Top 5 Mistakes in Cash Flow DST
Choosing a DST on cash flow alone may be a mistake.
The most important thing to know about cash flow is that no two cash flows are equal! There are certain factors that make up a property cash flow:
1. Purchase price/cap rate 2. Reserves 3. Underwriting
a. Starting rent b. Vacancy factors
i. Physical vs. Economic c. Rent growth rates d. Expense growth rates e. Expenses
ii. Insurance 4. Load/fees 5. Sustainability
Let's dive into all of them...
1. Purchase Price/Cap Rate -
Pretty straight forward here. In today's market, no one is giving away properties and if they are, then I would beware. You have to ask yourself if I were selling a property in this market...why would I sell at a discount? Why would anyone sell anything at a discount right now? 2. Reserves -
This is where a lot of Sponsors (particularly the newer ones) will skimp because the reserves dilute the return because those funds are not working for you (i.e. you have to raise more money or take a bigger loan out). So if you look closely, you will see most Sponsors’ reserves are lower than the older cornerstone sponsors. 3. Underwriting -
a. Starting rent...is it higher or lower than the seller's numbers or even the appraiser's numbers? And why? This will set the property up for potentially 10 years so it is important to know why they started where they did.
b .Vacancy Factor... Big difference between physical and economic - Physical is actual units unoccupied; Economic backs out loss to lease, concessions, bad debt and non-revenue units. Definitely where some Sponsors will get aggressive to make the numbers look better.
c. Rent Growth Rates -
Obviously, we are in tough times right now so expecting 3% rent growth for 2021 or even 2022 is probably a stretch, yet I see it all the time. Also, on value-adds...unless the rent is GROSSLY under market, it is risky to assume aggressive rent growth even with improvements being made. d. Expense Growth Rates -
If you assume high rent growth, you need to assume high expense growth too. They sort of go hand in hand. e. Expenses -
Taxes and insurance are an easy way to increase property cash flow but can really whack a cash flow if you are off. And more and more states are starving for tax $$ so being aggressive here usually comes back to bite you. We have been hearing that other Sponsors are running into trouble with insurance rates, particularly in hurricane prone areas. 4. Load/Fees -
This one is obvious too, the higher the load the lower the cash flow. Passco is certainly not the lowest on fees, but we are not the highest either. We are slightly high up front, but our ongoing is much less than most Sponsors.
5. Sustainability -
We underwrite what we think the property needs year 1 and then build from there because we recognize the importance of hitting your numbers out of the gate. It sets the property up on the right foot and if we are wrong and the property overperforms, then the investors get the bulk of it anyway (80%) so it is fair to them too.
Here's a quick example of how numbers make a difference...
A recent offering example:
Lowering the reserves to $1m (from over $3m) and reducing the economic vacancy from 19 to 10 would increase the property level cash flow from 4.44% to over 6%
The cap rate (unloaded) using the trailing 3 months financials equates to a 4.9% cap rate (ppm shows a purchase cap rate of 4.3% because of the conservative underwriting)
I hope this is helpful!
By Don Meredith, President of Tactical Income Inc.
Author of The DST Revolution –1031 Exchange into retirement mode. 2nd Edition
Contact Don Meredith of Tactical Income, to learn more about Delaware Statutory Trusts (DSTs) and 1031 Exchanges at: firstname.lastname@example.org or (619) 726-6100.
Securities through LightPath Capital, Inc., Member FINRA/SiPC, 1560 E. Southlake Blvd., Suite 100 Southlake, TX 76092 925-899-1709 Direct 214-734-2957 Office