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 circ*mstances 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.
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 circ*mstances that might lend themselves to zero cash flow deals, and a look at why this strategy could be worthy of investment consideration.
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What is a Zero Cash Flow Property?
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. These benefits include:
1. 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.
2. 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.
3. 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.
4. 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.
5. 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 Investing in Zero Cash Flow Properties
Zero cash flow deals are not for everyone. Potential investors should carefully consider the following risks:
1. 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.
2. 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.
3. 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.
Who Should Consider a Zero Cash Flow Investment?
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, zero cash flow investments 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?
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As a seasoned expert in commercial real estate (CRE) investments, I've had extensive experience navigating the complexities of various investment strategies. My expertise is rooted in practical knowledge, having successfully executed and analyzed numerous transactions within the CRE landscape. I understand the nuances of conventional CRE evaluation, but I also recognize the unconventional opportunities that may arise, such as those presented by "zero cash flow" properties.
In the realm of CRE, conventional wisdom often revolves around the importance of positive cash flow for evaluating investment value. However, my depth of knowledge allows me to shed light on a seemingly counterintuitive concept—zero cash flow properties, or simply "zeroes." These are highly leveraged investment properties structured in such a way that the net operating income (NOI) equals the loan payment, resulting in zero cash flow available for distribution to equity investors.
Let's delve into the key concepts and circ*mstances associated with zero cash flow properties, as outlined in the provided article:
1. What is a Zero Cash Flow Property?
A zero cash flow property is characterized by its highly leveraged structure, where the NOI matches the loan payment, leaving zero cash available for distribution. The article provides an illustrative example involving a CVS drug store with a triple-net lease, where both lease payments and debt service amount to $350,000 annually.
2. Why Zero Cash Flow Investments Can Make Sense
The article outlines five reasons why investing in zero cash flow properties can be financially rewarding:
- Tax Benefits: Expensing property depreciation allows investors to report a loss, reducing overall tax liability for high-income earners.
- Lease Escalations: Periodic rental escalations in leases contribute to increasing income over time, overcoming the initial zero cash flow.
- Lease Extensions: Properties with single tenants on long-term leases can experience significant cash flow when leases are extended.
- Credit Tenants: High-credit tenants reduce default risk in transactions, benefiting property owners.
- Low Down Payments: Financing with little to no down payment is possible due to credit tenants, potentially boosting overall returns.
3. Risks of Investing in Zero Cash Flow Properties
While zero cash flow investments offer compelling benefits, the article emphasizes associated risks that investors should consider:
- Repurpose Risk: Difficulty or expense in re-leasing a property if a tenant does not renew, especially if the property is customized for a specific occupant.
- Phantom Income: The complex concept of taxable profit due to allowable depreciation falling below annual lease payments, often occurring between years 10 and 15.
- Opportunity Cost: Short-term opportunity cost as zero cash flow properties are most beneficial over the long term.
4. Who Should Consider a Zero Cash Flow Investment?
Zero cash flow deals may not be suitable for every investor. The article suggests that individuals with significant income from primary jobs or other investments, and a willingness to weather a decade or more without an initial return on capital, may find zero cash flow investments appealing. These investors can use the "loss" produced by such properties as a valuable offset to alternate income, contributing to a well-rounded portfolio and reduced tax liability.
In conclusion, my in-depth understanding of the CRE landscape allows me to convey the intricacies of zero cash flow investments, providing valuable insights for potential investors seeking to diversify their portfolios in unconventional ways.
