This is the first down market — and subsequent credit shortage — in over a decade. Many investors may not have experienced a market with such extreme turbulence before, and if they have, it was at a different stage of their life. The levels of volatility we are witnessing aren't for the fainthearted. And while the current market environment wasn't triggered by a financial meltdown, it has dried up many revenue streams.
As the COVID-19 pandemic-fueled shockwaves continue to ripple across the globe, lenders are finding themselves in a precarious position; they don't want to be left without a seat if the music stops. With millions of our workforce sheltering-in-place, the prospects of generating income for a significant number have been devastated, with delinquencies expected to begin their ominous ascent. It's no surprise that it has become increasingly difficult to obtain financing. Many lenders are focused exclusively on salvaging loans that are already on the books. They are working feverishly with borrowers who have fired pre-warning flares, indicating they might not be able to make next month's payments. Thus, transaction volume has dropped precipitously; even institutional real estate investment groups are feeling the impact as they seek financing for new deals that are in their pipeline but not previously approved.
Banks and lenders have capital stashed away, but they are being more selective about which borrowers will receive loans. Importantly, the looming fear of defaults has already prompted the commercial mortgage-backed securities, or CMBS, market to close, and it appears it will not open again until they believe the storm has passed. In addition, spreads are drastically tightening in the secondary CMBS market. However, there appears to be some hope for assets that maintain a lower risk profile, as they may receive an infusion of capital in order to refinance. According to Steve Jellinek, vice president at Morningstar Credit Ratings, those subsectors include industrial properties, multifamily and self-storage.
In Pursuit Of Liquidity
The above commentary paints a bleak picture. Thus far, we've focused the spotlight on the glass that's more than half empty. These factors can be even more concerning for investors who are interested in conducting a 1031 exchange during the current environment. So let us assume you are a real estate investor who wants to execute the sale on a rental home, small apartment, vacant land or other investment property, but your lender or broker says you might not qualify for financing on a suitable replacement property. Given the headwinds that the pandemic has created, it is beneficial to examine the “typical” 1031 exchange from an empowered perspective.
If you have already sold the investment property and are contemplating executing a 1031 exchange, you may find it more challenging in today's environment to replace the value of debt in the near term. And with 1031 exchanges, you are on a strict timeline. Even with a recent IRS extension, the sand is running out of the hourglass. You might not be able to wait until financing becomes more readily available.
Racing Against The 1031 Exchange Time Clock
In the case of a 1031 exchange, you have 45 days from the time you sell your property to identify potential replacement properties, and a total of 180 days to find properties, get them under a solid contract, perform your due diligence and — hopefully — have a guaranteed mortgage in place. Note that this timeline has been extended for current 1031 investors in light of COVID-19. Even though you may feel as if it's an uphill battle to secure financing and locate a replacement investment property in the current environment, there is a well-established option that can help you fulfill the 1031 requirements. A Delaware Statutory Trust, or DST, may address and remedy the issues this pandemic has created.
If you are unable to obtain financing on a replacement property, you may have a couple options:
1. Sell the property without rolling over the proceeds, which could result in a large capital gains hit.
2. Roll over the proceeds of that property's sale into a DST.
Why DSTs Can Be Advantageous In This Situation
• Leveraged offerings already have financing in place.
• Large and experienced DST sponsors are able to obtain financing in down markets due to their operating track records.
• Debt is nonrecourse to the investors.
• Investors can close on DSTs quickly.
Some sponsors have deals in their pipeline that have already been approved by lenders, so they can still include debt in their new offerings despite the shortage of credit. A DST can provide a sigh of relief for investors facing a failed exchange scenario, helping them avoid paying a significant capital gains tax bill.
Are DSTs A Suitable Investment For You?
As with any investment vehicle, you should talk to a trained professional to determine whether something like this is an appropriate choice for you. Each investment comes with its own set of risks, but in a market pullback, a DST can offer more security in terms of credit than other real estate investments might — especially for those looking to complete a 1031 exchange.
Full disclosure. The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.