Tax law prohibits DST trustees from taking certain actions when leasing, financing and capital-raising for the property. Also, the beneficiaries have no control over the operations of the mortgaged property. Therefore, a master lease to a credit tenant is required.
The master tenant (generally affiliated with and controlled by the sponsor) will sublet the property to residential or commercial tenants, handle maintenance and repairs, and contract with a management agent (also often an affiliate of the sponsor) – everything a property owner would do. Such a master tenant/master lease arrangement satisfies the requirements of the law, is very attractive to institutional lenders, and eliminates the unanimous-consent concerns raised in TIC transactions.
Special Purpose Entity Structure
Structuring the master tenant as a Special Purpose Entity adds another layer of bankruptcy protection for the lender. Because most master tenants would only be minimally capitalized, the sponsors can own and control the master tenant and have the requisite net worth and liquidity to satisfy lenders.
The master lease will generally require the master tenant to pay rent to the DST in a set amount equal to debt service plus a market rate of return. The master lease structure economically incentivizes the master tenant to maximize the mortgaged property’s net operating income because it retains all net operating income over and above debt service and rent payments. This incentivizes the master tenant to cover short-term operating deficits to protect its desired return and its valuable investor reputation in the industry.
Better sponsors self-reserve from net operating income (over and above typical lender replacement reserves) for unanticipated repairs and uninsured losses. That is because there is no real ability to negotiate changes in the master lease terms and rent payments with the DST trustee.