Why do investors want to participate in Zero Cash Flow deals?
Hint: it’s about deferring taxes
Most zero cash flow Triple Net Lease (“NNN”) investments have two components. First, you purchase a high quality NNN investment with a long-term lease and a tenant with a high credit rating. Next, you obtain zero cash flow financing, where the rents from the tenant equals the debt service. This financing has an amortization period that is typically fixed to the term of the lease and a flat interest rate. Commonly, an investor will put between 10 and 20 percent down, and when the lease’s initial term ends, he or she will have a debt-free building.
Zero cash flow loans are highly leveraged and lenders require a strong credit tenant, which is why drug stores such as Walgreens and CVS are highly sought-after investments for these arrangements.
During the Lease Term
While the real estate investment is not providing current cash flow, the depreciation generated from these investments is structured to more than cover principal payments, leaving a net loss that can be used to offset other taxable income. Refer to my blogs on real estate professionals and passive loss limitations to determine if those losses can be used.
During the term of the NNN investment, principal payments will gradually grow. Once they exceed depreciation, you may be subject to phantom income, which is taxable. (See my previous blog on phantom income.) Prior to reaching this point, an investor should consider disposing of the asset (possibly through a like-kind exchange) or refinancing the property. If you have already reached the point in a zero cash flow deal where principal payments exceed depreciation, tax planning should be undertaken to minimize income taxes.
End of Lease Term
If an investor retains ownership until the end of the lease, the loan will be satisfied and the building will be owned without any debts. If there are options in the lease, it’s possible that the tenant exercises the option and the property will generate cash flow with no debt service. On the other hand, if the tenant decides to move out, it’s reasonable to assume the building will still have value.
While many investors acquire NNN properties for steady cash flow, that is not the only reason investors should consider a NNN deal. Astute investors use NNN investments as a way to minimize their tax exposure. Zero cash flow deals do not provide current cash flow, but can offer tax savings through depreciation deductions and appreciation of the real estate in the long-term.