Investing in real estate, whether through residential, multifamily or commercial properties, has long since been a staple of family office and high-net-worth individuals’ portfolios and related estate plans. While different in practice from each other, property ownership in general has proved to be a stable investment over the long term and a good vehicle to increase net worth.
Investing in net lease properties is an area where many commercial real estate investors choose to start. There are several types of net lease properties for investors to consider, and a variety of financial structures and vehicles can be used to acquire these assets. For example, an investor may purchase an asset with a single-tenant, triple-net lease. This triple-net lease allows an investor to acquire a free-standing,single-occupant commercial property with the tenant assuming responsibility for all expenses – most notably the taxes, insurance and maintenance – related to the property for a set term length. This gives the tenant control of the property while providing investor owners with steady, dependable “mailbox” money with virtually no responsibilities.
Other options include acquiring property under a double-net lease, which is similar in structure to triple-net, but the owner of the property is typically responsible for capital improvements to the roof and structure while the tenant remains liable for all other costs and expenses. However, there is another structure in the net-lease market that is largely overlooked and underutilized by investors, especially high-net-worth individuals who are looking for tax benefits not offered through traditional real estate investments: zero cash flow (ZCF) properties.
A ZCF property is highly leveraged and backed by a long-term, bond-quality lease guaranteed by an investment-grade tenant. Typically, the tenant is on a lease of 20 years or more and has an investment-grade credit rating. The result is that a lender is comfortable with monetizing the entire rent stream so the financing amounts to 100 percent of the rent through a nonrecourse, assumable, fixed-rate mortgage. The term “zero cash flow,” or “zero” as it is sometimes called, refers to all the property’s net operating income going to service the underlying loan, and there is no money remaining to be distributed to the owner. This might not sound attractive to all investors, but a property and related lease with this structure provides numerous financial benefits.
Overview of the ZCF Market: Valuation Method and Pricing
Most commercial investment properties are priced through a cap rate, which is simply a way to evaluate the unlevered return an investor can expect to receive on an investment. A cap rate is calculated by dividing the net operating income by the purchase price. For example, if you buy a property for $1 million and the net operating income is $100,000, you purchased that property at a 10 percent cap rate ($100,000/$1,000,000). While there are a variety of factors that can impact cap rates, there are three primary factors that provide for the biggest impact on the rate: credit of the tenant, quality of the underlying real estate and term of the lease.
The credit of the tenant, or more accurately the guarantor, is the first factor to consider as the investor is essentially underwriting and investing in the steady cash flow that comes from the triple-net structure of the lease. The lease and related income stream are only valuable for as long as the tenant remains in business. The stronger the guarantor’s credit, the lower the risk to the cash flow and thus the lower return and related cap rate.
Because the value in the income stream is derived from the tenant’s ability to continue to pay rent, the underlying real estate is typically a secondary consideration. With that said, two similar properties situated in two different geographies will drive different risk and different cap rates. For example, a FedEx distribution facility in Chicago will drive a better price (i.e., a lower cap rate) than the same facility in a tertiary market. Similarly, a Walgreens will drive a better price in Tulsa than in one of its rural suburbs.
The last consideration is the length of the lease. Again, because the value in the lease is the cash flow it generates, the longer the lease provides for the payment of that rent, the less risk and consequently the lower the cap rate. That is, all else being equal, a lease with 15 years left on the term is more valuable than a lease with just five years remaining.
ZCF properties are valued differently though. While a cap rate can be calculated using typical methodology, ZCF properties are valued by the amount of equity on top of the debt that is required to acquire the property, with most zeros trading for an equity position of 10 percent to 20 percent above the debt, rather than a typical transaction where a buyer would need to bring 30 percent to 40 percent equity. This unique value calculation results in ZCF properties serving as the most inexpensive way to acquire a quality commercial asset. For example, a typical $5 million triple-net property would require at least 30 percent equity resulting in an equity obligation of $1.5 million. In the ZCF scenario, however, if the equity obligation is reduced to 20 percent and the full debt stays at $5 million, a buyer would only need to bring $1 million to the closing table. Keep in mind, this example is a worst-case scenario in favor of the traditional triple-net property. In practice, the equity obligation in a ZCF as compared to a traditional triple-net property is usually substantially lower, making ZCF properties highly sought after and coveted. To give some context, there is approximately $2 billion of inventory in ZCF deals mixed across roughly 140 available properties, with some of those properties being offered as portfolios rather than on an individual basis. In comparison, there is more than $26 billion of traditional net-lease supply currently on the market, illustrating the rarity of ZCF offerings.
ZCF Buyer Types
There are generally two instances where a buyer would want to acquire a ZCF property. The first is the typical 1031 exchange buyer which, with the financing already in place and assumable at low cost, makes the ZCF structure attractive. A 1031 exchange buyer coming out of a high-leverage sale with minimal sale proceeds may look to a zero to fulfill their up-leg portion of the transaction given the low equity requirement. A buyer coming out of a sale with more modest leverage, or even all cash, may look to a zero in order to take advantage of the paydown/readvance feature available to them via the loan agreement. In short, this paydown/readvance feature allows the purchaser to put down funds generated by the initial sale toward the purchase of the subject property, thus meeting the 1031 exchange equity requirements. In turn, the lender will readvance funds back to the purchaser up to the amount of the loan balance on the transaction date. Importantly, those funds are readvanced on a tax-free basis.
The second instance where a ZCF property is a good option is the high-net-worth individual who does not need or want the positive cash flow typically received from most commercial property investments. Instead, the high-net-worth individual uses the loss through the depreciation and interest expense of the property to offset gains in other assets or investments. Importantly, the losses in the early years of the lease may be significant, especially if the owner utilizes accelerated depreciation. As the term progresses, however, the loan balance decreases as does the related reduction in interest expense. As a result, the lease will often generate “phantom income” beginning in year 10 to 12 and will occur for the remainder of the term.
The paydown/readvance feature is a key benefit in ZCF structured deals. This feature allows the purchaser of the ZCF property to put down funds generated by the initial sale toward the purchase of the subject property, thus meeting the 1031 exchange equity requirements. In turn, the lender will readvance funds back to the purchaser up to the amount of the loan balance on the transaction date, allowing the owner of the property to extract the equity from the property tax free.
There are two ways this paydown/readvance feature can be structured in the debt instrument: the traditional paydown/readvance language or a Substitute Collateral Right. The standard paydown/readavance language will look something like the following:
If the Company exercises the Paydown Option, the Company may request a readvance of the Principal Paydown Amount (the “Readvance Principal Amount”) which if advanced shall be deemed an advance of principal pursuant to the Senior Note (the “Readvance Option”) on any Business Day during the Readvance Option Period upon satisfaction of the Readvance Conditions (as hereinafter defined). The Company may exercise the Readvance Option, if at all, by giving written notice to the Mortgagee (or its designee) of the Company’s intention to exercise the Readvance Option (the “Proposed Readvance Notice”), which must specify the amount of the Readvance Principal Amount and the date on which the Readvance Principal Amount is to be disbursed (the “Readvance Date”).
The Substitute Collateral Right language, on the other hand, is a second option and may be included in the debt instrument.2 The Substitute Collateral Right produces the same result as the paydown/readvance feature above but does so in an infinitely more complex way. In short, the Substitute Collateral Right allows an owner of a ZCF property to extract equity through the issuance of a new debt instrument on the property which is backed by the cash being pulled out by the owner. Before the new note is created, the owner and a newly created bankruptcy remote, special purpose entity with substantively identical organizational documents execute an assignment and assumption agreement which assigns the cash collateral to the new entity, and the new entity assumes the debt obligations under the new note. Upon the satisfaction of numerous conditions, the owner then has the right to assume the debt of the newly created entity and the grantee executes a termination statement that releases its security interest in the cash collateral. The cash collateral funds are then released to the owner.
Regardless of the structure and language used in the debt instrument for the paydown/readvance feature, the end result is the same – the new owner of the ZCF property and related lease receives the readvanced dollars tax free. At this point, the owner is able to use the funds for any purpose, including funding new business investments, acquiring additional properties with a new baseline or acquiring securities.
Illustration of ZCF 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 ZCF 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 ZCF 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 ZCF 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 ZCF 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 ZCF property, the owner engages the mortgagee 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 ZCF 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.
In conversations with friends, family, investors and attorney colleagues about ZCF properties, I often hear two questions. First, “Does the IRS know about ZCF properties?” and second, “Why have I never heard of ZCFs?”
To address the first question, yes, the IRS is aware of these types of transactions. Congress recently restructured the tax code and added provisions and investment opportunities that expanded the tax advantages that real estate investors can achieve (i.e. opportunity zones, leaving the 1031 in place, etc.). Had Congress wanted to address or even eliminate the ZCF option, they most certainly could have done so. As for the second question, as mentioned earlier, the ZCF structure is not well known and often overlooked, and the perceived complexity of the structure is a primary cause.
Hopefully, this article provided enough general knowledge about the ZCF structure that you, the real estate, estate planning or M&A practitioner can ask your clients this question: “Have you considered a ZCF property?” Clients do not rely on their advisors to simply answer their questions. Instead, clients often wonder, “What questions am I not asking that I should be?” With even a basic understanding and awareness of the ZCF structure, advisors will be better equipped to serve their clients.