DST Lender Documents and Bad-Boy Carve-Outs

Non-recourse means the lender's remedy is the property, and that protection runs to the trust and to every beneficial owner

The loan in Rev. Rul. 2004-86 is a ten-year note secured by the property and nonrecourse to the borrower; when the property is contributed to the trust, the ruling states that neither the trust nor any of its beneficial owners are personally liable to the bank on the note. Delaware law adds a second layer: under 12 Del. C. chapter 38, beneficial owners are entitled to the same limitation of personal liability that stockholders of a Delaware corporation enjoy, and creditors of an owner cannot reach trust property.

Lender documents say the same thing in their own words. Freddie Mac's conventional fixed-rate term sheet lists the recourse requirement as non-recourse except for standard carve-out provisions, and an industrial REIT's Form 10-K describes its loan agreements as including customary market carve-outs and guarantees by the REIT itself.

Non-recourse protects your other assets, not your equity in the trust. If the property cannot cover the loan, the lender takes the property and your interest is worth what is left, which can be nothing; the leverage mechanics are at DST leverage and interest-rate risk.

The carve-outs are a list of bad acts, and some of them turn a non-recourse loan into a full-recourse one

The OCC's Commercial Real Estate Lending handbook describes the mechanism for examiners: on a nonrecourse loan a guarantee is usually executed with carve-out provisions that limit the guarantor's liability to losses caused by certain acts or omissions of the borrower, such as fraud or misrepresentation, voluntary bankruptcy, environmental issues, unapproved liens, waste of the collateral, prohibited transfers and the diversion of funds. It adds that commonly there are certain carve-outs that cause the loan to become full recourse.

Read the loan summary in the memorandum for both lists: the loss carve-outs, where the guarantor owes the lender's actual loss from the act, and the full-recourse triggers, usually a voluntary bankruptcy filing or a prohibited transfer of the property or of control of the borrower. In a DST the borrower is the trust, so the acts that matter are the trustee's and the sponsor's, and the documents are drafted so that investors cannot commit them.

The springing LLC provision sits inside this list. A conversion of the trust to a limited liability company is a transfer of the borrower, so the lender memo lists the springing LLC conversion with the sponsor as managing member as a pre-approved transfer; how that conversion works is at the DST springing LLC.

The guarantor is the sponsor, which is why sponsor strength is a credit question and not a marketing one

Freddie Mac's Delaware Statutory Trust memo states that guarantors are typically limited to those in the organizational chain of the sponsor, and lists as a lender benefit that only the DST borrower, the sponsor and related entities such as the guarantor and master tenant need to be underwritten, typically one guarantor. Fannie Mae's multifamily guide defines a guarantor as a key principal or other person executing a non-recourse guaranty, and a key principal as a person who controls or manages the borrower or the property.

The same entity often stands behind two promises: the carve-out guaranty to the lender and the master lease guaranty to the trust. One REIT's 10-K says its DST master leases are fully guaranteed by the operating partnership and in the same breath that there can be no assurance it can or will fulfill those obligations. A guarantor stretched across many trusts is the exposure to measure, using judging a DST sponsor's financial strength and how to evaluate DST sponsors.

The lender memo also lists sponsor bankruptcy as an event of default under the mortgage and names the possibility of a sponsor electing to walk away from the property instead of working out a troubled loan as a lender risk. Both are your risks too, examined at what if a DST sponsor or master tenant goes bankrupt.

The rest of the loan package fences the trust in: special-purpose covenants, reserves, escrows and a four-party agreement

The lender memo's standard requirements read like a checklist of what you will find in the memorandum's loan section. The trust and the master tenant must each be special-purpose entities. The master lease term must extend beyond the mortgage term. A replacement reserve sufficient for repairs is established at origination, and taxes, insurance and assessments are escrowed. The signatory trustee is typically required to retain a minimum interest in the trust.

The master tenant and any property manager sign a subordination, assignment and security agreement with the lender and the trust, which the memo calls a four-party agreement. It lets the lender step past the sponsor's operating affiliates if the loan defaults, and it is why those affiliates cannot be replaced without lender consent; the layers it binds are described at the layers that run a DST.

Transfers of beneficial interests are restricted only for any transfer of 25 percent or more of the aggregate interest to one person, so ordinary secondary sales and transfers to heirs do not need lender approval; the estate side is at transferring DST interests to heirs and trusts.

Your signatures are representations to the sponsor and the trust, not covenants to the lender

The subscription agreement asks you to represent your accredited status under 17 CFR 230.501, the source of your funds and your understanding of the risks. Filed programs add representations the lender cares about: the industrial REIT's 10-K requires each purchaser to represent that no portion of the purchase price for its interest, and no fee paid with it, has been or will be funded with any nonrecourse indebtedness other than the sponsor's own program loan.

That program is also the one filed example of investor-level debt. The REIT makes loans of no more than 50 percent of the purchase price of the interests to certain purchasers, secured by the interests, non-recourse to the investor subject to commercially customary recourse carve-outs, with an origination fee of up to 1.0 percent. A loan against your interest does not count as replacement debt for your exchange and should be reviewed with your CPA; the general rule is at does DST debt count as replacement debt.

The lender memo confirms that beneficial owners are not typically underwritten unless any one of them owns 25 percent or more of the trust, so for most investors the lender never sees a financial statement. Each form you sign is walked through at DST subscription documents.

The one thing the trust cannot do with its loan is change it, and that is where the lender documents meet the tax ruling

Rev. Rul. 2004-86 lists renegotiating or refinancing the acquisition debt among the powers that would turn the trust into a partnership, with the single exception of the tenant's bankruptcy or insolvency. The lender memo lists the mirror image as a lender risk: the inability of the DST to refinance at the end of the loan term, so that the borrower must take some action that eliminates the tax benefit, such as converting to an LLC or selling the property.

So the loan's maturity date is also the trust's exit deadline, and an interest-only period that ends before maturity is a scheduled drop in cash flow that nothing can be done about; both are measured at debt service coverage in DSTs and floating-rate debt and rate caps.