Is a Zero Cash Flow Investment Right for You?
- Jul 15, 2020
Conventional real estate investment strategy is built on a straightforward formula. You invest in a property, possibly make some capital improvements, and reap the ongoing returns until your hold strategy dictates a disposition.
There are, however, other nonconventional strategies. One that isn’t touted too often, that can provide an alternative for some investors—especially 1031 investors—is a zero cash flow investment. We should say upfront that this is essentially a tax play, and it is not for everyone. Rather, it is a producer of immediate cash for investors in specific situations, or it is a saving grace for some who may be facing a tax bill they couldn’t otherwise afford.
First, let’s take a look at how a zero cash flow investment works. At its core, it is exactly what the name states. While the property you would invest in will produce revenue, that revenue is tied to the acquisition loan. The debt service has been engineered to equal the property’s rent payments over the life of the lease.
Let’s take the case of pharmacy giant CVS. Among the truckload of stores they open every year, there are some that they build on their own account. As a retailer, and not wanting to have capital tied up in real estate, CVS can bundle these properties for sale and lease back, with the loan and lease terms—typically 25 years—baked into a single package. The loans are also structured in such a way as to provide for something called paydown re-advance, which we’ll explain in a moment.
Now let’s apply this to a sample scenario. An investor, we’ll call her Betty, has owned an apartment property, currently valued at $5 million, for a long time. She has refinanced it several times over the years, to the tune of $4 million. Now it’s time to sell. If she has fully depreciated the property, she’s going to have a gain close to the $5 million sales price, which will in turn mean she likely has a tax bill of $1 million headed her way. Since her mortgage was $4 million, it means that at the closing table she only got $1 million in cash, all of which is spoken for by the tax person.
Betty can exchange the apartment property for a $5 million CVS opportunity with $1 million in equity (Zero deals, or zeros, as they are called, can be purchased for equity as low as 20 percent or even 10 percent). With the 1031 complete—allowing Betty to defer the gain on the sale—she is giving up future cash flow in exchange for not having to pay the tax today. When the loan on the CVS opportunity is fully amortized in 20 to 25 years, Betty or her heirs will own it free and clear.
Another example is with an investor, we’ll call him Bob. He also owned an apartment building that’s currently worth $5 million. Unlike Betty, he has no mortgage. It’s not important how long he has owned the building, but let’s say that he, too, has fully depreciated the property. When he sells, he will also be subject to the same tax consequences as Betty, except that he’ll have plenty of cash to pay the tax bill. Regardless, a $1 million tax bill isn’t desirable.
If Bob purchases a zero cash flow property, he can take advantage of the paydown re-advance feature. It works like this: Bob takes all $5 million of his sale proceeds and puts it into the CVS purchase. The first $1 million goes toward the equity required to buy the property, the next $4 million goes to pay down the loan the property came with. Right after closing—his 1031 exchange having now been satisfied—he “re-advances” the $4 million he paid down. When all the dust has settled, Bob walks away with $4 million of the $5 million in cash he got from the sale of his apartment building. Bob is giving up future cash flow for having a lump sum today. However, he too will own a free and clear property in 20 to 25 years.
But what do Betty and Bob have to do with you? Why should you care?
You should care if you are finding it difficult to navigate the current high-barrier lending environment of more traditional lending institutions. You should care if you are planning to leave assets to your heirs, since in the long term you, or they, will own this asset outright. You should care if the apartment in the above scenario was financed nonrecourse and is now in danger of being foreclosed on. If the bank takes back the building, the owner has to pick up the debt forgiveness. You should also care if you’d prefer a lump sum of cash now, versus cash flow over time.
Now, of course 20 years is a long time to hold a zero. Around the seventh year, you might start asking yourself why you’re holding on to a property that long ago served its purpose. This is why some serious calculus has to be completed up front to ensure zeros are right for you. There are other phantom income considerations we haven’t gone over here, as well.
As we said at the beginning, they aren’t for everyone. But for those in immediate need of a tax-free exchange in the right situations, they might be just the ticket. In other words, depending on your specific situation, a zero can make you a hero.
Jonathan Hipp is principal & head of U.S. Net Lease Group of Avison Young.