The DST master lease indicates that rent is paid monthly by the master tenant to the DST and its beneficiaries in a set amount. The master lease rent agreement needs to be structured in a way that aligns the interests of the master tenant with that of the investors (DST beneficiaries) to incentivize the master tenant to maximize the mortgaged property’s net operating income. One way to incentivize the master tenant is to include a clause in the master lease stating that the master tenant retains a certain percentage of the net operating income, over and above debt services and contracted rent payments, to cover short-term operating deficits. By adding such a clause, the sponsors are protecting their desired return and their reputation in the industry. Furthermore, it is wise for the leading sponsors to stipulate in the master lease to reserve a portion of the net operating income (over and above typical lender replacement reserves) for unanticipated repairs and uninsured losses, because there is no way to raise additional capital after the initial capitalization of the DST.
There are three possible methods for the master tenant to structure the monthly rent payments to the DST and its beneficiaries. The structure that is most advantageous to the investors (DST beneficiaries) is a cash flow master lease, which states that the available cash flow is paid to the investor owners of the DST property. However, a lease agreement that does not allow for income or economic benefit to the master lessee could be deemed by the IRS as not a lease and could be disallowed. If the master lease is disallowed, then the 1031 tax benefits of the DST structure is jeopardized.
The second possible rent payment structure is called a base rent master lease. Under a base rent master lease, the net operating income after debt service is divided between the master tenant and the DST beneficiaries. While this method seems amicable, there is a danger that the structure could be considered by the IRS, under the REIT rules and the step transaction doctrine,[i] as an effective partnership between the master tenant and the DST. As mentioned above, if the DST property is deemed to be owned by a partnership, then it does not qualify for the 1031 exchange.
The third and most practical solution for a DST master lease payment structure is called a bonus rent master lease payment structure. The bonus master lease both incentivizes the master lessee and provides upside cash flow to the investors. While the details of the bonus rent master lease vary from sponsor to sponsor, the basic structure requires the master tenant to pay the trust three different types of rent monthly as follows:
The amount equal to the debt service payments, including principal and interest payments as well as necessary deposits into all lender-required reserve funds.
Additional Rent
The additional amount when the gross revenues from the property exceed the additional rent breakpoint after deducting the asset management fee (typically 3 percent of gross revenue as defined by the master lease). The asset management fee is deferred if gross revenues are below the breakpoint.
Bonus Rent
After the base rent and additional rent is fully paid, the bonus rent equals to 90 percent of the amount by which the annual gross revenues exceed the supplemental rent breakpoint, with the master tenant retaining 10 percent. Again, these percentages may vary from sponsor to sponsor.
The annual cash-on-cash return, or cash flow, as a percentage of invested capital for a DST ranges between 5 percent and 8 percent. Often cash flow increases each year over the hold period. In addition to the cash flow, the annual return includes the principal payments on an amortizing loan and adds 1 percent to 2 percent to the overall annual return. With loan amortization there is exposure to phantom income, which is income allocated to reduce the principal loan balance and is subject to income tax not received by the investor.
The actual cash flow depends on a host of variables including asset class, tenant credit worthiness, location, purchase price, and rent and expense projections. The sponsor of a DST offering takes these variables and other assumptions into a formal Argus data spreadsheet to calculate cash flow projections using their master lease payment structure. The cash flow projections are presented in the private placement memorandum, as well as a description of the master lease and the payment structure for the offering. These projections show a correlation between risk and return. The cash flow is paid monthly to parallel the cash stream of the property as well as the monthly rent payments from the tenant(s) and master lessee.
Gregory v. Helvering, 293 U.S. 465 (1935)