How a Master Lease Could Benefit You In an Inflationary Environment

Wally Smith:
Well, talk a little bit about master leases because you said there’s seven deadly sins. One of them is you can’t change the lease, right? So you’re a DST, you set up a trust, it is now leased to Acme Corporation or Walgreens or Amazon, pick a name. And they’ve got a lease and it’s generally going to be on a 10 year DST. It’ll be 15 year lease, for example. But how does that work then with fractional student housing, multifamily storage units?

Jeff Hertz:
Generally speaking I would say the longer term your lease is, and the fewer the assets you have, the less likely that you would need a master lease structure. To your point, where you have a 15 to 25 year lease with a single tenant, let’s say they’re investment grade, just to add in an additional layer, and I wouldn’t say there’s a consensus among all DST sponsors, some DST sponsors may put in a master lease even in that scenario. Others may say, hey, if something happens to this tenant who is again on the hook for 25 years in investment grade, we’re going to have a lot bigger issues to worry about than just refilling that space. So anytime you have assets like multifamily, student housing, self-storage, certain healthcare assets, you’re going to have a master lease structure. And so effectively, to satisfy the requirements of the IRS, it is considered to be a fixed lease. It is there in place to satisfy that lease.
Underneath that master lease is where all the sausage making happens, where you have tenants moving in and out, you have leases being signed, you have things like reserves and master tenant reserves. And really what that enables the sponsor to do is to manage the asset. If you have a 350 unit apartment complex, but you know you’re going to put in $8,000 a unit to upgrade the units. You know that there might be seasonality in leasing, you need to escrow taxes. That master lease can be extremely helpful in order to just manage that property on a daily basis. Again, it’s necessary to adhere to the DST regulations, but it also just can be in practicality, a very important way of managing the property, because-

Wally Smith:
So with a master lease, there’s generally going to be a fee. There’s a manager, so a master lease company will charge something., But explain how strong that is in an inflationary environment, it’s a huge benefit.

Jeff Hertz:
So then ultimately through the master lease structure, if the property performs better, maybe it performs in line with expectations which were to grow rents in revenue, or maybe it outperforms those situations, then it actually allows the sponsor to pass through that outperformance to the investors. DSTs cannot have what’s called a promote structure. In the private equity world you typically have a two and 20 where anything above and beyond a certain hurdle rate gets passed onto the investors. DSTs can’t technically have that because that would make them considered to be a partnership structure. What they do have in place of that is effectively a split with the investors.
Let’s say the split is 80, 20 or 90, 10, which means that above and beyond a certain threshold, the sponsor can pass through additional revenue to the investors. Different sponsors have different ways of distributing that. Many will do what’s called a 13th check, meaning that they’ll reconcile the books at the end of the year. If the property performed better than expected, then they’ll pay out an additional distribution to the investors. That’s all part of that master lease structure.