Zombie Real Estate Assets

A Zombie Asset is primarily an asset that is purchased for a very low cap rate and financed using a loan. For example, if you were to purchase a property in Beverly Hills, you would be buying the asset for a 2–4% cap rate. Unless you are an all-cash buyer, you must leverage the building with a loan.

Assume you get financing at 4%, interest-only, for 7 years, amortized over 30 years, with a loan-to-value of 75%. This 4% interest rate creates a loan constant of 5.729%. Therefore, the effective rate for the loan (5.729%) is greater than the 2–4% cap rate. The building's income cannot outperform — let alone keep up with — the cost of capital.

Many investors hold fast to the risky idea of "location, location, location." Yes — "risky" — that was not a typo. Because location means little if there is no cash flow. The downside of purchasing properties in prime locations is mediocre cap rates.

These investors hope that within two to three years the building will appreciate enough to cover the loan payments. Many investors who purchased real estate in 2005 and 2006 found out the hard way that things don't always work out as planned. In that recessionary period there were very few rent increases — and rents on many properties actually decreased. Assets did not appreciate, and their bank was not happy.

In essence, you are operating the building not for the benefit of your bottom line, but for the bank's bottom line. Over 75% of your time spent managing this building is just to make sure you can keep up with the loan payments. Hence, you are "working for the bank" and not for yourself.

"In these uncertain times, why would anyone want to own an investment that is a burden in the short-term with just the hope of long-term benefit?"

An investor that buys a building with a high cap rate turns the financial dynamic. For example, if an investor purchases a property for a 9% cap rate, they would be outperforming the interest rate of 4% — making a spread of 5% on the entire loan amount. This provides a foundation for purchasing a building and maintaining positive cash flow.

One uncontrollable risk factor most investors face is rising interest rates. If interest rates rise and rents do not increase, the value of the building decreases. Consider a situation where interest rates rise from 4% to 6%. An investor who owns real estate in a 5% cap rate area just experienced a negative shift in the value of their building — their asset became a Zombie Asset.

Therefore, it is very important to purchase property at a high cap rate in order to maintain a cushion from rising interest rates.