In Today’s Market, Zero Cash Flow Makes Sense
- Feb 06, 2013
By David Clary, Senior Director, Investment Sales, Stan Johnson Co.
One of the least understood types of real estate structure in the net lease market today is a zero cash flow property. Put simply, it is a highly-leveraged property backed by a long-term, bond-quality lease guaranteed by an investment-grade credit tenant. The tenant of the property is typically on a lease of 20 years or more, and has a credit rating of at least BBB. The result is a lender is comfortable with monetizing the entire rent stream, so that the financing amounts to as much as 85 to 90 percent loan to value. The term “zero cash flow,” or “zero” as it is sometimes called, refers to the fact that all of the property’s net operating income goes to service the underlying loan, and there is none remaining to be distributed to the owner. This might not sound attractive to all investors, but a property with this structure does have its benefits.
First, it is an opportunity to buy an absolute net leased property for a minimal amount of equity. Most zeros are purchased today with equity as low as 10 to 15 percent of the total value. Second, the financing is assumable, fixed-rate, non-recourse, and often fully amortizing. At the end of the loan term, the property is owned free and clear of debt. Third, it is a low cost way to obtain the tax benefits associated with ownership of real estate.
Zero cash flow deals are especially attractive to investors looking for a quick and efficient completion of a 1033 or 1031 exchange. The financing is already in place, and the loan is easily and quickly assumable at low cost. There is also an option provided in the loan that allows the purchaser to size the loan to match the particular debt and equity requirements of the trade, with a subsequent option to refinance and cash out a substantial portion of equity after the exchange is completed. This equity can then be deployed to other cash-flowing assets with full depreciable basis outside of the confines of the exchange.
Nearly all zeros generate net taxable losses that can be used to offset like-kind income elsewhere in the owner’s portfolio. These losses can be substantial in the early years of the loan, a time at which the combined offset from depreciation and interest expense far exceed the rental income. The owner’s use of accelerated depreciation where permissible can maximize the effect. A reality of the zero structure is that at some point the property will generate “phantom income,” since the rental payment equals to the debt payment. This results from the reduction of loan principal and corresponding decline in interest expense over time. Depending on the owner’s tax basis, phantom income typically appears in year 10 to 12 of the loan, and the taxes paid by the owner on the income is considered to be additional paid in capital.
Zero cash flow transactions require a skillful broker who can match the property to the investor, who understands and knows how to make the most of the tax consequences, and who can advise on long-term ownership of the asset. Stan Johnson Company has assisted clients in the purchase and sale of over $2 billion of these investments.