Why Investment Managers Are Gaining Interest In Zero Cash Flow Properties

President, Director & COO of Inland Private Capital Corporation, recognized as the industry leader in securitized 1031 exchanges. 

Last year was a bit different for the securitized 1031 market and its investors, as the industry experienced a cooling effect in demand throughout April and into May 2020. In response to the Covid-19 pandemic, many buyers and sellers hit the pause button on pending transactions and this “wait and see” approach was further intensified by the IRS’ extension of the 1031 exchange deadlines. This extension offered investors more time to identify and purchase a replacement property.

Section 1031 of the Internal Revenue Code allows an investor to defer the payment of capital gains taxes that may arise from the sale of a business or investment property. By using the proceeds of the sale to purchase “like-kind” real estate, federal income taxes may be deferred, as long as the investor satisfies specific conditions. Meeting the debt replacement requirement is an important aspect in maximizing tax deferral in a 1031 exchange transaction. In order to achieve full tax deferral, investors must invest 100% of the sales proceeds received from the sale of their relinquished property into a replacement property. In addition, the sum of the cash invested, and the debt placed on the replacement property, must be equal to or greater than the sum of the cash invested and the debt relinquished on the property being sold.

For investors selling a property with a large amount of debt as a percentage of total sales price, one type of investment structure that can be especially beneficial — but is often overlooked — is a zero cash flow property, often referred to as a “zero.” Zero cash flow investment programs, particularly in the form of Delaware Statutory Trusts (DSTs), provide investors a turnkey solution designed to satisfy high debt replacement requirements while also achieving equity growth and capital preservation through ongoing principal paydown of the loan balance.

Zeros are typically long-term, triple-net leased commercial real estate assets backed by tenants with an investment-grade credit rating. Industrial distribution centers, necessity-based retail centers and corporate office headquarters are examples of properties that may be structured as a zero. These properties are often highly leveraged, with a loan-to-value ratio (LTV) ranging between 80% and 90% and requiring a minimal equity down payment for acquisition. By design, these opportunities are often structured so that all net operating income (NOI) is paid to the lender in the form of principal and interest payments until the principal balance of the loan has been repaid in full.

High leverage often carries a connotation of greater risk, which is why it is so important for investors interested in zeros to identify assets that are considered mission-critical facilities, occupied by tenants with strong balance sheets and investment-grade credit. Identifying assets with these characteristics is essential to lenders as they work closely with landlords and developers in procuring first mortgage financing that matches monthly rent and mortgage payments. 

A successful zero investment strategy requires credit analysis, real estate underwriting and financing execution. A zero DST is not only a real estate investment; it is also an investment in the underlying financing. It takes time and patience to find attractive opportunities; however, what once was a small, niche investment segment of the market has grown considerably in scale, particularly in the DST market. I’ve seen the growth firsthand: To date, our firm has syndicated more than $1 billion in transactions structured as zeros with a number of Fortune 500 tenants. 

Investor interest in zeros is often motivated by the desire to strategically acquire a position in an institutional-grade property with minimal equity contribution. The ability to assume high LTV, non-recourse financing in a turnkey zero transaction may present a compelling opportunity for 1031 investors, as well as cash investors seeking to accomplish this objective. The tax benefits are potentially plentiful for both cash and 1031 investors, but vary considerably, dependent upon an investor’s cost basis at the time the investment is made. Investors should consult their tax advisor for additional specifics surrounding their specific transaction. For 1031 investors, however, the structure has been a useful tool in covering a high LTV need in the purchase of their replacement property. 

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

Forbes Real Estate Council is an invitation-only community for executives in the real estate industry. Do I qualify?