One of the least understood types of real estate structure in the net lease market today is a zero cash flow property.  Put simply, it is a highly-leveraged property backed by a long-term, bond-quality lease guaranteed by an investment-grade credit tenant. 

 

The tenant of the property is typically on a lease of 20 years or more, and has a credit rating of at least BBB.  The result is a lender is comfortable with monetizing the entire rent stream, so that the financing amounts to as much as 85 to 90 percent loan to value.

 

The term “zero cash flow,” or “zero” as it is sometimes called, refers to the fact that all of the property’s net operating income goes to service the underlying loan, and there is none remaining to be distributed to the owner. This might not sound attractive to all investors, but a property with this structure does have its benefits.

First, it is an opportunity to buy an absolute net leased property for a minimal amount of equity.  Most zeros are purchased today with equity as low as 10 to 15 percent of the total value. Second, the financing is assumable, fixed-rate, non-re-course, and often fully amortizing. At the end of the loan term, the property is owned free and clear of debt.  Third, it is a low cost way to obtain the tax benefits associated with ownership of real estate.

 

Zero cash flow deals are especially attractive to investors looking for a quick and efficient completion of a 1031 or 1033 ex-change.  The financing is already in place, and the loan is easily and quickly assumable at low cost.  There is also an option provided in the loan that allows the purchaser to size the loan to match the particular debt and equity requirements of the trade, with a subsequent option to refinance and cash out a substantial portion of equity after the exchange is completed.  This equity can then be deployed to other cash-flowing assets with full depreciable basis outside of the confines of the exchange.

 

Nearly all zeros generate net taxable losses that can be used to offset like-kind income elsewhere in the owner’s portfolio.  These losses can be substantial in the early years of the loan, a time at which the combined offset from depreciation and interest expense far exceed the rental income.  The owner’s use of accelerated depreciation where permissible can maximize the effect.  A reality of the zero structure is that at some point the property will generate “phantom income,” since the rental payment equals to the debt payment.  This results from the reduction of loan principal and corresponding decline in interest expense over time.  Depending on the owner’s tax basis, phantom income typically appears in year 10 to 12 of the loan, and the taxes paid by the owner on the income is considered to be additional paid in capital.

 

Zero cash flow transactions require a skillful broker who can match the property to the investor, who understands and knows how to make the most of the tax consequences, and who can advise on long-term ownership of the asset.

Zero cash flow properties are good choices for estate planning, as well as pension and trust investment that will yield income after the debt is retired. Such properties may also satisfy requirements for 1031 exchange without committing a great amount of equity while maximizing interest and depreciation deductions. While a low-risk investment, zero cash flow transactions often include high loan-to-value ratios, lockout periods and prepayment penalties.

How does one calculate the possible market value of a zero cash flow property?

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Values for zero cash flow properties are usually expressed as a percentage over the debt. That is to say, some percentage in excess of the debt. As an example, a brand new CVS zero with 25 years left on the lease/loan that fully amortizes would price in today’s market at probably between 9% and 10% over the debt, such that if the loan balance were say $10Mil, then the total value be about $11Mil, meaning you could buy it with approx. $1Mil in equity. Further, the more seasoned that zeros become (older) the more valuable they tend to get, as you are closer to the day that you own it free and clear.

 

Another way to approach the problem would be to value the store as you would any other NNN property by applying a cap rate to the NOI. However, by applying a cap rate to the NOI, you would probably need to add at least 150 basis points premium to the cap rate. This helps account for the constraints of the zero deal (i.e. inability to refinance etc.). Said differently, If you have a deal that would otherwise trade at a 5.00%, as a zero it would probably value closer to an 6.5%.

 

It should be noted that both of these methods determine “gross” values and not a “net” value. That is to say that the net value (Gross Value minus the Debt) is the actual out of pocket cost to you to do the deal.

 

Lastly, as should be obvious, the real estate itself should play a role in it’s valuation in that, location, possible reuse, and building condition may drive whether or not their is any residual value to the building at all in the absence of the tenant exercising their renewal options. A critical mistake that many people make when looking at zeros is to discount the real estate and simply view them as a security or abstract financial instrument. This is not the case, real estate fundamentals still apply.

In commercial real estate, defeasance is a process a borrower may need to go through when selling property or refinancing a loan encumbered by CMBS debt.

 

Defeasance is a substitution of collateral activity where a portfolio of government securities are purchased from new loan proceeds, and the cash flow from these securities are used to satisfy the remaining debt service of the existing CMBS loan.


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The CMBS loan is subsequently assumed by a Successor Borrower, which is an entity created to hold the securities and make the future ongoing monthly loan payments.

 

The process can be complicated, and it is common for borrowers to engage a consultant on their behalf to help them navigate through the process since it involves structuring a portfolio of approved securities and coordinating the activities of multiple parties to meet closing schedules.  Call for more details.