What is a Zero Cash Flow (“Zero”) property?

A Zero Cash Flow property (Zero) is real estate property where the net operating income matches the debt service expense on its mortgage loan and, the transaction falls under IRS code 467.

Example

If the investor is not concerned with current income, but with a free and clear property beyond 2 decades, then the zero strategy may fit.  These are not designed for the inexperienced investor with shallow pockets. Typically, an investor purchases a triple net NNN property with an investment grade tenant (CVS, Chick-Filet, Wal-Mart, etc.) with a minimal down payment (10-20%) and uses 75-100% of the free cash flow generated to pay off the mortgage (that’s why, zero cash flow). At the end of the long (15-25 years) loan term, the investor owns the NNN property free and clear and renews the lease or 1031 exchanges into another like-kind Zero cash flow property.

Trading values for Zero cash flow property are usually expressed as a % in excess of debt. 

E.g. a brand new Wal-Mart Zero with 15 years left on the loan until maturity, would price in today’s market at probably between 10% – 11% over debt, meaning if the loan is at $10MM, then the total value be about $11MM, meaning it can sell for $1MM plus, in equity.    Alternatively, a property that would otherwise trade at a 6.00% cap, structured as a Zero, one must adjust the cap rate upward with a deal premium of up to 1.5%, thus obtaining a true value near 7.5%.

Benefits of a Zero Cash Flow property

• Generate tax free equity within a 1031 or 1033 exchange

The best benefit for investors is the Pay-down/Re-advance feature which provides for the tax-free, equity via Substitute Collateral Right language in the mortgage, or, more commonly, the Pay-down/Re-advance feature, as follows:

An investor will sell property for $40MM and exchange into a triple net NNN Zero. The property is currently held with debt of $10MM and $30MM equity. The owner identifies a Zero for $40MM with $4MM as equity (trading at 11% above debt) and will assume $36MM. The owner applies $30MM in equity to purchase the Zero replacement, thus meeting the equity obligations of the 1031 exchange. Prior to closing, within the time restrictions of mortgage covenants, the owner notifies the lender to exercise the Pay-down/Re-advance directly after closing.

The owner thus applies the full $30MM in original equity to the purchase price of the Zero, and of that $30MM, $26MM is available as excess from the $4MM of equity required to purchase the Zero property. At this point, the debt re-advances from the original $10MM to the new $36MM, with the proceeds of $26MM going to the new owner of the Zero cash flow NNN property. 

As a result, the owner pulls out $26MM in tax-free cash from the 1031 exchange, holds a new triple net NNN property worth $40MM, with $36MM in debt.

• Generate passive losses to tax-shelter other investment income

Owners of Zero Cash flow property get tax benefits in the early part of ownership. This is due to the ability to report a tax loss due to structured depreciation which more than covers principal payments, under Code 467, for the first 10 -15 years of the loan.

• Significant investment upside at end of loan period

Usually an upside accrues to the investor due to market appreciation over the lengthy time period of the investment, usually greater than 20 years.

• Control real estate assets with minimal equity

Zero triple net NNN properties greatly help 1031 investors to build trusts for their families or create long-term portfolios. Due to the minimal down payment, institutional credit of tenants and little to none asset management, they are great opportunities for growing wealth, passively.

Features of a Zero Cash Flow Property

1. Investment Grade Tenants

The credit of the tenant – or guarantor – is the main thing to consider as the investor is investing in the cash flow that comes from the triple net NNN lease. The stronger the guarantor’s credit, the lower the risk of the investment and thus, a lower cap rate. In Zero 1031 exchange deals, Investment Grade Tenants are commonly used because the value in the income stream is derived from the tenant’s superior ability to pay rent, with the underlying real estate given a secondary consideration.

• Triple Net NNN Leases

NNN leases are most commonly used to structure a Zero deals since 1031investors want passive, not active, property management.  Triple Net NNN leases allow investors to acquire a single-tenant, property with the tenant assuming all expenses.  This gives the tenant de-facto control of the property while providing the investor with dependable cash flow with minimal responsibility

• Assumable debt

Lenders in Zero NNN deals stereotypically offer a nonrecourse, assumable, fixed-rate mortgage, which can be assumed very quickly, under mortgage covenants to give investors the nimbleness they need to get into (and out of) Zero property.

• Maximum Depreciable basis

When a 1031exchange investor LLC or partnership needs to offset current income with a higher depreciable basis, they may consider a Zero cash flow triple net NNN property, as their first choice. Essentially, IRS Code Section 467 allows for very flexible and aggressive structuring of depreciation, which in turn can generate maximal tax losses.

Important Considerations

• Ensure a 6-12 month cash buffer to hedge a compromised cash flow from the Zero triple net NNN property.

• Have a well-thought out plan for the end of the lease/loan for the tenant and property. 

• Don’t discount the intrinsic potential of the real estate and simply view the Zero cash flow NNN property as a security or abstract financial instrument.

• Ensure proper underwriting and due diligence is done to maximize returns.

• Conduct a last owner’s search to confirm any title defects since the date of the existing title policy.

• To protect against any untoward liens, consider buying UCC insurance, which insures the lien-free status of the new owner. Especially, consider adding an Equity Ownership rider, which insures the investor from any adverse claims that accrued prior to the effective date of the policy.
• If any bulk sales laws apply to the transaction, then failure to comply will expose the investor to liability that is otherwise the responsibility of the Seller.
• A Zero cash flow triple net NNN property is relatively illiquid, as there are fewer buyers in the market for zeros as compared to more traditional commercial property investments.

• The 1031 exchange investor needs to consider the phenomenon of “phantom income” when the property no longer amortizes at a loss (depreciation minus principal payments) – usually in Year 12  –  and the owner must pay tax on the principal pay down of the loan.   

• Investors can acquire 100% of the corporation that holds title, avoiding loan transfer fees and taxes in some states such as FL, NV and OH.  In addition, start-up costs are minimized since the investment vehicle already exists. 

Alternative/comparable investments

• If an investor has capital and an experienced real estate team, the investor could: a) buy the land and do a ground lease, or, b) participate in development, or 3) participate in both (a) & (b). When a Zero cash flow triple net NNN property is structured as a “Pre-Commit” or “Forward Purchase”, an investor contracts – at a pre-determined cap rate – with a developer to buy a new, occupied, single-tenant building. Typically, cap rates are higher under this type of purchase than other, traditional, sale structures.

• Essentially, a Zero Cash Flow NNN property can be mimicked by a zero coupon bond where an investor buys a bond, without any cash flows (i.e. no interest income or coupon).  Ultimately, this bond generates a large upside by virtue of the difference in the initial discounted purchase price of the bond versus the “face value” of the bond, resulting in a “balloon” at maturity.

Professional Involvement

• Lenders must be comfortable with monetizing the entire rent triple net NNN stream, so that the financing amounts to as much as 85 to 90 percent loan to value (LTV). Lender fees are lower for transfers of ownership and a new loan document may not be required.

• When using a title company, consider a national (versus a local) title underwriter, who is acutely familiar with such transactions. Because of their niched expertise with Zero loan and transfer documents, closings are conducted without unnecessary hiccups and delays.
• Although most real estate attorneys can navigate a Zero cash flow property transaction, an attorney who has extensive experience in this arena, is best retained.
• 1031 Exchange “agents” are also best used should an investor be using a Zero for 1031 or 1033 transaction
• Finally, contact Triple Net Investment Group real estate NNN advisors for your Zero cash flow triple net NNN property transaction and benefit from their decades of expertise in helping investors, nationally, achieve their 1031 or 1033 goals, efficiently and hassle-free.