How Master Tenant Lease Structures Work in Your DST Investment
Navigating IRS Lease Restrictions in Delaware Statutory Trusts
Key Takeaway
Master tenant lease structures allow DSTs to navigate IRS lease restrictions while maintaining 1031 exchange compliance. The DST leases the entire property to a master tenant (typically a sponsor subsidiary), which then manages all subleasing activities. While this provides operational flexibility and stable income for DST investors, it creates complex three-tiered rent structures and concentration risk that requires careful due diligence and conservative underwriting.
In our previous article, we explored the Seven Deadly Sins of DSTs, including the critical restriction that prohibits DSTs from negotiating new leases. This poses a significant question for investors interested in passive real estate investments like multifamily or self-storage properties, which often have leases turning over frequently. What happens if a tenant in a single tenant triple net lease DST property goes bankrupt or doesn't renew their lease?
The answer lies in the Master Tenant Lease structure. If you're involved in structured real estate investments, particularly DSTs, understanding the Master Tenant Lease is crucial. It can offer stability and encourage a conservative operating strategy, but it also comes with its own set of complexities and risks.
The Challenge: IRS Lease Restrictions and DSTs
The IRS's guidelines for Delaware Statutory Trust properties are strict, aiming to ensure that the DST maintains its "passive" nature. This means the DST cannot actively manage the property, which includes the inability to renegotiate or enter into new leases with individual tenants.
So, how do DST properties like multifamily complexes or self-storage facilities, where tenant leases can turn over annually or even daily, maintain their compliant status? And how are single tenant triple net lease properties protected if a tenant defaults?
Critical Compliance Issue
Without a solution to the lease restriction, DSTs would be limited to properties with very long-term, stable leases, severely limiting investment opportunities in popular asset classes like multifamily and self-storage properties.
The Solution: The Master Tenant Lease Structure in DSTs
In response to lease restrictions, sponsors implement the Master Tenant Lease structure. Essentially, it's an agreement where the DST, as the property owner, leases the entire property to a single entity: the master tenant. This master tenant is typically a wholly-owned subsidiary of the sponsor.
The master tenant then assumes the responsibility of subleasing the property to individual tenants. This clever arrangement ensures that the DST itself remains a passive entity, compliant with IRS regulations, while the property can be actively managed.
How the Structure Works
DST owns the property and maintains passive investor status
Master tenant leases the entire property from the DST
Master tenant subleases to individual tenants and actively manages
DST receives consistent rental income from master tenant
Major Benefits for Investors
1. Flexibility for Sponsors
It allows the sponsor, through the master tenant, to manage multiple subleases, handle tenant turnover, and perform property management without compromising the DST's 1031 exchange status.
2. Predictable and Stable Income
DST investors receive consistent rental income from the master tenant, regardless of the occupancy levels of the individual subleased spaces. This steady cash flow is particularly appealing for those prioritizing predictable income from their passive real estate investments.
To ensure the effectiveness of the Master Tenant Lease structure, sponsors must maintain adequate reserves and underwrite conservatively. This ensures the base rent is consistently provided to the DST, protecting investor distributions.
Complexity of the Three-Tiered Rent Structure
One major concern is the inherent complexity. Often, there's a three-tiered rent structure: base rent, additional rent, and bonus rent. Distribution forecasts in the pro forma are a combination of these tiers. Sponsors employ varying revenue strategies, and some may be entitled to a percentage of one or more of these revenue tiers.
Base Rent
Guaranteed minimum rent paid to the DST regardless of property occupancy
Additional Rent
Variable rent based on property performance above base rent threshold
Bonus Rent
Performance-based rent when property exceeds optimistic projections
Critical Due Diligence Point
It's crucial for investors in Delaware Statutory Trust offerings to understand how cash flow is actually distributed to them and how the sponsor earns their revenue. This transparency helps to uncover potentially obscure DST risks or unpleasant surprises when cash flow is calculated.
Challenges and Risks: Understanding the Master Tenant Lease
While stable income is a significant draw, it's essential to understand the potential DST risks and complexities this structure introduces:
Inflexibility of the Master Lease
Another critical risk in the DST structure is that the master lease cannot be easily broken or renegotiated without potentially jeopardizing the 1031 exchange status of the DST. Therefore, it is paramount that the property consistently generates sufficient revenue to cover the distributions dictated in the master lease.
Why Conservative Underwriting Matters
Conservative underwriting and adequate reserves are especially important in a DST because, in addition to the master lease obligation, a DST cannot do capital calls, and the loan cannot be renegotiated or refinanced. We delve deeper into these restrictions in our article on "The Seven Deadly Sins of the DST."
Concentration Risk
Unlike direct property ownership where you deal with multiple tenants, the master tenant structure creates concentration risk. If the master tenant faces financial difficulties, it could impact distributions to all DST investors, regardless of the underlying property's performance.
Due Diligence Recommendations for DST Investors
So, how should you approach these DST risks when evaluating an investment opportunity?
1. Perform Your Own Due Diligence on the Master Tenant Lease
Take your time to thoroughly review the Master Tenant Lease, typically found in the private placement memorandum. Don't hesitate to ask your registered representative, advisor, and the sponsor any questions you may have. It's also vital to consult with your legal counsel and CPA.
2. Understand Sponsor Incentives
Investigate if and how the sponsor profits from the lease to ensure their incentives are aligned with yours. Pay close attention to the bonus rent. Does the sponsor take a portion of it, or all of it? While a sponsor taking a larger share of bonus rent can incentivize them to increase property efficiency, it might also reduce short-term income for DST owners. This is an important consideration for your passive real estate investments.
3. Understand Preventative Measures
It's critical to understand what preventative measures are in place should the Master Tenant Lease face challenges. Sponsors often build in mechanisms to safeguard a DST if it struggles to produce enough rent revenue. For instance, there are levers that can be pulled if, for example, a tenant in a single tenant net lease building declares bankruptcy and stops paying rent. We will cover these emergency mechanisms in our article on the "Springing LLC".
Key Questions to Ask
- • How is the base rent determined and what happens if property performance declines?
- • What percentage of additional and bonus rent goes to the sponsor vs. investors?
- • What are the financial strength and track record of the master tenant entity?
- • What reserves are maintained to support master lease obligations?
- • What emergency mechanisms exist if the master tenant cannot meet obligations?
- • How does the lease termination or default process work?
Frequently Asked Questions
About Thomas Wall
Thomas Wall has nearly a decade of experience in alternative investments and real estate. He has helped financial advisors at banks and wirehouses navigate a broad spectrum of equity, debt, and retirement investments at AIG which contributed to over $200MM of capital invested. From there, Thomas specialized in helping real estate investors navigate the transition from active management to passive real estate investing. He advises high-net-worth investors on 1031 exchanges, DSTs, private real estate offerings, and REITs. He has helped investors through hundreds of 1031 exchanges, placing over $230MM of equity into real estate. Today, with Anchor1031, he focuses on providing his investors with the tools they need to accurately assess risk and successfully defer taxes when repositioning their real estate portfolio and making the transition from active manager to passive investor.
Continue Your DST Education
The Springing LLC Safety Mechanism
Learn about the emergency contingency plan that can protect DST investments in worst-case scenarios.
DST Fee Structure Analysis
Comprehensive analysis of Delaware Statutory Trust fees, debt risks, and investment considerations.
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Disclosure
Tax Complexity and Investment Risk
Tax laws and regulations, including but not limited to Internal Revenue Code Section 1031, bonus depreciation rules, cost segregation studies, and other tax strategies, contain complex concepts that may vary depending on individual circumstances. Tax consequences related to real estate investments, depreciation benefits, and other tax strategies discussed herein may vary significantly based on each investor's specific situation and current tax legislation. Anchor1031, LLC and Great Point Capital, LLC make no representation or warranty of any kind with respect to the tax consequences of your investment or that the IRS will not challenge any such treatment. You should consult with and rely on your own tax advisor about all tax aspects with respect to your particular circumstances. Please note that Anchor1031 and Great Point Capital, LLC do not provide tax advice.
The information contained in this article is for general educational purposes only and does not constitute legal, tax, investment, or financial advice. This content is not a recommendation or offer to buy or sell securities. The content is provided as general information and should not be relied upon as a substitute for professional consultation with qualified legal, tax, or financial advisors.
Tax laws, regulations, and IRS guidance regarding 1031 exchanges are complex and subject to change. Information herein may include forward-looking statements, hypothetical information, calculations, or financial estimates that are inherently uncertain. Past performance is never indicative of future performance. The information presented may not reflect the most current legal developments, regulatory changes, or interpretations. Individual circumstances vary significantly, and strategies that may be appropriate for one investor may not be suitable for another.
All real estate investments, including 1031 exchanges, are speculative and involve substantial risk. There can be no assurance that any investor will not suffer significant losses, and a loss of part or all of the principal value may occur. Before making any investment decisions or implementing any 1031 exchange strategies, readers should consult with their own qualified legal, tax, and financial professionals who can provide advice tailored to their specific circumstances. Prospective investors should not proceed unless they can readily bear the consequences of potential losses.
While the author is a partner at Anchor1031, the views expressed are educational in nature and do not guarantee any particular outcome or create any obligations on behalf of the firm or author. Neither Anchor1031 nor the author assumes any liability for actions taken based on the information provided herein.