with turnover expenses and releasing of the space, you are likely failing to maximize your cash flow and therefore the value of your investment.
In normal circumstances, a property with a lower net operating income (due to a failure to maximize rents) would likely be worth less to a potential buyer than one where the rents have been pushed up to current market levels. In today’s low interest rate environment, we’ve experienced some divergence from that normal rule of thumb. What has actually occurred is a reduction of the overall capitalization rates (or cap rates) that the new investors require to take on the investment risk of the apartment property. As cap rates decline, the value of the property is increased even though rents and net operating income may be held static. In essence the new investor is willing to pay more for the same amount of cash flow that the current investor is receiving.
Ex: Investor A owns a 4-plex that generates $30,000 of net operating income (NOI) over the course of a year. If that $30,000 amounted to a 6% return on investment, the property would be worth $500,000 (calculated by dividing the $30K of NOI by the 6% cap rate). If Investor B is willing to accept a 4% return on investment (or in other words, a 4% cap rate) given the same $30,000 of NOI, the property would actually be valued at $750,000.
In this example, Investor A has the potential to capitalize on Investor B’s willingness to accept a lower return (or lower cap rate) by selling the asset to Investor B and pocketing the $250,000 difference.
In the event of a sale under the circumstances described above, Investor A would be faced with a decision – cash out and pay the taxes due for the capital gain and recapture of depreciation OR complete a 1031 exchange to defer the recognition of the tax liability into the future. At South Coast, we always recommend that investors seek guidance from their tax counsel before making any decisions regarding this issue. If it is determined that an exchange is the prudent course of action, the investor must then seek out a viable replacement option in the time window allotted under 1031 exchange rules.
The investor can most certainly look out into the local market for a replacement property but they will likely face an unenviable reality – sell high and then buy high. They would be buying back into the same LA & OC market that has heated up due to low interest rates and a significant lack of viable inventory.
The next most likely option is to explore buying an investment property in another market throughout the country where cap rates have not compressed to the extremely low levels that we are experiencing in this area. This may be a good decision but it invariably comes with a new set of risks. 1) Can I really manage the property adequately from a far? 2) Will a 3rd party property manager make the decisions that are in my best interests or will they do what is best for them? 3) How will I source the new property? 4) How will I complete adequate due diligence on a property in a market that I am unfamiliar with?
In any investment, there is going to be risk. Selling the local property to capitalize on what Mr. Gorman has affectionately termed, “dormant equity”, or the equity premium that can be untapped in the sale and put to use potentially earning increased cash flow in a replacement property.
At South Coast, we feel there is a structure that may be a tremendous solution to the dilemma facing local apartment owners that find themselves in a situation like I’ve described above, the Delaware Statutory Trust (DST). A DST is a separate legal entity formed as a trust under Delaware law. If properly structured, the DST will be classified as a grantor trust for federal income tax purposes and, as a result, the purchaser of the beneficial interest in the trust will acquire an undivided interest in the asset(s) held by the DST. Thus, an investor can use a beneficial interest in a DST as a replacement property in a 1031 tax deferred exchange.
The IRS issued Revenue Ruling 2004-86 that set forth parameters a DST must meet in order to be viewed as a grantor trust and qualify for a viable tax deferring vehicle. The following is a list of parameters that the structure must comply with:
- The DST may not sell or exchange property and reinvest the proceeds. The DST does however allow for the individual investors to conduct their own 1031 tax deferred exchange once the DST is liquidated (property is sold).
- The DST may not accept additional contribution of assets. There can be no capital calls added to the DST. As part of the due diligence, a Sponsor would anticipate the amount needed to properly maintain the property over the holding period and that amount would be included in the initial capital raise (and held in reserve until required).
- The DST may not renegotiate the loan terms. The loan terms are finalized prior to the point that the beneficial interest holders acquire the property. In the event that the property is not sold before the loan matures, there are provisions in place to convert the DST to a Limited Liability Company (“Springing LLC”). This allows the Trustee the ability to take the necessary actions to remedy the situation if, for example, the property needed major capital improvements or the loan needed to be refinanced.
- The DST may not renegotiate or enter into new leases. The investors, through the Trust Agreement, enter into a Master Lease with the Trustee in order to avoid having to renegotiate leases or enter into new leases with the actual tenants living at the property.
- The DST may not make major structural changes. Any major improvements will be done or have been done by the seller prior to the purchase of the property. Normal “turn-over” expenses fall within the DST guidelines and do not create an issue with the DST structure.
- The DST must distribute all cash, other than the necessary reserves, to the beneficiaries (the investors). Distributions are made to all beneficiaries on a monthly basis.
The Benefits of Using a DST Include:
- The DST is the single owner and borrower; the lender only underwrites the DST, not each individual investor. The investors do not have to have their own SPE (Single Purpose Entity) as required through other investment vehicles.
- Compared to TICs, the transfer of beneficial interests in a DST can be easier and less expensive.
- A lower minimum investment allows more flexibility for investors to diversify their exchange into several properties.
- The DST allows cash investors (non-1031) the option to complete a 1031 tax deferred exchange when the current property is sold.
- Investors are not required to sign on the guaranties for the non-recourse carve-outs on the loan.
Potential Drawbacks of DST Ownership:
A DST investment is an investment in real estate; any investment in real estate is subject to market value and rental income fluctuations, tenant issues, vacancies, taxes and governmental regulations. There are costs and fees associated with the DST investment and management and the tax benefits must be weighed against the investment costs.
A DST owner does not maintain management control or dictate day-to-day property management operations. DST ownership is also subject to additional IRS regulations that affect the management of the property and your ownership interest. Investors should investigate and thoroughly understand these issues prior to investing.
No public market is likely to exist for such investments, they are not freely transferable and substantial restrictions may apply to the transfer of interests.
So why consider a DST?
Investing in a DST may provide a local investor with the opportunity to add geographic diversification to their real estate portfolio while exchanging from a smaller scale investment property to a larger, institutional quality complex that no longer requires the investor manage the day-to-day operations… including everyone’s favorite Terrible T’s: tenants, toilets, termites, & trash.
If you are an investment property owner and are interested in getting a current perspective on the real value of your property in today’s market and some great insight into how South Coast may be able to help “unlock your dormant equity”, please call the South Coast office today.
All of the information in this newsletter is provided and intended to be used for general educational and informational purposes only and is not intended as a solicitation for you to buy or sell securities. Nothing contained in this newsletter shall be construed or interpreted by any party as a commitment or intent to purchase or sell any products or services; to initiate discussions; or to engage in any business relationship, contract, or future dealing with the other party.
Investors should not invest in DST’s if they cannot afford to lose their entire investment. Due to the lack of liquidity in every DST investment, DSTs are long term investments. The current economic downturn and disruption in financial markets has had a negative affect on real estate net income and values, including both TIC and DST investments. There is no information available as to when, or if, the real estate market will become less volatile, net income will improve, and/or property values will stabilize.
Hypothetical return rates used in the examples are used to help explain the educational concepts more thoroughly and for illustrative purposes only and are not guaranteed; past performance is not a guarantee of future results. Net return rates used in all examples represent an estimation of performance results after deduction for all investment fees & expenses.
Investing in a Delaware Statutory Trust – DST property carries all the potential risks and potential benefits associated with real estate investing, with additional DST specific risks. There is no guarantee that DST net income will flow to an investor as originally projected, and there is no guarantee that a DST property will appreciate in value, or that it won’t go down in value. DST investments are illiquid assets, and there is currently no established secondary market.
Even if an investor gains a large tax deferral from investing in a DST property, if a DST investment makes up a large portion of an investor’s total net worth, a thorough analysis must be completed to determine that the DST investment is appropriate, as a large investment concentration in any single asset is not suitable for many investors. Fees associated with investing in a DST property should also be compared to the overall potential tax benefits and financial benefits, because as fees increase, both tax and financial benefits decrease for an investor.
DST real estate investments are not appropriate for all individuals or all situations. DST real estate investments are only suitable for Accredited Investors as defined in Regulation D of the 1933 Securities Act. Accredited Investors who are individual persons must have a minimum net worth of $1 million, or have $200,000 of annual income if single, or $300,000 of annual income if married, in the last two years, and have a reasonable expectation that this income level will continue in the future. Specific individual DST 1031 Tax Deferred Exchange real estate investments can only be offered for sale through a Private Placement Memorandum, which explains the various risks associated with the offering and should be read very carefully prior to investing. None of this report may be construed as an offer to you to buy and/or sell securities, including DST interests.
In addition, a potential DST investor must meet suitability requirements established and maintained by each individual Broker Dealer. Suitability requirements can include but are not limited to investment knowledge, investment time frame, investment control, liquidity needs, income needs, portfolio allocation, diversification, income risk, principal risk, age, and pre-liquidation fund access. Any investment in a DST property should only be made if the DST property has an accompanying legal opinion stating that the specific DST transaction “should” or “will” qualify for exchange under Section 1031 of the Internal Revenue Code.
None of the material in this newsletter is intended to give you specific tax, investment, real estate, legal, estate, or financial advice, but rather to serve as an educational platform to deliver information; nor is it intended to show you how the strategies presented can specifically apply to your own tax, investment, estate, or financial position, but rather to offer an idea of how these principles generally may apply. This data is furnished with the understanding that the authors and publishers are not engaged in rendering legal, real estate, accounting, estate, investment, tax, financial, or other professional advice or services. Before taking any steps to invest in a DST, or any other investment, you should seek the advice of qualified professional tax, legal, and financial planning advisor regarding your own financial situation.