Zero-Cash-Flow 1031 Deal Realigns Portfolio

LOS ANGELES-Pegasus Investments, an investment advisory firm that operates from offices in Century City and Encino, has closed on a highly structured zero-cash-flow 1031 transaction that is the latest step in “an extremely detailed portfolio repositioning strategy” on behalf of Los Angeles-based Inglewood Family Corp. Inc. This is according to president Ken Chasin and executive vice president David Chasin of Pegasus. The closing of the transaction, in which Pegasus acted as the lead adviser in Inglewood Family’s acquisition of a CVS pharmacy in Prattville, AL, “helps the buyer continue a complex unwinding of an 11-property retail portfolio,” David Chasin says.

The property, which is located within Montgomery, AL's most densely populated suburb, sits as an outparcel to Pratt Plaza and across the street from a neighborhood grocery center anchored by Winn Dixie. The site includes numerous other outparcels with tenants such as Colonial Bank, Wendy's and Hardee's. Although the buyers were at first unfamiliar with the Montgomery suburb, Pegasus recommended it to the buyer after an extensive review of the site and surrounding area.

"At first glance it would be easy to dismiss Prattville as a tertiary location, however there are very strong demographic, traffic flow and site fundamentals which contribute to our expectation that this will continue to be a dominant site for CVS for many years to come," David Chasin explained. "The store is a relocation from within the same center. CVS moved from its in-line space to its newest prototype, which is a freestanding 14,000-square-foot building with a drive-through," Chasin added. "The fact that CVS already knew what its sales were before making this type of investment added another layer of confidence we already had in the site."

A Complex Unwinding

Pegasus was first retained by the buyer in 2009 to provide advisory services in connection with a portfolio of 11 properties that the buyer had recently inherited in Los Angeles. Upon its initial review, Pegasus valued a significant portion of the portfolio less than the outstanding debt and determined that the best strategy would be to prevent the defaulted loans from affecting the healthy, performing properties. "Given the cross-collateralization and cross-default provisions, the trick here was to carve out [via sale] the toxic assets from the healthy assets within the client's portfolio," Chasin explained. Within a few months, Pegasus had completed sales on seven of the assets in the portfolio and recapitalized the remaining four. The net effect of this strategy was that the Portfolio began cash-flowing again, the negative equity in the underperforming properties had been recapitalized with the substantial equity in the remaining balance of the portfolio, and the client “had avoided what was an inevitable catastrophe,” Chasin says. "The next problem we needed to solve was how to accomplish a 1031 exchange when the sale of the 'toxic 7' had netted zero proceeds to the seller," Chasin added.

10% Down, Zero Cash Flow

The concept of a highly leveraged, zero-cash-flow deal is nothing new, according to David Chasin. "There are plenty of assets floating around the market with high leveraged bond financing on them, and they've been popular with many of our clients seeking a tax shelter during a 1031 exchange," Chasin commented. He explained that this type of financing is most commonly found collateralized by a single-tenant, investment grade-rated tenant on a long term lease. They can range from CVS stores, to Wal-Mart distribution facilities, to government office buildings. Since the minimum debt service coverage ratio on a bond-financed deal can be as low as 1.01, the leverage can get up to 80% to 90%. “The lender will often peg the amortization term with the remaining lease term, thereby recouping its entire loan by the termination of the base term of the lease,” Chasin points out. "In the example of the CVS in Pratville we just sold, the property was engineered as a zero-cash-flow deal from the start, thus the cap rate, interest rate, amortization, etc. were all structured together."

This type of niche investment has been growing in popularity over the years because the buyer doesn’t need a large equity contribution to buy one and it allows the buyer to replace significant debt in a 1031 exchange. "For the Inglewood Family Corp., this was ideal because it accomplished the 1031 exchange requirement without having to come to the table with 40% equity," the Chasins say. They note that it is important to point out that there are future tax consequences associated with these types of transactions which present themselves 10 to 20 years down the road, depending on the basis the investor is exchanging out of. They recommend that anyone considering a transaction of this type contact a tax adviser.

The Remaining Portfolio

Since the acquisition of the CVS Zero, Pegasus has completed the sale of one more asset within the Los Angeles Portfolio and will be closing shortly on the subsequent 1031 exchange property. There are currently only three remaining properties within the portfolio and are currently being offered for sale by Pegasus. These properties are nearly 100% occupied and being offered at cap rates of 9-10% on existing NOI.