Delaware Statutory Trusts (DSTs) have become a popular investment vehicle for accredited investors seeking to diversify and take a passive investing approach in their real estate portfolio. Many turn to DSTs for their tax advantages, passive income potential, fractional ownership benefits, and access to institutional grade properties in various markets across the country.  The performance of the DST is not solely reliant on the properties it holds.  Naturally, the financial tools employed, like debt structure, reserve accounts and more, play a vital role from the very onset of what becomes a positive experience for investors.  Let’s dive into the significance of financing, and in particular, bridge loan terms to better understand their role in DSTs and what may affect the property and its investors.

Understanding Bridge Loans in DSTs

Bridge loans, also known as interim financing, serve as a short-term funding solution that “bridges” the gap between the acquisition of a property and the permanent financing, after the offering is fully subscribed.  In the context of DSTs, these loans are often used to acquire a building, allowing the sponsor who is putting the deal together to secure valuable assets without a prolonged waiting period for the DST to come to market.

Key Elements of Bridge Loan Terms

Flexibility in Repayment (& Prepayment):

One of the critical aspects of bridge loan terms is the terms of repayment.  DST sponsors repay the bridge loan as investor money comes in.  This provides flexibility for the unpredictable nature of real estate transactions, and at the same time, uncertainty given the unforeseen length of the capital raise period.  Another important item to look into is prepayment penalties to see if the loan terms allow for reasonable prepayment without exorbitant penalties.  DST sponsors who utilize bridge loans strive to better position themselves to capitalize on opportunities, and attempt to keep any rents that are being collected from the tenants to continue flowing to the investors as the beneficial owners in the trust.

Interest Rates and Costs

We’ve been in an interest rate environment where rates have doubled over the past 18 months. Favorable interest rates and costs impact the financial health of DSTs, and the opposite can also be true.  Lower interest rates contribute to reduced holding costs during the bridge loan period, which helps to maximize potential returns for investors.  Bridge loan market interest rates usually begin at least one point higher than the Prime Rate (currently at 8.5%).  Understanding the current interest rate market helps investors to make more confident decisions.  They should discuss with their DST advisor the associated costs, such as origination fees and closing costs, to ensure that the DST is in a good position to reduce or eliminate unnecessary risks.

Term Length

The duration of the bridge loan term goes hand-in-hand with repayment terms, which can significantly impact the performance of the asset, especially if that property is in a DST.  A well-calibrated term length allows sufficient time for the sponsor to raise enough capital or sell the property without incurring excessive penalties.  Striking the right balance between providing ample time and avoiding unnecessary extension costs is a delicate balance, as the bridge lender can sometimes take the asset if the Sponsor cannot service the debt.  This can lead to a huge problem for DST investors.  If a bridge lender takes control over the asset, they could convert the DST into an LLC, which has the potential to leave 1031 exchange investors with a massive capital gains tax problem.

In other words, it’s important for DST investors to talk with their advisors to better understand the loan structure on the DST and what potential tax risks they could be faced with if the deal goes South.

Loan-to-Value (LTV) Ratios

One of the many benefits of DSTs and reasons why so many investors use these offerings as solutions to their 1031 exchange, is because debt on DSTs is assumable and non-recourse. Generally speaking, an accredited investor who is needing to replace some debt, can use the DST to satisfy those LTV requirements, which can be daunting when trying to work through underwriting, due diligence, acquisition, and loan applications on their individually owned property while simultaneously trying to complete a 1031 exchange on time.

Typically, more debt on a property means less initial cash flow.  The reason why is because you’re paying more in debt service when you first take ownership of the property.  The same can be said of DSTs which normally have a set time of Interest Only (I/O) payments when the deal is inked.  Some deals have 10 year I/O debt while others have a few years followed by principal and interest.  Sponsors who use I/O debt in their DSTs can usually seek to offer higher starting cash flows than those that don’t.  When bridge financing is in the picture, that can change.

Bridge loans are usually higher cost loans and are for shorter terms (remember: Prime Rate + 1 point = 9.5% at a minimum).  If a sponsor is using bridge financing to acquire a property to then put into a DST, it’s important to know how much was borrowed and how the cash flow on the deal can be affected, especially when the DST LTV is between 40% and 50%.

Conclusion

Bridge loans can be both good and bad in DSTs.  Sponsors must carefully evaluate and negotiate these terms to ensure a balanced, flexible, and financially sound approach to the deal and for their investors.  It behooves investors to ask the right questions to better understand what the terms are on each loan and how that financing is affecting the deal, the cash flow and the overall structure of the DST.  Recognizing these pieces when considering a DST for a 1031 exchange can’t be overstated. Equally as important is to work with someone who knows this space intimately who should help point you in the direction.

Written by Derek Vogel