The “3-Q” Test

Jun 8, 2020

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Assess the Quality of Investments You Choose

Consider the “3-Q” Test to Assess the Quality of Investments You Choose.

As we discussed in prior blogs, investors who are tired of day-to-day active management may want to consider a Delaware Statutory Trust (“DST”). DST’s are pre-restructured 1031 investment solutions that offer a lower minimum investment, greater diversification, and passive monthly income. With so many DST’s to choose from, making the right investment decision comes down to the experience of your 1031 DST investment specialist and their ability to align real estate investment fundamentals with your risk tolerance. The two-fold mandate of a successful 1031 DST is simple: Preserve capital and Protect dividends. Now more than ever is a time for quality and stability in a real estate portfolio.

To help evaluate alternative 1031 investment programs, investors should consider the “3-Q” test to allocate investment capital and manage risk. The performance of investments generally depends upon three key components:

  • Quality of the Assets
  • Quality of the Income
  • Quality of the Sponsor

Quality of Assets

A 1031 exchange generally represents a large portion of an investor’s net worth. At its core, a 1031 exchange is a store of capital and a tax efficient vehicle for income and generational wealth preservation. As the downturn of 2008/2009 revealed, not all income-producing real estate is created equal. Consequently, individual property investments and related portfolio construction must be “weatherproofed” to withstand any economic cycle. Purpose-built properties that offer essential services like food, shelter, distribution, and healthcare are among the most popular DST offerings. Ideally, these properties are located in high-traffic locations with strong demographics and growing markets and a potential for future capital appreciation. Some of the key attributes to look for when assessing the quality of the assets:

  • Strength of the sector                               
  • Stability of occupancy rates
  • Credit quality
  • Business format/sector
  • Development cost
  • Comparable leasing rates
  • Stress tested underwriting assumptions
  • Projected rental growth
  • Feasibility of exit strategy      
  • Threat of future competition and possible impact on future rent growth and property values                 

Quality of Income

Just as all real estate investments are not created equal, property-level cash flow widely varies depending on the underlying real estate economics. Income is the plumb line for most 1031 investors. Income from 1031 properties is generally used to fund lifestyle expenses as well as ongoing financial liabilities. Financial Advisors call this Liability Driven Income (“LDI”). Simply stated, LDI is defined as income that you need today to fund liabilities for tomorrow.

A well-underwritten and risk averse DST should be generating proven monthly cash flow. This cash flow should be stable, durable, and repeatable. Historically low interest rates have contributed to an increase in real estate values. Consequently, investors should expect the majority of their “total return” to come from current cash flow versus capital appreciation. This is not to say that there will be no capital appreciation – as has historically been the case with commercial and residential real estate. Investors just need to calibrate expectations for total returns and not be tempted to chase higher yields at the expense of higher risk and potential capital loss.

Remember, the investment that promises you everything you want…will risk everything you have. Projected investment yields should be “risk-adjusted” and be rationally based on realistic property valuations and actual lease income expected. When assessing the quality of income, consider:

  • Lease terms     
  • Length of the lease
  • Realistic assumptions for revenue and expense growth
  • Stress-tested cash flow projections
  • Structure and terms of the debt
  • Breakeven occupancy analysis

Quality of Sponsor

As legendary investor Warren Buffet says… “It is great to learn from experience, but preferably someone else’s.” There is no substitute for experience when it comes to investing. As an investor, you want an investment manager and program sponsor that has a combination of integrity and expertise. Successful investing is derived from developing a plan and having the discipline of sticking to a defined strategy. The track record of a trustworthy DST Sponsor provides a history of proven performance demonstrated over an extended period through both good markets and bad. It shows whether a sponsor has delivered on their promise to generate a return of, and a return on, the original capital invested. Always consider these attributes of a sponsor:

  • Years of experience    
  • Defined investment strategy 
  • Prior performance track record
  • Defined exit strategies
  • Succession plan