Zero Cash Flow (ZCF) investments are an often misunderstood subset in the world of Commercial Real Estate (CRE). This article will discuss how ZCF investments work, the benefits of ownership, and some of the common pitfalls to be aware of.
Zero Cash Flow investments involve the acquisition of an income-producing property typically leased to a creditworthy tenant under a long-term, absolute-net lease agreement. An investor purchases the property and assumes a loan that is usually highly leveraged, where the lease payments received from the tenant are structured to match the debt service payments on the assumed loan. The loans associated with ZCF properties are typically fully-amortizing, and contain terms matching the length of the lease, usually between 20-25 years. Upon loan maturation, the owner will own the property free and clear of any debt. The tenant is solely responsible for property expenses including taxes, insurance, and maintenance. This creates a scenario where the investor’s cash outflows and inflows are fixed and balanced until the loan matures, hence the term “Zero Cash Flow”.
While this investment structure certainly does not make sense for those chasing immediate cash flow, ZCF properties have unique features that can benefit certain buyers. Some of these benefits include: Paydown/readvance, tax benefits, and high leverage.
Paydown Readvance
Perhaps the biggest benefit for investors in ZCF properties is the paydown readvance feature. The Paydown feature allows the borrower to pay the balance of the loan down in full at any point during the term of the loan. If a borrower elects to use the paydown feature, the readvance then allows the borrower to instruct the lender to refinance the loan back to the balance and terms it was at prior to the paydown. This allows the borrower to pull out built-up equity from the property without being penalized. This feature is already built into the existing loan and requires no additional loan documentation.
Alternatively, if the property is part of a 1031 exchange, the buyer can exercise this option to purchase the property while fulfilling the debt and equity requirements of their exchange, and later pull out some of their equity tax free. Let’s say that an owner just sold their property for $30,000,000, of which there was $25M in equity and $5M in debt obligations. The owner finds a zero cash flow property that they want to purchase for $30M using $3M as equity and assuming $27M in debt, thus covering their debt requirement. To meet their equity requirement, the owner decides to apply all $25M in cash to purchase the zero cash flow property.
Before closing, the owner notifies the lender that they want to use the Paydown Readvance feature. The owner puts down $25M cash towards the purchase of the property paying the loan down to only $5M. After closing, the debt is readvanced to the original $27M and the owner pulls out $22M in tax-free proceeds.
Paydown/Readvance Hypothetical Summary:
- Sale Proceeds to place in 1031 – $30,000,000.
- Purchase price of the ZCF CVS in California – $30,000,000
- Equity Requirement: $3,000,000
- Loan Balance: $27,000,000
- Tax-free equity pulled out of the Exchange – $22,000,000
- The Owner has now completed their exchange. They now own a new CVS that is quickly building equity and were able to pull out $22,000,000 in equity tax-free.
Tax Benefits
Taking advantage of the tax benefits of ZCF properties is another reason why investors purchase these assets. ZCF properties provide a source of depreciation and interest expenses that an owner can use to offset income received from other qualifying investment properties, thus lowering the Owner’s overall tax obligation. These benefits are generally available within the first 10-15 years of ownership. It is always a good idea to consult a professional to properly plan out and utilize this benefit.
Appreciation
Despite not generating positive cash flow in the near term, ZCF properties still provide an owner with the possibility of substantial returns down the line. As mentioned, ZCF properties generally feature high-leverage loans. That means a buyer can put a significantly lower amount of cash into the acquisition of the property. Additionally, ZCF properties are generally located in areas that are already well-established or projected to experience significant growth. The reason behind this is simple, these areas provide the highest likelihood of appreciation throughout the term. Similarly, ZCF leases are entered into with strong credit tenants as they have the best chance of thriving in the long run. Combine the high-leverage, fully amortizing loans with the high-quality of the locations, and the likelihood of the tenant renewing is high. Therefore, with a small equity investment, investors can realize significant cash flow once the tenant exercises its option.
It’s important to note that the long-term appreciation of a ZCF property is not guaranteed. Real estate markets and economic conditions can fluctuate, thus making it even more important to conduct thorough research and work with knowledgeable professionals, like the professionals at Quantum, to give yourself the best chance of realizing significant appreciation when the loan matures.
Potential Pitfalls
While the potential advantages are now evident, it would be remiss to not also discuss some of the common pitfalls associated with ZCF properties.
Phantom Income
When looking at ZCF properties, it is important to look out for and understand the impact of Phantom Income. Phantom income refers to a situation where an investment property generates taxable income for the owner, even if there is no actual cash flow received. In the case of ZCF properties, even though the owner does not receive any cash, the rental income minus the deductible expenses may still result in taxable income. This is another reason why it is important to fully understand your potential obligations and avoid any surprises.
High Leverage
As discussed, ZCF properties are typically acquired with a high level of debt and have no direct cash flow, resulting in limited equity in the early years of ownership. While the ability to highly leverage ZCF properties is a benefit in the initial acquisition, it can also be the cause of some issues if the Owner decides to sell prior to the loan maturing. If an Owner decides to sell prior to the maturation of the loan, they must make sure that they can generate enough proceeds to cover the outstanding loan balance and transaction expenses, and hopefully earn a profit. If you are doing a 1031 exchange, you also need to pay special attention to the debt and equity requirements.
The highly leveraged nature of ZCF properties coupled with limited equity and potential loan restrictions can make it challenging to sell these properties and initiate a new trade in the middle of the term. Owners may face difficulties in recovering their investment and finding buyers willing to take on the complexities associated with ZCF properties. This is why it is important to work with professionals who understand these intricacies and can properly advise you no matter your position.
Conclusion
When done correctly and under the right circumstances, the combination of a low equity requirement, no management responsibilities, and long-term leases with credit tenants make ZCF properties a great opportunity to build passive wealth. Having closed in excess of $100,000,000 of ZCF properties, we at Quantum Real Estate Advisors are well-positioned to help our clients navigate this complex landscape and set them up for long-term success.
