In the world of real estate investment, portfolio diversification is paramount in optimizing the value of your portfolio. One strategy that savvy investors can use to defer capital gains taxes and reallocate their investment capital is the 1031 exchange. Within this framework, identifying a suitable replacement property is critical, and many investors are turning to Delaware Statutory Trusts (DSTs) which own triple net leased (NNN) properties as an attractive solution. In this blog, we explore the underwriting process for NNN properties within a DST structured as a replacement property in a 1031 exchange, offering insights into how investors can navigate this complex yet rewarding investment landscape.

Understanding the Basics

First, let’s lay out the components. A 1031 exchange, named after Section 1031 of the U.S. Internal Revenue Code, allows investors to defer capital gains taxes on the sale of like-kind properties. A DST is a legal entity created as a trust under Delaware law that can hold investment properties and qualifies as a like-kind exchange. NNN properties are commercial real estate assets where the tenant is responsible for all expenses of the property, including taxes, insurance, and maintenance, in addition to rent and utilities.

Why Choose a DST with NNN Properties?

DSTs holding NNN properties are an attractive option for several reasons:

  1. Hands-off Investment: With the tenant handling most expenses, investors enjoy a passive income stream without the day-to-day management hassles.

  2. Stable Cash Flow: NNN leases typically have long-term tenants, providing a predictable and steady cash flow with minimal expense or capital expenditure leakage.

  3. Diversification: By investing in one or multiple DSTs, investors can own fractional interests in high-quality commercial real estate, which creates the ability to diversify their portfolio as compared to investing in a single property.

Underwriting Considerations for NNN DSTs

Underwriting a DST holding NNN properties involves thorough analysis to ensure a successful 1031 exchange investment:

  1. Tenant Creditworthiness
    The financial health of the tenant occupying the NNN property is crucial. A tenant with strong credit and a healthy operating business is less likely to default on their lease, ensuring stable rental income.
  1. Lease Terms
    Long-term leases with rent escalations are preferable as they provide income growth potential and cash flow stability.
  1. Property Location and Quality
    The location and condition of the property can significantly impact its desirability and value. Prime locations in growing markets are typically more resilient and offer better appreciation potential. Additionally, understanding why a location is important to the tenant’s business model helps increase renewal probabilities and reduces vacancy risks.
  1. Financial Performance
    Analyzing a DST’s financial  statements and model is important to understand its actual and projected performance and assess any potential risks. This includes looking at the income generated by the property, operating expenses, as well as the track record of the Sponsor to ensure there is a strong distribution history to investors.  
  1. Legal and Regulatory Compliance
    Ensure the DST and its assets comply with all legal and regulatory requirements, including those specific to 1031 exchanges. This is crucial to maintain the tax-deferred status of the investment.
  1. Market and Economic Factors
    Understanding the broader market and economic environment is vital. This includes assessing market rental rates, vacancy rates, and economic trends that could affect the performance of the NNN property.

Conclusion

Investing in a DST with NNN properties as a replacement in a 1031 Exchange offers a compelling opportunity for investors seeking to defer capital gains taxes while benefiting from passive income and portfolio diversification. However, it is important to underwrite to mitigate risks and ensure the investment aligns with your financial goals. By carefully evaluating the tenant’s creditworthiness, lease terms, property location and quality, financial performance, legal compliance, and market conditions, investors can make informed decisions and capitalize on the benefits of DST investments structured as 1031 exchanges.

Written by: James Gagliano