Much of the conventional thought used to evaluate a potential commercial real estate investment focuses on the amount of cash flow that a property produces. The greater the cash flow, the higher the value. Because this concept is so fundamental to CRE analysis, it may come as a surprise that there are certain circumstances where buying a property that produces zero cash flow can be financially rewarding. These are referred to as “zero cash flow” properties or just “zeroes” for short, and they are the subject of this article.
What is a Zero Cash Flow Property?
By definition, a zero is a highly leveraged investment property that is structured so that the net operating income (NOI) is equal to the loan payment. As a result, the cash flow available to distribute to equity investors is $0.
To illustrate such a deal, suppose that an investor is considering the purchase of a CVS drug store, with a triple-net lease (NNN)—meaning the tenant pays all of the operating expenses—for which both the lease payments and the debt service are $350,000 annually. The simplified Income Statement would look like this:
Because CVS pays all of the operating expenses, the rental income less expenses is $350,000. The loan’s payments are also $350,000, which leaves the property with $0 in cash available for distribution. Conventional wisdom states that this structure does not make any sense. In reality, there are several important benefits.
Why Zero Cash Flow Investments Can Make Sense
There are five reasons why a zero cash flow property can be a good investment:
- Tax Benefits: IRS accounting rules allow investors to “expense” a portion of the property’s value each year to account for its physical deterioration. This is a concept known as depreciation and it appears as a non-cash line item expense on a property’s income statement. As a result, a zero cash flow property’s taxable income turns negative and allows the investor to report a loss. This loss is passed through to the owner, and can be used to reduce his or her overall tax liability. This is particularly helpful for high income earners who can benefit from an offsetting loss to lower their overall tax bill.
- Lease Escalations: Many CRE leases include periodic rental escalations that cause a tenant’s rent to increase. The exact escalation can vary by lease, but it is usually a small percentage on a regular basis. For example, the lease terms could state that the rent will go up 3% annually. Because a zero cash flow property’s debt service is fixed, every increase in income will result in more cash available to be distributed to investors. So, a property may start with zero cash flow, but lease escalations will drive income higher over time, ensuring that it does not continue to have zero cash flow.
- Lease Extensions: In many cases, zero cash flow properties have a single tenant on a long term lease. In addition, the loan term is generally designed (with amortizing payments) to meet the lease term so that the last lease payment and the last loan payment occur in the same month. The reason for this is that the lender does not want to have an outstanding loan balance should the tenant decide not to renew their lease. But, if the tenant does decide to renew or extend their lease beyond the original term, the property can quickly go from zero cash flow to significant cash flow because the loan is paid off at that point.
- Credit Tenants: Because zero cash flow properties are financed with high leverage, the lender is going to require investment grade tenants like Walgreens. This is good for the property owner because this type of “credit tenant” significantly reduces the default risk in the transaction.
- Low Down Payments: Because of the credit tenants, zero cash flow deals qualify for financing that may require little or in some cases even no down payment. Over the long term, these can boost overall returns. It should also be noted that financing for zero cash flow deals can be non-recourse and have low interest rates, both of which are favorable for borrowers.
While the benefits of zero cash flow investments are impressive, they are not without risk.
Risks of Zero Cash Flow Properties
Zero cash flow deals are not for everyone. Potential investors should carefully consider the following risks:
- Repurpose Risk: In many cases, zero cash flow properties are leased to a single tenant and built out to that occupant’s specifications. For example, a drug store is fitted with refrigeration systems, shelving units, and an area for a pharmacy. If a drug store tenant were to not renew its lease, it could be very difficult and/or expensive to re-lease the space to a non-drug store tenant.
- Phantom Income: This one can be a bit complicated, but phantom income is income produced by the property, but never actually received. This happens when the amount of allowable depreciation falls below the annual lease payments, which results in a taxable profit for the property. This usually happens between years 10 and 15, which is why many sellers elect to sell their property around this time.
- Opportunity Cost: Zero cash flow properties are most beneficial over the long term. In the short term, there is some opportunity cost to purchasing them. This is defined as the forgone benefit from not purchasing another asset that produces positive cash flow.
If investors are comfortable with these risks, they can take steps towards making an investment in a zero.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.