In commercial real estate investing, the prevailing wisdom is to focus on net cash flow-that is, structuring the purchase of a property with the right combination of debt and equity so the property is cash flow positive. For many investors, this tried and true approach is the best option. However payday advance loans East Liverpool OH, it’s not the only option; in fact, there are certain situations in which zero cash flow investments, or “zeroes,” may be a more appealing structure.
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 circumstances 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?
By definition, a true zero cash flow property or “zero” is a highly leveraged asset that is structured so the net operating income (NOI) is equal to the loan payment, effectively producing $0 in net cash flow to be distributed to equity investors.
To illustrate such a deal, assume that an investor is considering the purchase of a Walgreens drug store, with a triple-net lease (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:
In this example, the property produces zero cash flow-an outcome that may seem undesirable on its surface, but there are actually several inherent benefits to this approach.
Benefits of Investing in Zero Cash Flow Properties
- Taxes. Zero cash flow investments afford the opportunity to shelter income. Because real estate is a physical asset whose condition degrades over time, the accounting principle of depreciation (a non-cash expense) allows the property owner to expense a portion of the overall value each year, which offsets the property’s income. When applied to a zero cash flow property, this “loss” is passed through to the owner to reduce overall tax liability. While this tends to be a primary benefit associated with buying “zeroes”, it could also create tax issues down the road.
- Lease Escalations. Zero cash flow properties are commonly associated with triple-net lease agreements, which tend to have lengthy terms that include “lease escalations,” or contractual rent increases at set intervals (often annually). As such, this structure affords the opportunity for the property to gradually generate positive cash flow over time. For example, a triple-net lease could have a 25-year term with 3% rent increases every 5 years; because the debt service is fixed for the term of the loan, these increases ensure that while it may begin as a zero cash flow property, the net cash flow will scale over the life of the investment.
- Lease Extensions. Keeping in mind that lease terms for zero cash flow properties tend to be lengthy relative to other investments, they do typically offer built-in lease extension options that can rapidly turn a zero to a deal with significant upside. For example, consider a zero cash flow property lease with an initial 25-year term that has three 5-year extension options. By holding the property until the end of the initial lease term, the loan balance should be paid to $0 by the end of those 25 years; at that point, should the tenant elect to extend their lease, the property would become substantially cash positive without any associated debt.
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