How to Read a DST Pro Forma

A pro forma is a forecast the sponsor wrote, and your broker-dealer is expected to have tested it

FINRA's Regulatory Notice 10-22 lists what a reasonable investigation of a private placement can include: requesting the financial models used to generate projections or targeted returns, analyzing management's assumptions, testing models with information from representative assets, and keeping a file summary of stress tests run on the issuer's assumptions. Regulatory Notice 23-08 adds scrutiny of past-performance claims that may be cherry-picked, and says offering materials a member helped prepare are communications that must be fair and balanced.

So ask the person recommending the offering two questions before you read a single line: what did your firm change when it reran the sponsor's model, and what does your downside case show? If the answer is that the firm accepted the sponsor's numbers, do the work below yourself, and use the broader list at the DST offering due-diligence checklist.

The top half turns rent into net operating income, and every line should tie to the property's actual history

The OCC's commercial real estate lending handbook tells bank examiners what an income analysis should cover: historical, current and projected rents, operating expenses, capital expenditures and vacancy; lease renewal trends; past-due leases; comparable rents, expenses and sale prices; current lease terms; and cap rates. It adds that each factor should be considered under both normal and stressed conditions, and that inadequately supported projections should be challenged. Use the same list on the pro forma.

Lay the projected first year beside the trailing twelve months the memorandum discloses. Rent should match the rent roll; vacancy should be no lower than history without a reason; expenses should not fall. The handbook notes that an NOI analysis may include non-cash items such as management fees and reserves for capital replacements, and that office management fees are typically underwritten at 3 to 5 percent of effective gross income. A filed DST loan agreement defines net cash flow as gross income less operating expenses less the full amount underwritten for the replacement reserve, which is the number the lender cares about.

If the trust uses a master lease, the trust's income is the master lease rent, not the building's rent. One sponsor's 10-K describes that rent as debt service to the lender plus additional rent. Read both the building's projection and the master lease schedule; the difference is the master tenant's margin or shortfall, explained at DST master leases and their risks.

The bottom half turns NOI into your distribution, and the denominator is your equity including the load

Hypothetical: a trust buys a building for $30 million with NOI of $1.8 million and a $15 million interest-only loan at 5.5 percent, or $825,000 a year. It sets aside $90,000 for replacements, pays a sponsor asset fee of $26,000 and trust expenses of $40,000. Cash available is $819,000. If the offering raised $17 million of equity, because commissions, closing costs and reserves sit on top of the $15 million of property equity, the projected distribution is about 4.8 percent of equity, while the building's cap rate is 6.0 percent. Run your own numbers with your CPA.

Fees in the bottom half are disclosed in the memorandum's compensation section; one REIT's DST program pays its DST manager an annual fee of 1.0 percent of gross rents, according to its Form 10-K. Rev. Rul. 2004-86 lets the trustee hold a reasonable reserve and requires all other available cash to be distributed, so the reserve line is the only place the sponsor can hold money back. Why the cap rate and your cash yield differ is the subject of cap rate vs cash yield in a DST.

Six assumptions decide whether the projection holds, and each has a year when it bites

The OCC handbook notes that interest-only terms can raise coverage early but increase repayment risk at maturity, and that lenders should test debt service as though the loan amortized. Do the same: recompute the distribution in the first full amortizing year and in a year with one point higher vacancy and one point lower rent growth than the sponsor assumes.

• Rent growth: compare the annual increase with signed lease escalations and market history; see rent growth assumptions.
• Vacancy and credit loss: a single-tenant pro forma often shows none; ask what happens in the year the lease expires.
• Expense growth: taxes and insurance rarely grow slower than rent; a flat expense line is a question.
• Interest rate: fixed for the term, capped or floating; floating loans need the cap's strike and expiry.
• End of interest-only: the year amortization starts, debt service rises and distributions can fall; see debt service coverage in DSTs.
• Exit cap rate: the projected sale price drives the total return figure; see exit cap rate assumptions.

What the pro forma will not show you: where a distribution came from and what happens if the reserve runs dry

A projected distribution can be paid from operations or from money raised in the offering and held in reserve. The SEC order approving FINRA's statement-value rules required firms using the net investment method to warn that any distribution that represents a return of capital reduces the estimated per-share value. Ask the sponsor to show, for its prior programs, how much of each year's distributions came from operating cash flow.

Reserves are finite. The filed loan agreement requires a debt service reserve at closing that the lender may draw on to cover payment shortfalls, which must then be replenished. If a pro forma depends on drawing a reserve to keep distributions level, that is the first number to fall when rent does. How sponsors size reserves is at how much reserve a DST should hold, and why distributions vary is at DST distributions: timing and reliability.