Master Tenant Lease Structure in DSTs | (Episode 3)

Hello and welcome to Exchange Insights, your resource for 1031 market intelligence and education. My name is Tom Wall, partner here at Anchor1031. In today's video, we're going to be covering the master tenant lease, a creative solution that sponsors use to work around some of the seven deadly sins of a DST. If you haven't watched the previous episode on the seven deadly sins, I highly recommend you go back and watch it before this one.

So in the last episode, we discussed how one of the restrictions on DSTs is that they cannot renegotiate or enter into new leases. This creates some challenges for sponsors who want to offer DSTs with multi-tenant properties or shorter-term leases. That's where the master tenant lease comes in.

A master tenant lease is a structure where the DST leases the entire property to a master tenant, which is typically a subsidiary or affiliate of the sponsor. The master tenant then subleases space to actual tenants. This creates a layer between the DST and the underlying tenants.

The DST only has one lease to manage: the master lease. The master tenant handles all the underlying lease negotiations, tenant improvements, re-tenanting, and day-to-day property management activities. From the DST's perspective, they have a long-term lease with a single tenant, which keeps them in compliance with the seven deadly sins. The sponsor or master tenant takes on more risk and more responsibility, but also has more control over the property.

So, let's talk about the rent structure of a master tenant lease. There are usually three tiers of rent that the master tenant pays to the DST.

The first is base rent. This is the minimum rent the master tenant owes the DST regardless of how the underlying tenants perform. It provides stable income to DST investors.

The second is additional rent. This kicks in when the property generates cash flow above the base rent threshold. If the master tenant collects more rent from underlying tenants than what's owed in base rent, some or all of that excess gets passed through to the DST.

The third tier is bonus rent. This is often tied to a disposition or capital event. When the property sells, a portion of the upside is shared with DST investors.

So, investors should know that these rent tiers create different risk-return profiles. The base rent provides downside protection, but the additional rent and bonus rent expose investors to more performance variability.

Now, let's cover a few key items for due diligence.

First, investors should evaluate the financial strength of the master tenant. Who is the master tenant? What is their balance sheet? What happens if they default? In many cases, the master tenant is a special-purpose entity created by the sponsor specifically for this DST. They may not have significant assets outside of the property. Investors should understand this risk.

Second, understand the alignment of incentives. The master tenant structure means that the sponsor is taking on more risk and control. In some cases, sponsors may benefit from decisions that don't align with investor interests. For example, keeping reserves at the master tenant level rather than distributing excess cash to investors.

Third, review the cash flow projections closely. Master tenant leases can be structured in ways that make cash flow projections look better than they are. If the base rent is low and the projections rely heavily on additional rent or bonus rent, investors should scrutinize those assumptions.

Finally, ask about the reserves. Where are reserves held? At the DST level or at the master tenant level? If reserves are held at the master tenant level, investors have less visibility into how that money is being managed.

So in summary, the master tenant lease is a useful structure that allows sponsors to offer DSTs with more complex properties. It provides flexibility for the sponsor while keeping the DST in compliance with IRS rules. However, it introduces additional complexity and risk that investors should understand. Make sure you ask questions about the master tenant structure before investing.

Thanks for tuning in. Up next, we'll cover episode four: the springing LLC, a safety mechanism built into most DSTs. If you'd like to learn more about DSTs, please visit anchor1031.com.