Top 3 Factors to Evaluate in a 721 Exchange Investment Exit

At 1031 Exchange Place, we understand that selecting the right Delaware Statutory Trust (DST) with a 721 exchange exit strategy can be challenging, especially with the growing number of options available. It’s crucial for investors to assess several key factors when making this decision to ensure they are choosing the most suitable path for their financial goals.

Here are three critical factors to evaluate when selecting a DST with a 721 exchange exit strategy:

1. Evaluate the REIT’s Debt Levels

When considering a DST with a 721 exchange exit strategy, one of the most important factors to evaluate is the level of debt that the Real Estate Investment Trust (REIT) holds. Debt plays a significant role in how a REIT operates, affecting both risk and potential return. Here are the key elements to understand:

Leverage Magnifies Gains & Losses

REITs often use debt to acquire and improve properties, which can magnify the potential returns for investors. However, it’s important to recognize that leverage, while it can accelerate growth during good times, also significantly increases risk. Some REITs may have debt levels as high as 300% of their equity, meaning the REIT is highly leveraged. Such a level of debt can expose the REIT—and by extension, its investors—to increased volatility.

Even REITs with more conservative debt levels, such as a 50% loan-to-value (LTV) ratio, still carry risk. For instance:

• Upside Potential: If property values increase by 10%, the equity in a REIT with 50% LTV increases by 20%, effectively doubling the return on equity.
• Downside Risk: Conversely, if property values drop by 10%, the REIT’s equity decreases by 20%, increasing the LTV from 50% to 70%. This magnifies losses, making it harder to recover if the market continues to decline.

Impact of High Debt Levels on Investor Equity

When a REIT takes on high debt levels, it is more vulnerable to economic downturns or unforeseen challenges in the real estate market. For example, if the REIT faces a period of declining rental income or falling property values, it could struggle to meet its debt obligations, leading to financial stress. This, in turn, can affect the distributions paid out to investors or even force the REIT to sell properties at unfavorable terms.

Debt-Free or Low-Leverage Alternatives

Investors who are cautious about the risks associated with high leverage may want to consider REITs that utilize little to no debt. Debt-free or low-leverage 721 exchange vehicles provide a safer, more conservative option. These REITs are typically structured with a 0% loan-to-value ratio, meaning they do not rely on borrowed funds to acquire or operate properties.

While debt-free REITs may not offer the same high returns as their leveraged counterparts, they also present less risk. Investors in these vehicles can “sleep well at night” (SWAN), knowing that their exposure to market downturns is minimized. The trade-off is that the upside may be more limited in strong markets, but the downside protection is much greater, especially during periods of economic uncertainty.

How to Assess the REIT’s Debt Levels

To evaluate a REIT’s debt position, investors should carefully examine the REIT’s prospectus or private placement memorandum (PPM). These documents provide detailed information about the REIT’s financing structure, including the amount of leverage it uses. Key terms to search for include:

• Leverage
• Financing
• Debt levels

Understanding the REIT’s overall debt load will give you a clearer picture of how it might perform under different market conditions, allowing you to align your investment with your risk tolerance.

2. Evaluate the REIT’s Exposure to Floating-Rate Debt

In addition to examining the total debt levels of a REIT, investors must also pay close attention to the type of debt the REIT holds. Specifically, understanding the REIT’s exposure to floating-rate debt is crucial for assessing the overall risk of the investment.

Floating-Rate vs. Fixed-Rate Debt

There are two primary types of debt that REITs may use:

• Fixed-Rate Debt: The interest rate on this debt remains constant throughout the life of the loan. This stability allows the REIT to predict its interest payments over time, reducing uncertainty and allowing for better long-term planning.
• Floating-Rate Debt: Also known as variable-rate debt, the interest rate on this type of loan fluctuates based on prevailing market rates. When interest rates rise, the cost of servicing floating-rate debt also rises, which can squeeze a REIT’s margins and put pressure on its ability to deliver returns to investors.

Risks of Floating-Rate Debt in a Rising Rate Environment

In recent years, floating-rate debt has become more common in the real estate market, as low interest rates made it an attractive option for financing property acquisitions. However, as interest rates rise, the cost of servicing this debt increases as well, which poses significant risks for REITs and their investors.

• Increased Interest Payments: When interest rates increase, REITs with floating-rate debt face higher interest payments. This can eat into the REIT’s operating income, reducing the funds available for property maintenance, improvements, and, most importantly, distributions to investors.
• Potential for Distress: If a REIT is heavily exposed to floating-rate debt and interest rates rise too quickly, it may struggle to meet its debt obligations. This can lead to financial distress or even foreclosure, particularly if the REIT’s rental income or property values decline simultaneously.

Many investors recall the problems caused by adjustable-rate mortgages (ARMs) during the 2008 financial crisis. Just like ARMs, floating-rate debt exposes a REIT to unpredictable and potentially significant increases in interest costs. As interest rates rise, the risk to the REIT—and by extension, its investors—grows.

Historical Impact: The Great Financial Crisis Example

During the Great Financial Crisis of 2008-2009, many homeowners who had adjustable-rate mortgages found themselves unable to afford their rising mortgage payments as interest rates increased. Similarly, many REITs lost properties to foreclosure during that period due to the rising costs of floating-rate debt. The same risks apply today in REITs with a high percentage of floating-rate loans.

How to Assess the REIT’s Floating-Rate Debt Exposure

To evaluate a REIT’s exposure to floating-rate debt, investors should carefully review the REIT’s financial disclosures, such as its 10-K (annual report) and 10-Q (quarterly report). These documents will typically provide a breakdown of the REIT’s debt structure, specifying how much of its debt is floating-rate versus fixed-rate. You can also look for specific details on the percentage of the REIT’s debt that is floating-rate, as this will give you an idea of the level of risk involved.

For example, a REIT with 80% of its debt in floating-rate loans would be far more vulnerable to interest rate hikes than a REIT with only 20% in floating-rate debt. Understanding this ratio is critical for assessing how rising interest rates could impact the REIT’s ability to meet its financial obligations and continue paying distributions to investors.

3. Evaluate the REIT’s Dividend Health Percentage

A key factor in determining the stability and long-term success of a Real Estate Investment Trust (REIT) is its ability to consistently pay dividends to investors. The dividend health percentage, often measured through a REIT’s Adjusted Funds from Operations (AFFO), is crucial for assessing the REIT’s financial health and its capacity to maintain or grow dividends. Here’s how you can evaluate this critical metric:

What is Adjusted Funds from Operations (AFFO)?

Adjusted Funds from Operations (AFFO) is a financial metric used to measure a REIT’s performance by looking at its core operating income, excluding capital expenditures and other non-recurring expenses. AFFO is considered a more accurate representation of a REIT’s cash flow than basic net income, as it focuses on the funds available for paying dividends to shareholders.

The Importance of Dividend Health Percentage

The dividend health percentage represents the proportion of a REIT’s AFFO that is allocated to dividend payments. This percentage is a critical indicator of the REIT’s financial sustainability and stability:

• Above 100%: If a REIT’s AFFO is higher than the dividends it pays, this suggests that the REIT is generating more than enough income from its operations to cover its dividend obligations. This indicates that the REIT has the potential to maintain or even increase its dividend payments over time, a positive sign of financial health.
• Below 100%: When a REIT’s dividend health percentage is less than 100%, it means the REIT is not fully covering its dividends from its core operating activities. In this case, the REIT may be relying on borrowing, selling assets, or using other non-operational income sources to maintain its dividend payments. This can signal potential financial strain, as the REIT is essentially “kicking the can down the road” by using debt or reinvested capital to meet current dividend commitments.

Why Dividend Health Matters

For investors, the dividend health percentage is crucial for understanding the reliability of future income from the REIT. Here are a few considerations:

• Sustainable Dividends: REITs that maintain a healthy dividend health percentage above 100% are more likely to provide consistent and predictable income to investors. This is especially important for those who rely on dividends for regular cash flow.
• Signs of Trouble: REITs with dividend health percentages significantly below 100% may face challenges in the future. If a REIT is borrowing to pay dividends, it may struggle to maintain those payouts in the long term, particularly if market conditions worsen or property income declines. Investors should be wary of REITs that consistently operate below 100%, as they may need to cut dividends or restructure their finances during difficult times.

Assessing Dividend Health Through Financial Reports

To evaluate a REIT’s dividend health, investors should review its annual (10-K) and quarterly (10-Q) financial reports, paying special attention to the AFFO and dividend coverage ratios. These documents provide insight into the REIT’s ability to meet its dividend obligations from its operating activities, without relying on external financing or asset sales.

By understanding the REIT’s dividend health percentage, investors can make more informed decisions about whether the REIT is a stable source of income or if it poses higher risks of dividend cuts in the future.

Example: Real-World Impact of Low Dividend Health Percentages

A number of DST and 721 REITs in the market today have dividend health percentages ranging from as low as 40% to 90%. In these cases, the REIT is unable to cover its dividend payments entirely from its operating activities, which may lead to future financial difficulties. Investors who prioritize consistent monthly dividends should carefully assess this percentage, as it signals the likelihood of the REIT maintaining its dividend payout in the long term.

A REIT with a higher dividend health percentage not only provides more security to investors but also demonstrates strong financial management, giving investors confidence in the REIT’s long-term performance.

Professional Guidance is Key

With the complexities involved in selecting the right DST and 721 exchange vehicle, professional guidance can be invaluable. At 1031 Exchange Place, we have extensive experience working with investors to navigate the intricate details of DST, REIT, and 721 exchange investments. Here’s why professional advice is crucial:

Navigating the Complexities of REITs and DSTs

The landscape of real estate investing through 1031 exchanges and 721 UPREIT strategies can be intricate. Each DST and REIT is different, with varying levels of debt, dividend health, and exposure to risk factors like floating-rate debt. A deep understanding of financial reports, prospectuses, and private placement memorandums (PPMs) is essential to make informed investment decisions. Many investors may not have the time or expertise to thoroughly analyze these documents.

At 1031 Exchange Place, we offer:

• Expert Analysis: Our team has decades of experience in reviewing and analyzing the financial health of REITs, including their debt levels, exposure to interest rate fluctuations, and dividend sustainability. We’ve helped thousands of investors navigate countless DST, REIT, 1031 exchange, and 721 exchange investments. We use this experience to help you understand the full scope of risks and benefits in any given investment opportunity.
• Customized Guidance: Not all REITs or DSTs are right for every investor. We take the time to understand your financial goals, risk tolerance, and long-term strategy to ensure that the investment aligns with your specific situation. Whether you’re looking for high growth potential or a more conservative, debt-free vehicle, we provide recommendations tailored to your needs.

Avoiding Common Pitfalls

Without professional guidance, investors may overlook important details that could expose them to unnecessary risk. For example, a REIT with a high level of floating-rate debt may look attractive at first glance due to its higher potential returns, but the increased risk from interest rate fluctuations could be devastating to an investor’s portfolio if rates rise. Similarly, a REIT with a low dividend health percentage may offer higher short-term returns but may be unable to sustain those returns over the long haul.

By working with professionals who have a deep understanding of these investments, you can avoid common pitfalls and choose strategies that support your long-term financial success.

The Importance of Comprehensive Due Diligence

Before making any investment decision, it’s crucial to perform thorough due diligence. This includes:

• Reviewing Private Placement Memorandums (PPMs): The PPM provides a detailed overview of the DST’s business plan, risk factors, and financial structure. Investors should carefully examine this document to understand the specific risks involved in the investment.
• Analyzing the REIT’s Financial Reports: As mentioned earlier, reviewing the REIT’s annual and quarterly reports is essential for understanding debt levels, leverage structure, and dividend sustainability. These documents give you a clear picture of the REIT’s current financial health and future prospects.

At 1031 Exchange Place, we guide our clients through this due diligence process, helping them identify key information in these documents that can influence their investment decisions. Our goal is to equip you with the knowledge and insights needed to make confident, informed choices.

Investing in a DST with a 721 exchange exit strategy offers significant opportunities, but it also comes with complexities. At 1031 Exchange Place, we provide the expertise and personalized guidance needed to navigate these investments effectively. With nearly two decades of experience and a track record of helping thousands of investors across the country, our team is ready to assist you in building a strong, lasting portfolio.