We have reached a unique time in the net lease investment environment due to COVID-19—tenants are seeking rent relief, investors are taking capital off the table, and lenders are pulling back. There is a litany of questions around where the market goes from here as the environment continues to prove uncertain at best. But where do zero cash flow structured assets fit in this rapidly changing marketplace? Here are some questions and answers that address this and other issues.
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 NOI goes directly to servicing the debt. Appropriately coined, zeros are commercial properties that produce no cash flow to the owner.
Who buys zeros?
Zeros can be attractive to several investor types, though the largest pool of zero buyers are those with a 1031 exchange need.
- A zero is attractive to exchange buyers who have little or no equity, seeking to fulfill their trade need by replacing a significant amount of debt with as little equity as possible.
- An exchange buyer with a larger amount of equity may seek a zero in order to use 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 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 zeros 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.
Commercial real estate has obviously been impacted by COVID-19. How are zeros performing?
The commercial real estate industry has definitely been impacted, and the affected asset types have been well-documented, but zeros appear to be insulated so far. There are countless stories of tenants requesting rent relief or abatement, but we have yet to see this on a zero. With the market’s instability, buyers are seeking a flight to credit quality, and the investment grade quality inherent in zero cash flow assets strengthens the appeal to buyers in today’s environment.
With the current market uncertainty, why zeros?
The phrase “cash is king” has never been more true than it is right now, as we’re seeing investors place great importance on liquidity. Because zeros require minimal equity, they are the most economical way to purchase a net lease asset, obtain a long-term lease, and defer your tax burden. Furthermore, utilizing paydown/readvance with the purchase of a zero will net the investor additional liquidity that would have otherwise been tied up due to exchange requirements.
Zeros can also be a great solution for 1031 exchange needs resulting from deed-in-lieu or foreclosure scenarios. Both are considered by the IRS to be a sale of the asset to the lender, resulting in possible gains that can be deferred by a 1031 exchange.
Lastly, a cornerstone of a zero cash flow asset is its long-term, non-recourse, fixed rate financing that is readily assumable. Because zeros are acquired with an in-place loan, the investor isn’t restricted by the lack of financing options currently available.
Does today’s market benefit zero cash flow buyers or sellers?
The short answer is, “both.” The net lease market has been challenged in recent months as a result of weakening tenant credits. This is juxtaposed by significant demand from an unusually high number of 1031 exchange buyers as a result of currently extended exchange timing requirements. This results in a market that is prime for zero cash flow transactions for both buyers and sellers. Sellers can take advantage of a market that is still producing attractive pricing from buyers hungry for quality credit, while buyers can retain as much equity from their relinquished property as possible by replacing that asset with a zero while utilizing paydown/readvance.
What does the future of zeros look like?
We don’t have a crystal ball, so predicting where the market goes from here is quite difficult. However, we do know that zeros continue to be attractive, and the market remains strong at more than $2.0 billion per year in transaction volume. As long as properties are being sold and resulting 1031 exchanges need to be fulfilled, there will be a market for zero cash flow assets.