Benefits of the Tenant-In-Common Vs. Delaware Statutory Trust

Real Estate Tenant-In-Common or TIC Offerings 

Technically there are two types of Proportional Ownership products referred to as Tenant In Common  (TICs), which are structured as a securitized TIC or a Real Estate TIC.

Since the favorable ruling by the IRS in 2004 allowing a Delaware Statutory Trust, under specific restrictions, to be eligible for a 1031 exchange the use of securitized TICs has diminished.  Some security professionals have abandoned the TIC structure for the more lucrative business model that the DST format offers. For the sake of this comparison we will focus on the Real Estate TIC and how it compares to a DST.

A tenancy in common investment (better known as a real estate TIC) is an investment in real estate which is co-owned with other investors. Since the taxpayer holds a deed to real estate as a tenant in common, the investment qualifies under the like-kind rules of IRS Section 1031.

This type of an investment can appeal to taxpayers who are tired of managing real estate. TICs can provide a secure investment with a predictable rate of return. Real Estate TICs are often developed by commercial real estate professionals with an emphasis and expertise on the underlying real estate asset. They are marketed by real estate professionals and not security brokers.

A small number of TIC sponsors take the steps necessary to structure their TIC so that the investment is a real estate investment not subject to state security laws. Usually this means that the TIC sponsor will not be responsible for management of the investment and independent management will be employed by the owners.

Real Estate TICs have significant limitations when it comes to leveraging the properties with debt or investing in large complex commercial real estate that require ongoing management where the quality of the return is reliant on a third party. These limitations force Real Estate TIC sponsors to invest in debt-free high-quality Triple Net Leased properties. These limitations tend to produce a simple structure with a high level of safety and security.

The largest draw back to a Real Estate TIC is that each owner must take an active roll in decision making. This can be cumbersome with even a modest number of owners. The need for decisions can be mitigated up front by not taking out debt against the property and engaging in long term Triple Net Leases with investment grade tenants. This structure effectively eliminates the need for decisions in the near and intermediate term.  The tenant in common agreement for each property sets forth the structure whereby these decisions are to be made. Some can be structured with drag rights or other provisions to facilitate decision making.  Investors should closely review the tenant In common agreement.

Delaware Statutory Trust or DST Investment Offerings

In an effort to create an instrument that would increase the profitability for securitized TIC Sponsors as well as facilitate the placement of debt on properties the securities industry joined with commercial lenders and invested significant resources in developing a complex alternative fractional ownership structure that would overcome what they saw as the weaknesses and limitations of the traditional Real Estate TIC Investment Property offerings.  The result was the fractional ownership structure known as the Delaware Statutory Trust or DST.

The Internal Revenue Service issued Revenue Ruling 2004-86 on August 16, 2004. This ruling offered seven significant management limitations that if followed, permitted the use of the fractional ownership structure of the Delaware Statutory Trust or DST to qualify as replacement properties as part of an investor’s 1031 Exchange transaction.

Each co-investor owns an individual beneficial interest in the Delaware Statutory Trust. The DST itself shields the investor from liability with respect to the underlying investment property owned and held inside the DST.  These instruments are created and sponsored by securities professionals with expertise and an emphasis on creating a quality security instrument. They are sold by securities brokers with no required training, experience or education in real estate and are governed by the SEC.

As discussed above individual investors in a Real Estate TIC structure must vote on all major property decisions. Without a majority owner and appropriate structure, it can be somewhat dysfunctional to get the individual TIC Investment Property co-investors to agree on major decisions. To address this issue, the individual investors or beneficiaries in a Delaware Statutory Trust are not permitted to vote. In the DST structure partners relinquish the agency and authority to make all decisions regarding the management and wellbeing of the property and investment and vest it in a single trustee – the sponsor. However, for the DST to be 1031 qualified the Trustee must relinquish the right/ability to make major property decisions. This can create an even more difficult situation than the TIC structure.

Financial institutions can loan to a DST entity. Because the loan is made to the Trust there is no need for a lender to separately underwrite each co-investor for purposes of loan qualification since the DST is the borrower and not each individual investor. This structure allows DSTs to hold multiple properties with multiple and varied debt structures. This can provide a false sense of security to investors. Although individual investors are not underwritten by the lender or personally sign on a loan, their investment is used as collateral and is 100% at risk in the event market conditions, fraud or other issues create a default. The debt structure of any DST should be thoroughly evaluated and understood by each individual investor.

The Seven Deadly Sins of a DST

Internal Revenue Ruling 2004-86, which forms the income tax authority for considering a Trust as Real Estate for use with a 1031 Exchange has extensive prohibitions over the powers of the Trustee of the DST. In a 1031 qualified DST structure, the trustee is restricted from many actions that would otherwise be normal in typical ownership structures such as an LLC. The trustee may not renegotiate leases, make capital calls, or even re-finance the property. These IRS imposed restrictions are sometimes referred to as the “seven deadly sins,” and include the following:

  1. Once the offering is closed, there can be no future equity contribution to the Delaware Statutory Trust or DST by either current or new co-investors or beneficiaries.
  2. The Trustee of the Delaware Statutory Trust or DST cannot renegotiate the terms of the existing loans, nor can it borrow any new funds from any other lender or party.
  3. The Trustee cannot reinvest the proceeds from the sale of its investment real estate.
  4. The Trustee is limited to making capital expenditures with respect to the property to those for a) normal repair and maintenance, (b) minor non-structural capital improvements, and (c) those required by law.
  5. Any liquid cash held in the Delaware Statutory Trust or DST between distribution dates can only be invested in short-term debt obligations.
  6. All cash, other than necessary reserves, must be distributed to the co-investors or beneficiaries on a current basis, and
  7. The Trustee cannot enter into new leases or renegotiate the current leases.

The Springing LLC aka The Nuclear Option

These restrictions are significant. They are put in place to enable favorable consideration by the IRS and may even seem to provide protection for individual investors. However, they place significant limitations on the trustee in the event tenants default or market conditions require deviation from the management plan. In the event any of the above seven restrictions need to be violated, there is a way out. Delaware law permits conversion of the trust to an LLC. This is referred to as a “springing LLC”. This will allow for any or all the prohibited actions to be performed by the trustee without the consent of the members. This is the ultimate safeguard, but it comes with a massive price. This action will disqualify any of the tax-deferral benefits afforded by Section 1031 to the initial investors. The springing LLC clause is required in most DSTs because it gives the lender additional comfort that the trustee can perform necessary actions in the best interest of the bank even though activating this clause will have detrimental tax consequences to all 1031 investors in the fund. The alternative to having a Springing LLC clause is not pretty and typically does not provide the Trustee the tools necessary to react to even slight deviations in the anticipated investment course. This could result in a catastrophic failure of the Trust during a market correction.

For more information on 1031 strategies, please contact us.

 

Real Estate Agents and 1031s

According to the National Association of Realtors, in 2017, 60% of all real estate agents in the US participated in one or more 1031 replacement transactions. 

The history of 1031 exchanges goes back to 1921. Most people in the real estate industry have heard of them and seem to have a good working grasp of how they work, and what the requirements are. Occasionally we get calls from someone who has not heard of a 1031 exchange, or has no clue what the rules are. So now would be a good time to do a refresher on the basic rules of an exchange.

People ask, “Why should I do a 1031 exchange?” I can answer this question in two words: “Financial Leveraging.” By doing a 1031 exchange, the taxes you would have paid to the government are now working to earn you money.

A 1031 exchange allows a taxpayer to postpone their long-term capital gains tax when selling an investment property by exchanging both the basis and the gain into a new investment property. This gives an investor financial leverage. If you have a property used for investment or business and you plan on buying another property used for investment or business, then yes, you need to do a 1031 exchange.

In simple terms, a 1031 exchange moves the gain from the sale of an old investment property into the purchase of a new investment property. By moving the gain into a new property, you defer paying tax on that gain into the future.

A 1031 exchange is NOT ‘a-sale-and-a-purchase,’ but an exchange of one property for another. There must be a written exchange agreement that shows that ALL the steps, from the transfer of the old property to the receipt of the new, is part of an overall plan.

For more information, please contact us to discuss your situation.

 

 

Observations and Outlook April 2018

First quarter of 2018 turned out much differently than investors had been expecting at the turn of the New Year.  In January’s note, there were many sentiment indicators that had eclipsed their all-time highs. The highest percentage of investors expecting higher prices in twelve months was recorded.  Equity markets peaked on January 26 and fell 12%, followed by a large bounce into mid-March then subsequent decline that left us at quarter end about 4% above intraday lows from February.  We may be seeing the first stages of the end of the 9-year-old bull market.  Looking back at 2007 and 2000, the topping process can be choppy with market gyrations of +/-10%.   This is a complete 180 degree turn from the past two years where volatility was non-existent and equity markets went the longest period ever without a 5% decline.  Expect continued choppiness as the impact of Tax Reform filters through the economy and if corporations can continue the blistering pace of earnings growth going forward.  At the same time for mostly the same reasons, interest rates are likely to be range-bound.  Very recently the price of oil climbed on a news release that the Saudis would like to see $80/bbl oil.  Rising oil prices would be akin to a tax on consumers and hamper US growth.

Sentiment as seen by the AAII % bullish rolling 8-week average has declined from its euphoric high at 49% in January, down to 33%.  At the bottom of the last correction in early 2016 this average was 23%.  The current correction may be over and a lot of selling pressure has been exhausted there is room to the downside still. A reading in the mid 20% has been a good area to mark a low in the markets.  Sentiment is often a lagging indicator.  Investors are most enthusiastic after large price gains.  The opposite is true too in that sentiment numbers go low after a price decline.   It can be helpful to take a contrarian view as sentiment measures move to extremes.

aaii rolling bulls 4 2018

Blame for the downturn in January was due to a slightly hotter than expected print of Average Hourly Earnings (AHE), and the resulting concern over how quickly the Fed will raise interest rates.  The rapid change in AHE has not followed through into February and March, yet stocks remain well off their highs.  Analysts have been looking for wage pressures due to very low unemployment numbers for a long time.  The lack of wage growth is likely to the re-entrance of discouraged workers back into the labor force.  As a discouraged worker, who ‘hasn’t looked for work in the past month’, they are removed from the workforce.  When the number of unemployed decreases (the numerator) along with the total workforce (the denominator), the unemployment percentage rate goes down.  A low unemployment rate at the same time there is little wage pressure is due to the workforce participation rate being very low.  Focusing on the total number of people employed, which is still growing on a year over year basis, may give us a better read on employment situation without looking at the unemployment rate.  Any impact from Tax Reform should show up in an acceleration of year over year Total Employees growth.

total employed 4 2018

A more telling chart, and perhaps the real reason behind President Trump’s fiscal stimulus is the following chart. Using the same raw data that created the above chart, the chart below tracks the monthly, year over year percentage change in total nonfarm employees in the United States.  There are no seasonal adjustments etc.  While we are growing, the rate of increase in the total number of people working, is slowing.

% change in total employed 4 2018

Forward guidance from companies will be critical.  Expectations are still quite high regarding full year earnings and end of year price target for the S&P500, currently about 3000, 15% higher than todays price level.  During the first quarter, when earnings from Q4 2017 were reported, companies beating earnings estimates were rewarded only slightly, while companies missing earnings had their stock prices pushed down.  It seems there is still a ‘priced to perfection’ hurdle that companies must overcome.

 

The largest macroeconomic driver for the remainder of the year is the now global shift from QE (quantitative easing) to QT (quantitative tightening).   This global liquidity spigot the Central Banks have been running on full blast for the past 9 years has begun to end.  The US Federal Reserve stopped buying bonds (adding dollars to markets) and began raising rates.  These are tightening liquidity.  While in 2017 the European and Japanese central banks more than made up for the Federal Reserves actions, both have been broadcasting plans to temper their liquidity injections.  China is tightening as now in preparation for increased stimulus to coincide with the Communist Party’s 100th anniversary in power in 2021.

Over the past 9 years global liquidity additions has been the key driver to global asset prices.  As these additions slow and become subtractions, one must assume it will impact financial markets.  Most importantly global US Dollar-liquidity is the most important as the Dollar is the global reserve currency.  Recently the LIBOR-OIS has been in the news, having risen dramatically over the past few months.  This index is a rate that compares the overnight cost of interbank dollar borrowing in the US vs Europe.  The cost to borrow US Dollars in Europe has gone up dramatically.  A low cost would reflect ample Dollars for those who need them, a higher cost reflects a shortage of dollar-liquidity.  The TED Spread compares the interest rate on 90-day treasury bills and the 90-day LIBOR rate.  The TED spread is 90-day rates and the LIBOR OIS is overnight rates, and they follow each other closely.    The crux of it that they both measure the availability of funds in the money markets.  If these rates go up, it is seen as a decrease in available funds.

ted spread and us dollar 4 2018

The chart above tracks the TED spread and the US dollar.  The relationship is loose but fits well over multiple quarters.  If this relationship is correct, the US dollar should dramatically increase in value in the coming months.  An increase in the US Dollar will push the prices of non-US assets lower, make dollar denominated debt widely used in emerging markets more difficult to pay back and have further repercussions in debt markets.  A weak US Dollar is the underpin of global asset prices, and a stronger dollar, along with Quantitative tightening will be a strong headwind to asset prices in the second half of 2018.  If earnings can continue to growth strongly and more workers can be added at a strong pace, both leading to more credit growth, this headwind may be able to be offset.

In addition to international money market rates, the slowing velocity of money has been a constant impediment to economic growth.  Or, rather, the low velocity of money is indicative of an economy that continues to languish despite massive amounts of new money put into the system.  If the pace of money flowing through the economy slows, GDP can be increased by putting more money into the system.  More money moving slowly can be like a small amount of money moving quickly.   If money is removed from the system via tightening measure from central banks, and we do not see an increase in the velocity of money, GDP will decline.  The slowing of VoM has been a problem since 2000 and is likely directly related to ‘why’ the Fed keeps rates extremely low for very long periods of time.  Of course, if VoM were to return to 1960’s levels, interest rates would be substantially higher, causing a re-pricing of all assets—which is a topic for another day.

fredgraph

Adam Waszkowski, CFA

awaszkowski@namcoa.com    239.410.6555

This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable, but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision.  Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com

DST as a 1031 Solution

A Delaware Statutory Trust (DST) is a legally recognized trust that is set up for the purpose of business, but not necessarily in the U.S. state of Delaware. It may also be referred to as an Unincorporated Business Trust or UBO.

This type of investment structure was created in Delaware in 1947, and in 2004 the IRS issued Revenue Ruling 2004-86 which permits real estate investors to perform a 1031 exchange into and out of a DST that holds title to real estate.  Today, DSTs are used for fractional 1031 exchange investments, offering investors an alternative way to benefit from management-free ownership while still potentially deferring up to 100% of the taxes that would otherwise be due from the sale of an investment property.

DST Investments are offered as replacement property for accredited investors seeking to defer their capital gains taxes through the use of a 1031 tax deferred exchange and as straight cash investments for those wishing to diversify their real estate holdings. The DST property ownership structure allows the smaller investor to own a fractional interest in large, institutional quality and professionally managed commercial property along with other investors, not as limited partners, but as individual owners within a Trust.

DST held properties are passive real estate investments that have professional asset management firms overseeing property acquisition, due diligence, loan sourcing when financing, asset management, property management when not triple net (NNN) leased, and property disposition.

Interests in the trust can be purchased, sold and otherwise transferred without affecting title.  Allowable transfers include donations to charity and transfer to heirs as specified in wills. Also Sellers of their interests in DSTs are eligible to invest the proceeds in other real estate investments via 1031 exchange.

Interests in DSTs are also available to buyers looking to satisfy 1031 exchange requirements.  As with an LLC, DSTs provide liability protection to investors in the trust.  Each DST may own one or more properties, and up to 499 investors may invest in a single DST (though most DST trustees limit the number of investors to fewer than 499).

Investors do not have voting rights over the operation of property owned by a DST.  Instead, a DST trustee (also known as an asset manager or sponsor) maintains 100% of the managerial duties of the asset(s) held by the DST.

For more information, please contact us.

Was that the Top or the Bottom?

The Wall Street Journal had a very good article detailing one of the root causes of the February decline.  A classic ‘tail-wagging-the dog’ story about derivatives and how they can impact other markets that are seemingly unrelated.  While the outlook for global equities informs the level of the VIX, we have just seen an incident where forced trades of VIX futures impacted futures prices of equity markets.   Its as though the cost of insuring against market declines went up so much that it caused the event it was insuring against.

Even with that being known, the impact to market sentiment has been dramatic.  Most sentiment indices went from extremely optimistic to extreme fear in a matter of days.  This change in attitude by market participants may have a lasting impact.  A rapid decline like we saw in February will reduce optimism and confidence (which underpin a bull market rise), and increase fear and pessimism, which are the hallmarks of a bear market.   Short term indicators turned very negative and now are more neutral, but longer-term sentiment indicators will take a longer decline to move negative.

Often the end of a bull market is marked by a rise in volatility, with equity prices falling 5-10%, then climbing back up only to get knocked down again, until finally prices cease climbing back up.  This can take several weeks or months.  We can see this in the market tops in 2000 and 2007.  This may be occurring now.  Many of the market commentary I follows the approximate theme of ‘markets likely to test the 200-day moving average’.  This is the level the February decline found support.  This would be about 7% below current prices, and have the makings of a completed correction, finding support once and then retesting.

Since the market highs in late January the major stock indices fell 12%, then gained 6-10% depending on the index.  Since that bottom and top; markets moved down about 4.5%, then again up into yesterday (3/13/2018) gaining 4% to 7%.  Tech shares and small caps have outperformed large cap along the way, rising more, but falling the same during this series.   Recognizing the size of these moves and the time frame can help manage one’s risk and exposure without getting overly concerned with a 2-3% move in prices.  But if one is not aware of how the 3% moves are part of the larger moves, one might wait through a series of small declines and find themselves uncomfortable just as a decline is ending—contemplating selling at lower prices as opposed to looking to buy at lower prices.  Hedging is a process to dampen the markets impact on a portfolio in the short term while looking for larger longer-term trend turning points. The high in January and current decline and bounce are likely a turning point over the longer term and in the near term provide investors with parameters to determine if the bull trend is still intact.

February Correction: VIX and XIV

Markets in February saw the end of a 499-day (almost two years) winning streak, when the S&P 500 had avoided even a 5% pullback.   At the end of that period equity markets were climbing at a parabolic fashion, with gains quickening into January 26th top.   From December 26th to January 26th saw a gain of 7.2%, or an annualized pace of 132%, capping a two-year gain of more than 55% for the S&P500.

The current correction, has given back almost 12%.   The cause has widely been attributed to a climb in interest rates and finally a larger than expected print in Average Hourly Earnings.  While this data point coincided with the turn, rates had been climbing since early September and accelerated along with stocks in January.  There were a few weeks where rapidly climbing rates occurred at the same time as rapidly climbing stock prices, and then when prices fell, the fall was attributed to those same rising rates.

Todays Wall Street Journal finally had a decent article on another cause of the rapid decline in stock prices.   Over the past few years, “selling volatility” via a few inverse-VIX etp’s had been a huge winner. The largest vehicle, ticker XIV, had gone from $20/share in early 2016 to $146/share in January 2018.  This ETP’s price would go up an equal amount, in percentage terms that the VIX (aka ‘fear index’) would decline. As long as volatility stayed low, XIV’s price would climb.

There were two big problems with this product.  As it grew to several billion in assets, it became so large that that it dwarfed the underlying derivatives market in which it participated.  If the VIX moved a little more than it had in recent weeks, it would cause the fund to overwhelm the derivatives market.   In early February the fund owned 42% of all the outstanding March VIX futures contracts.  Any disturbance in the VIX could require the fund to purchase more than half of all the contracts, that it had originally sold in a very short period of time.

The second problem was that its returns were 100% of the opposite of whatever the VIX did in one day.  That means if the VIX moved from 10 to 20, a gain of 100%, then XIV should lose 100% of its value.  The kicker is that this indeed has happened a few times over the past 10 years.

So the set up was a parabolic price advance, and then a concern that maybe rates were going up too fast, which may push central banks to tighten monetary policy more quickly, which caused the VIX to rise from all time lows, forcing XIV to overwhelm the underlying markets, creating a vicious circle of selling that spilled over into equity futures, exacerbating the stock market decline.  XIV stopped trading on February 21st, closing at $6.04.

Adam Waszkowski, CFA

Ritz-Carlton Sarasota Sold for $171 Million

That works out to $643,000 a key!   

Ashford Hospitality Prime, Inc. (NYSE: AHP) on Friday announced that it has entered into a definitive agreement to acquire the 266-room Ritz-Carlton Sarasota in Sarasota, Florida for $171 million, or $643,000 per key.

Ashford Hospitality Prime is a real estate investment trust (REIT) focused on investing in luxury hotels and resorts.  The purchase price for the Ritz Sarasota represents, as of December 31, 2017, a trailing 12-month capitalization rate of 6.0% on hotel net operating income of $10.2 million. The Company expects to realize a stabilized unleveraged yield of approximately 8% on its investment.  On a trailing 12-month basis as of December 31, 2017, the Property achieved RevPAR of $284.38, with 78.1% occupancy and an average daily rate (ADR) of $364.04, according to unaudited operating financial data provided by the sellers.     Read entire story here.