In commercial real estate investing, the prevailing wisdom is to focus on net cash flow—that is, structuring the purchase of a property with the right combination of debt and equity so the property is cash flow positive. For many investors, this tried and true approach is the best option. However, it’s not the only option; in fact, there are certain situations in which zero cash flow investments, or “zeroes,” may be a more appealing structure.
It may seem counterintuitive to invest in something that does not produce a net positive cash flow, but it may make sense given the right situation. Below is an exploration of the various circumstances that might lend themselves to zero cash flow deals, and a look at why this strategy could be worthy of investment consideration.
What is a Zero Cash Flow Property?
By definition, a true zero cash flow property or “zero” is a highly leveraged asset that is structured so the net operating income (NOI) is equal to the loan payment, effectively producing $0 in net cash flow to be distributed to equity investors.
To illustrate such a deal, assume that an investor is considering the purchase of a Walgreens drug store, with a triple-net lease (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:
In this example, the property produces zero cash flow—an outcome that may seem undesirable on its surface, but there are actually several inherent benefits to this approach.
Benefits of Investing in Zero Cash Flow Properties
While the upside to zero cash flow investments can be limited, there are five key benefits to note:
- Taxes. Zero cash flow investments afford the opportunity to shelter income. Because real estate is a physical asset whose condition degrades over time, the accounting principle of depreciation (a non-cash expense) allows the property owner to expense a portion of the overall value each year, which offsets the property’s income. When applied to a zero cash flow property, this “loss” is passed through to the owner to reduce overall tax liability. While this tends to be a primary benefit associated with buying “zeroes”, it could also create tax issues down the road.
- Lease Escalations. Zero cash flow properties are commonly associated with triple-net lease agreements, which tend to have lengthy terms that include “lease escalations,” or contractual rent increases at set intervals (often annually). As such, this structure affords the opportunity for the property to gradually generate positive cash flow over time. For example, a triple-net lease could have a 25-year term with 3% rent increases every 5 years; because the debt service is fixed for the term of the loan, these increases ensure that while it may begin as a zero cash flow property, the net cash flow will scale over the life of the investment.
- Lease Extensions. Keeping in mind that lease terms for zero cash flow properties tend to be lengthy relative to other investments, they do typically offer built-in lease extension options that can rapidly turn a zero to a deal with significant upside. For example, consider a zero cash flow property lease with an initial 25-year term that has three 5-year extension options. By holding the property until the end of the initial lease term, the loan balance should be paid to $0 by the end of those 25 years; at that point, should the tenant elect to extend their lease, the property would become substantially cash positive without any associated debt.
- Credit Tenants. In a zero cash flow deal, a bank will typically only agree to a loan that is conditioned upon occupancy by a tenant who has significant financial resources and very little risk of default. As a result, these properties tend to be leased by “credit” tenants with a proven track record of on-time rent payments. Such a “credit” rating is generally granted by a third-party agency—for example, Walgreens is a credit tenant with debt rated Baa2 by Moody’s, qualifying them as investment grade.
- Low Down Payments. Understanding the benefits of having low-risk credit tenants, it follows that zero cash flow properties are often available to purchase and finance with relatively small down payments. Whereas a typical commercial real estate property may require a down payment in excess of 25% of the purchase price, a zero cash flow investment can require as little as 10% down based on the reasonable assurances that credit tenants are unlikely to default.
The Risks of Investing in a Zero Cash Flow Property
For those with the appropriate portfolio composition and risk profile, the benefits of a zero are clear—but as with any investment strategy, there are risks.
- Tenant Repurpose Risk. Single-occupant, zero cash flow properties tend to be constructed to the exact specifications of the tenant. Consider the Walgreens example, or a fitness studio, fast casual restaurant or office space. In many cases like these, there is a risk that the tenant may decide not to exercise their lease extensions and may vacate, leaving the investor with one of two likely outcomes: either the property will sit vacant for some period of time, or in the event that a new tenant is found, they may require extensive improvements prior to occupancy. In either event, it may be costly and time-consuming to re-lease the property.
- Phantom Income. While many investors opt to buy zeroes for the tax benefits, it is possible that “phantom” income—that is, income that’s taxable but not actually received—can negate these benefits. This happens when the annual depreciation expense falls below the annual lease payments, which results in the appearance of profit. In a typical zero, this is likely to occur between years 10 and 15 of the investment, and as a result, many investors opt to sell prior to this point rather than accept the liability of phantom income.
- Opportunity Cost. As with any investment strategy, there is the consideration of what could have been done with the same funds otherwise. These are the forgone benefits one might have gained from an alternative investment. Buying a zero, by definition, will not produce any cash flow. As a result, there is some opportunity cost associated with investing when that same capital could have been used for something that does return cash in the short term.
Who Should Consider in Zero Cash Flow Investments?
Weighing the risks against the potential benefits, it’s apparent that zero cash flow deals are not for everyone. Many investors are not equipped with the resources to weather a decade or more without an initial return on their capital, and not all investors have the risk profile or portfolio makeup to make buying a zero an appealing option when compared to other investment strategies. Still, zeroes may be a sound choice for a very specific investor—one who earns significant income from a primary job, from other investments or both. For those who understand the risks, the “loss” produced by a zero cash flow property can be a valuable offset to their alternate income, helping to round out their portfolio and reduce overall tax liability.
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, including zero cash flow properties, contact us at (800) 605-4966 or email@example.com for more information
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