How Master Leases Work in a DST

Written by Chicagoland 1031 Exchange September 3, 2024

Many real estate investors consider investing in a DST when they sell property and are looking to complete a 1031 exchange. A Delaware Statutory Trust, or DST, is a legal structure that is often utilized to hold title to property and form certain real estate investments. The DST structure may resemble a limited liability company (LLC), a real estate investment trust (REIT), or a limited partnership (LP). However, unlike those structures, IRS Revenue Ruling 2004-86 considers a DST direct ownership of property vs. owning a business that owns property. As such, a properly structured DST property may qualify as a like-kind exchange property for a 1031 exchange.

DSTs appeal to many investors for reasons such as the potential for cash flow and appreciation of real estate, all while avoiding the day-to-day management responsibilities. We like to remind clients that, at the end of the day, an investment in a DST is still an investment in real estate with many of the same potential risks and benefits. However, there are nuances to the DST structure that, understandably, investors have a desire to comprehend prior to investing. One nuance that is often asked about is the existence, operation, and structure of the master lease.

The Master Lease: An Overview

In order to comply with certain IRS regulations DSTs have several rules they must follow. One of these rules is that a DST cannot restructure or renegotiate a lease with a tenant. This can become very restrictive to the management of a property because there are often cases where it is essential to the investment that a lease be restructured or renegotiated.

A typical example is a multifamily property where the leases are typically one year in length and new people are moving in and out on a regular basis as leases expire. Because of this, it becomes essential to create what is known as a “master lease.” The master lease creates an entity controlled by the DST sponsor known as the “master tenant” which leases the property from the DST, then subleases the property to the end tenants, such as residents of an apartment, guests at a hotel, self-storage renters, or retail tenants. This arrangement satisfies the need to adjust leases while also being compliant with the rules the DST must follow.

Please note that each DST offering is unique, and this is meant to be a general high-level overview of what a master lease is. For details about a specific DST offering please consult the offering documents. As always, we welcome you to reach out to our team.

How a Master Lease Works

With an understanding of why the master tenant is established within a DST, we can discuss how the income at the property flows to the master tenant and the DST investors. The master tenant collects rents from the subtenants (the individuals renting the apartments, hotel rooms, etc.) and then pays the master lease rent to the DST. This is typically a set amount based on predictable expenses such as loan and tax payments (often called “base” rent or “stated” rent).

The income received from the master lease is used by the DST to pay debt obligations, make reserve contributions, pay expenses, and make distributions to DST investors. If a DST property is performing as planned the amount collected from the subtenants is expected to be more than the amount the master tenant pays in rent to the DST. In this scenario the master tenant can pass additional income to the DST, this additional income is typically referred to as “bonus” ”supplemental,” or “additional” rent,” and is often calculated with a split between the master tenant and the DST.

Most DST investors look to these investments in part for the ongoing income they are typically expected to provide. To understand how income eventually flows to DST investors it is helpful to think of it in that the DST owners receive, in distributions, whatever gross rent is collected minus the master tenant’s fee, property and loan expenses, reserve contributions, and the various fees charged by the sponsors. In other words, the master tenant resembles a funnel through which income flows, and also as the day-to-day operating mechanism of the DST.

Master leases are an integral part of the DST structure, and reviewing them is part of our due diligence process. Because of the nuances involved, we believe that any investor considering investing in a DST – even seasoned real estate investors – should work with an advisor experienced in DST products who can assist them in understanding and evaluating the investments.

Have more questions? Please reach out to a member of our team.