What Is a Zero Cash Flow Investment?
A zero cash flow property oftentimes called a “zero,” is defined by having a few characteristics, including a highly leveraged asset, long-term financing, a fixed rate, and the guarantee of an investment-grade tenant. In this type of investment, all net operating income services the debt owed on the property, meaning the property owner receives zero cash flow.
Pros & Cons of a Zero Cash Flow Deal
Although investing in a property with zero positive net income may not seem appealing, there are benefits to the deal type’s structure, and it may be the best fit for certain investors.
Pros of a Zero Cash Flow Deal
- Taxes: A zero cash flow investment allows an individual to essentially shelter income. Since the capital is resting in a physical asset, over time, the physical asset will depreciate due to natural wear and tear. As the asset degrades, it will depreciate and allow the owner to cash in on a portion of the overall value each year, offsetting the investment’s income. Simply, the owner is receiving payment for the value lost each year on the property, reducing their tax liability.
- Qualified Tenants: Because these deals produce zero income, a bank will ensure an investment-grade tenant occupies the property. An investment-grade tenant is a reliable and fiscally secure tenant that has a credit rating by a third-party agency that rates the company’s ability to repay its obligations. For example, CVS, a common zero tenant, is ranked BBB+ by Moody’s. CVS and other investment-grade tenants help mitigate the investment risk.
- Opportunity in a Tough Market: Securing financing and lenders during volatile markets can be difficult as the risk goes up. When debt and equity are hard to come by, investors with a small amount of capital and large amounts of debt struggle. Acquiring a zero property negates the financing issue by requiring a small percentage down payment compared to a traditional commercial transaction because a secure tenant backs the loan.
Cons of a Zero Cash Flow Deal
- Loss of Control: Most zero cash flow leases are structured to the tenant’s demands and wants. This most likely isn’t an issue, but in the off chance the tenant decides to vacate, the owner may be stuck with a vacant property for months or years. In addition, it’s a costly process to find a new tenant.
- Tricky Taxes: The biggest benefit to a zero cash flow deal is the tax break; it can also be the most challenging part of owning this type of facility. Typically, 10 to 15 years into the investment, the annual depreciation will fall below the yearly lease payments, making the investment appear profitable. This situation is called phantom income, income that is taxable but not actually received and can often cancel out the tax benefits the zero cash flow once boasted.
Why Investors Should Consider a Zero Cash Flow Deal
When considering a zero cash flow deal, it is key to evaluate the investor’s current portfolio, capital, and tax requirements, but sometimes it is the best option available.
Zeros are most attractive for 1031 Exchange buyers that need to replace their investment but have little to no equity. This investment strategy can replace a large amount of debt in a tight timeline without the start-up costs. 1031 Exchange buyers with equity may also consider acquiring a zero, as it will allow them to cash in on the paydown readvance they get from the loan and receive a significant amount of tax-free equity.
Beyond 1031 Exchange buyers, zero cash flow deals can work in struggling economic climates where capital is restrained, and lenders are cautious. According to GlobeSt., because zero cash flow properties are purchased with an in-place loan, investors aren’t hindered by the limited financing options. In an unpredictable market, zeros can also provide liquidity, which experts say is the most important thing when entering a possible recession. Investors can place capital in a long-term lease and defer the tax burden while gaining liquidity from the readvance of the loan.
Overall, the current market lends itself to zero cash flow investments, especially for those looking to defer capital gains and complete a 1031 Exchange with a stable and secure tenant.