A Zero Cash Flow Net Lease Portfolio Trades for $570M. Why?

In the second half of December, Mesirow Sale-Leaseback Capital sold two structured credit tenant, net-leased properties to private buyers.

Together, the transactions, which included an on-airport Amazon distribution center, totaled more than $570 million in value and 1.4 million square feet.

While Avison Young, which closed the deals, was restricted from sharing broader details of the transactions,  Jonathan Hipp, head of US Net Lease Group, tells GlobeSt.com it was unique because it was a zero-cash flow deal—meaning the rent the buyer receives is equal to what it will pay on its mortgage. The structure only works if the tenant has strong credit and is on a long-term lease, which allows the buyer to put maximum leverage on the property.

But why would a sophisticated buyer want something without any cash flow?

Traditionally, there were two significant reasons that buyers would take on zero-cash flow deals. The first is when 1031 exchange buyers are highly levered on the deals they’ve sold.

Zero-cash flow deals allow them to find a deal with financing at 80% percent-loan-value included.

“That is a loan they may not be able to get otherwise,” says Avison Young Senior Vice President Rich Murphy. “It lets people accomplish their 1031 exchange.”

The second reason investors may want a zero-cash flow deal is for a pay down readvance. In this case, the buyer has sold a property with little or no leverage and faces a considerable capital gain.

“By purchasing a zero-cash flow deal via a 1031 exchange, the borrower can use, potentially all of, their sale proceeds to buy the property and then readvance the portion beyond the equity required to purchase the deal, post-closing,” Murphy says. “This lets them retain a large portion of the cash from their sale.”

But the 2017 Tax Law gives another group of buyers reasons to pursue zero-cash flow deals. The law included bonus depreciation provisions that allow buyers to write off a significant portion of their initial investment in a building all at once, according to Murphy.

“While you could always perform a cost segregation study and perhaps get 20% of the purchase price re-allocated to a shorter-lived asset class, the 2017 act permitted that portion to now be directly written off,” Murphy says.

However, the Mesirow Sale-Leaseback Capital deals were different.

“What made these properties unique was the ability to get an enhanced amount of depreciation expense, along with bigger price points,” Murphy says. “Because of some of the unique construction attributes of the buildings, they were able to get more than typically is possible subject to bonus depreciation.”

Murphy says the depreciation deduction can eat up a large percentage of the buyers’ equity requirements. “If you could take the benefit of the deduction, the cost of the investment, after-tax, becomes very small and can really change the economics of the deal,” Murphy says.

In a couple of years, Murphy says these depreciation benefits will phase off. But, in the meantime, more zero-cash flow deals should trade, including one that Avison Young is bringing to market in the first quarter.

“It’s possible that you could see more stuff like this on the horizon,” Murphy says. “It’s just a function of what’s in the development pipeline for folks out there.”