That's an excellent question because there is a good deal of confusion surrounding the topic.
SHORT ANSWER: depreciation and to protect equity against rising cap rates.
SIDE NOTE- NNN Brokers USA is currently marketing over 30 zero cash flow CVS deals.
LONG ANSWER: Zero cash flow deals, also known as “Zeros,” are structured so that all the rent paid by the tenant goes to the lender. These real estate deals are structured similar to bonds and usually take advantage of high debt to equity ratios (LTV’s in excess of 85%).
There are few zero products on the market because they must meet several criteria. The property must be leased by an investment grade tenant (BBB or higher), the base lease term must be for at least 20 years, and the lease has to be an absolute triple net lease (bond lease).
The main advantage of these zero cash flow deals, real estate bonds, or self-liquidating properties is leverage and depreciation. Zero cash flow properties are great options for various situations.
1) Historically capitalization rates have followed interest rates and it is fact that a property’s value is determined by its capitalization rate ( CAP = NOI/Value ). If interest rates rise, CAP rates follow. For example, say your property type is trading at a 6% CAP rate and CAP rates jump 200 basis points to 8%. Your property’s value just dropped 25%. If you had an LTV of 75% or greater you are now underwater (owing the bank more than your property is worth). Fluctuations in CAP rates and interest rates do not affect the value of zero cash flow deals. Being underwater can lead to foreclosure which often triggers a taxable gain. Keep in mind that even if the CAP rates rise and the property value drops below the debt, the owner is not in jeopardy because the lease payments will still satisfy the debt service (in a zero cash flow deal).
2) Maybe you are focused on growing your portfolio but want to do so with as little risk as possible. Zero cash flow transactions allow investors to leverage their tenant’s investment grade credit rating thus allowing them to purchase property with as little as 10% down. These debt structures can be non-recourse and have balloons of up to 20 years. Some are even self liquidating (you own the property free and clear at the end of the 20 year term).
3) Consider another scenario, it is 2008 and you just sold at the top of the market. You would rather invest in another business venture than buy back in an overpriced market. A zero cash flow deal enables you to cash out your gain and postpone your tax recognition. Basically a bond type of refinancing.
4) One last common scenario… Your corporation, LLC, or partnership needs a higher depreciable basis to offset current income. A zero cash flow deal as we previously mentioned, provides the ability to buy one of the most depreciable basis’ with the least amount of equity (other than leasehold interests ).
An example of a zero transaction is a CVS pharmacy with the following terms:
(1) Initial lease term 25 years, expiring on January 31, 2035.
(2) Loan term is 22 years
(3) Fully-amortizing, non-recourse loan.
(4) Interest rate is 7.507%
(5) Tenant has a 3 year rent holiday in the last 3 years of the initial lease
(6) Property may be acquired all cash (subject to paydown/readvance feature), or as debt assumption.
(7) Property is zero cash flow
(8) Absolute net lease; no landlord responsibilities.
Oct 25, 2010