For investors, there are numerous opportunities for creative real estate financing, each with its own unique advantages. Zero cash flow properties offer many benefits to investors with low equity, high tax burdens, or investors who want to extract equity without diminishing their portfolio.
What is a zero cash flow property?
A zero cash flow property, or a “zero,” is a highly leveraged asset with in-place, assumable, fixed-rate, long-term financing (typically 15 - 25 years) backed by a bond-style, absolute net lease guaranteed by an investment-grade credit. The high leverage nature is such that all net operating income goes directly to servicing the debt. Appropriately coined, zeros are commercial properties that produce no cash flow to the investor.
Who buys zero cash flow properties?
Zero cash flow properties can be attractive to several investor types, though the largest pool of zero buyers are those with a 1031 exchange need.
- Zero cash flow properties are attractive to 1031 exchange buyers who have little or no equity and are seeking to fulfill their trade need by replacing a significant amount of debt with as little equity as possible.
- A 1031 exchange buyer with a larger amount of equity may seek a zero cash flow property in order to take advantage of the paydown readvance feature provided in the loan, allowing the buyer to right-size the debt and equity requirements of the trade and extract a significant amount of tax-free equity once the 1031 exchange is completed.
- A non-exchange buyer may be looking to purchase an asset that will produce net tax losses, off-setting income elsewhere in the owner’s portfolio.
How are zero cash flow properties priced?
The most common method of pricing net lease investments is by using a cap rate, which is a one year cash rate of return on the purchase price, ignoring leverage. Given the high-leverage structure resulting in no cash flow, cap rates are typically ignored on zeros. These assets are priced instead based on the equity investment over the existing debt, expressed as a percentage of equity over the debt. Pricing of zeros will vary due to factors including the loan structure (fully amortizing vs. balloon), maturity of the loan/lease, perceived residual value, and availability of paydown readvance, among others. While many other structures are declining in value, zeros remain near their all-time high pricing at a range of 12 to 24 percent equity over the debt.
How does the paydown readvance feature work?
Paydown/readvance is a revolving credit feature in the existing loan. The loan provides the borrower the right to exercise an option to pay the balance of the loan down in full (i.e., the “paydown”) at any time during the term. The borrower has a subsequent right to exercise an option to instruct the lender to refinance the loan back to the balance it was prior to it being paid down (i.e., the “readvance”). Both the paydown and readvance options are rights provided the borrower in the loan agreement, and all terms and conditions of the loan remain constant during and after the process. There is no additional loan documentation required as part of the process. Certain requirements must be met in the exercising of both options, and to the extent those requirements are met the lender is obligated to perform.
The paydown option may be exercised in order to allow a 1031 exchange buyer to purchase the property while matching the equity requirements of the exchange. Post-acquisition, the buyer may exercise the readvance option to extract equity from the asset.
Illustration of zero cash flow transaction
As noted above, in addition to the tax loss and relatively low initial equity investment, the most significant benefit for most investors is the paydown readvance feature which provides for the tax-free extraction of equity dollars through either the standard paydown readvance or Substitute Collateral Right language in the existing mortgage documents. In practice, here is how the feature works.
An owner of a traditional investment property is preparing to sell the asset for $20 million and exchange into a zero cash flow property. She has held the property for a substantial period of time resulting in a debt obligation of $5 million with $15 million of equity. The owner has identified a zero cash flow property she can purchase for $20 million with $2 million as equity (approximately 11 percent above the debt) and assuming $18 million of debt. The owner applies the full $15 million in cash to purchase the zero cash flow replacement property, thus meeting the equity obligations of the 1031 exchange. The debt obligation is also covered as the $18 million of debt clearly covers the $5 million of outstanding debt on the original property. Prior to closing, the owner notifies the lender of her intent to exercise the paydown readvance feature in the loan documents after closing. The owner closes on the sale of the zero cash flow property, and her 1031 exchange is complete.
The next day, or whenever she wants to within the timing restrictions in the debt instrument for the zero cash flow property, the owner engages the lender and provides notice of her intent to exercise the paydown readvance or the substitute collateral feature within the debt instrument. The owner had applied the full $15 million in equity to the purchase price, and of that $15 million, $13 million is available as excess from the $2 million of equity required to purchase the property. At this point, the debt is readvanced from $5 million to the original $18 million, with the proceeds of $13 million going to the zero cash flow owner. As a result, the income deferment protections under the 1031 have been successful, and the owner has pulled out $13 million in nontaxable proceeds from the transaction.