What is a Zero Cash Flow (“Zero”) property? (2024)

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

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

E.g. a brand new Wal-Mart Zero with 15 yearsleft on the loan until maturity, would price in today’s market at probablybetween 10% – 11% over debt, meaning if the loan is at $10MM, then the totalvalue be about $11MM, meaning it can sell for $1MM plus, in equity. Alternatively, a property that wouldotherwise trade at a 6.00% cap, structured as a Zero, one must adjust the caprate upward with a deal premium of up to 1.5%, thus obtaining a true value near7.5%.

Benefits of a ZeroCash Flow property

• Generate tax free equity within a 1031 or 1033 exchange

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

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

The owner thus applies the full $30MM inoriginal equity to the purchase price of the Zero, and of that $30MM, $26MM is availableas excess from the $4MM of equity required to purchase the Zero property. Atthis point, the debt re-advances from the original $10MM to the new $36MM, withthe proceedsof $26MM going to the new owner of the Zero cash flow NNNproperty.

As a result, the owner pulls out $26MM intax-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 investmentincome

Owners of Zero Cash flow property get taxbenefits in the early part of ownership. This is due to the ability to report atax loss due to structured depreciation which more than covers principalpayments, 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 dueto market appreciation over the lengthy time period of the investment, usuallygreater than 20 years.

• Control real estate assets with minimal equity

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

Features of a ZeroCash Flow Property

1. Investment Grade Tenants

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

• Triple Net NNN Leases

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

• Assumable debt

Lenders in Zero NNN deals stereotypically offera 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 partnershipneeds to offset current income with ahigher depreciable basis, they mayconsider a Zero cash flow triple net NNN property, as their first choice. Essentially,IRS Code Section 467 allows for very flexible and aggressive structuring ofdepreciation, which in turn can generate maximal tax losses.

Important Considerations

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

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

• Don’t discount the intrinsic potential of the real estate andsimply view the Zero cash flow NNN property as a security or abstract financialinstrument.

• Ensure proper underwriting and due diligence is done to maximizereturns.

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

• To protectagainst any untoward liens, consider buying UCC insurance, which insures the lien-freestatus of the new owner. Especially, consider adding an Equity Ownership rider,which insures the investor from any adverse claims that accrued prior to theeffective date of the policy.
• If any bulk saleslaws apply to the transaction, then failure to comply will expose the investorto 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 moretraditional 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, avoidingloan transfer fees and taxes in some states such as FL, NV and OH. In addition, start-up costs are minimizedsince the investment vehicle already exists.

Alternative/comparableinvestments

• 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) participatein development, or 3) participate in both (a) & (b).When a Zero cashflow triple net NNN property is structured as a “Pre-Commit” or “ForwardPurchase”, an investor contracts – at a pre-determined cap rate – with adeveloper to buy a new, occupied, single-tenant building. Typically, cap ratesare higher under this type of purchase than other, traditional, salestructures.

• Essentially, a Zero Cash Flow NNN property can be mimicked by azero coupon bond where an investor buys a bond, without any cash flows (i.e. nointerest income or coupon). Ultimately,this bond generates a large upside by virtue of the difference in the initialdiscounted purchase price of the bond versus the “face value” of the bond,resulting in a “balloon” at maturity.

ProfessionalInvolvement

• Lenders must be comfortable with monetizing the entire rent triplenet NNN stream, so that the financing amounts to as much as 85 to 90 percentloan to value (LTV).Lender fees are lower for transfers of ownership anda 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.