Jun192015
Big losers in real estate buy negative cashflow investments
Negative cashflow investments are generally a losers game. The only path to success is for rapid appreciation that often fails to materialize.
Real estate investors during the housing bubble put their money to work on faith. There is no logical reason to believe house prices only go up. In fact, there have been two prior periods in California’s recent history where house prices did, in fact, go down. However, with kool aid intoxication, otherwise known as faith-based investing, reality is ignored.
If you truly believe house prices only go up, no price is too high, and you don’t have to worry about a backup plan if house prices don’t go up. There is only one viable backup plan when a speculative play on appreciation does not pan out: renting the property until you get out at breakeven.
For some people, this was as far as they took their analysis. A glib idea of renting it out gave them all the assurance they needed to pull the trigger on a foolish deal. If they had stopped to do the math, they would have quickly realized rents would only cover a portion of their monthly cost of ownership. A wise person would have recognized this risk and passed on the speculative bet. Investors during the housing bubble were not very wise.
I have read many accounts where everyone claims a collective ignorance. “Nobody could have seen the crash coming” or some other such nonsense. Any investor who bothered to consider their plan B would have quickly realized the risk of an extended period of negative cashflow was an unacceptable risk. Prices didn’t have to crash to make this risk a pocketbook-burning reality. Even a flattening of prices for an extended period would have been a problem.
The people who ignored this risk and bought properties are now bagholders. They own property consuming their income and providing no benefit to them whatsoever. Many still cling to their denial and hope for rapid appreciation to bail them out, but many others capitulate to the market and sell. As they sell they keep prices from rising and discourage others. One by one, each market participant moves from denial to acceptance and capitulates by selling at a loss.
When to cry ‘uncle’ on an investment property
August 16th, 2011, 6:00 am — posted by Marilyn Kalfus, real estate reporter
Christine Donovan, a Realtor and attorney who does the weekly “Huntington Beach real estate minute” on listings, homes in escrow and sales, offers some advice in her blog about when to unload real estate bought as an investment that’s failed to pay off.
She writes:
“Have you been watching the value of your investment property go down and wondering what you should do about it?
“It likely depends on what your goals are. If you have lost value, are living in the home, can afford the payments, and it meets your needs, you’re one of the lucky ones, and you should probably just stay where you are. Perhaps when you’re ready for your next home, your home will have regained some of the lost value.
Or perhaps you are just a fool in denial.
“If on the other hand, your investment property is underperforming, perhaps you need to look at it carefully. For instance, let’s look at the following scenario.
“You have equity in your home …
- But, it’s $250,000 less than it was in 2006.
- You put money down on the home, and you’ve made payments for several years.
- You feel that selling it would result in a loss.
- It’s a rental, and you’re losing $600/month after your mortgage payment.
This is the folly of negative cashflow investment. Nobody should ever be in this circumstance. Nobody who follows my advice ever will be. I advise owner occupants not to pay more than rental parity for the same reason. Negative cashflow is a black hole on your balance sheet sucking the money out of your family never to be returned.
“At this point in time, you may want to do a few things:
Actually, you only need to do one thing: sell. Any rationalization you come up with is foolish denial.
- Review rental rates and see if you can increase rates to limit the loss or make the property cashflow
- Sit down with your accountant and see if you need the loss for income purposes.
- If you don’t need the loss and still can’t make it cashflow, it might be time to consider selling the property and reinvesting in a better performing one.
- Some people don’t want to “give up” and think that holding it might make more sense.
- But, if you’re losing $7,200 per year, you need to gain that amount in equity plus the amount that you lost when the market values fell, especially if you bought it for less than current market value.
I doubt many investors can review the rental comps and find they are under the market by $600 a month or more. Nice idea, but not very practical.
This woman claims to be a financial adviser, yet she perpetuates the myth that anyone should take a loss for tax reasons. Perhaps tax implications may favor taking the loss this year or next, but waiting several months or years will usually make for larger losses as the negative cashflow eats you up.
The people who doesn’t want to “give up” are the ones still in denial. Holding a negatively cashflowing investment never makes sense. Her final point is a good one. For an negative-cashflow investment to make sense, the appreciation must compensate for the negative cashflow. If you examined such an investment’s internal rate of return, it would be horrendous because the ongoing negative cashflow compounds against you. It isn’t just the lost money, it is the lost opportunity cost on the lost money that really hurts.
“So, when is it time to cry “uncle” on your home? When the loss on your investment property just doesn’t make sense any more.
Anyone in a negative cashflow investment should dump it as soon as possible. It was a bad idea when it was purchased, and holding it makes it even worse.
This is really about investor psychology. Many, many speculators in Orange County are sitting on negatively cashflowing investments waiting for the magic appreciation fairies to wave a wand and make them whole again. It isn’t going to happen.
So how do you recognize capitulation when you see it? From the comments on the OC Register post:
InTheSameboat says:
Sounds like the situation my wife and I are in. Bought a condo in 2006 at the price peak (sigh). Lived in it for 2.5 years then started renting it out while renting out a bigger place for ourselves and new baby hey not so bad right? 2.5 years later and the loan modification (discount) expired when you add up the taxes, insurance, hoa. It looses 400 a month. $800 a year for the corporation to lease it under of course. Pay for those taxes filed separely of course.
Like a lot of young couples on the move fast and making decisions fast we never really factored in all the costs to rent it out in a professional manner. Now with a second child on the way its more like good grief as long as we have a mortgage on this condo we don’t live in and loose so much money on we will never be able to buy a home for 25 years unless we drop it.
So we cried uncle, after 6 months of thinking about it and stubbornly thinking “just keep it” we just couldn’t shake the feeling that rents are going to go up, but only a little bit. The value will go up, but only a little bit. You can call it a recession, and recession part 2 but I think this is the new norm. The painfull and humbling decision was made to short sell it.
With noteable employers leaving the state its going to slow down the recovery and price increases we all prayed for the last few years. Jobs came back and values went up… just not around here. Accepting this reality strenghtened this decision and suppresed the remorse feeling.
I would like to know more about this (if you lived in it 2 years of the past 5 you won’t have to pay capital gain taxes) Our CPA told us otherwise, he said we would have to move back in for 6 months and then sell it to avoid the heavy taxes. Other than that we’ll just have to eat it.
That is capitulation.
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Rising input costs, legal, property taxes, insurance, utilities, maintenance, unexpected structural repairs, delinquent tenants, destructive tenants (aka the inflation of costs of holding-up a manipulated structure and costs of doing business) is ‘busting’ many an LA/OC landlord these days who did not understand the consequence of price.
Just wait till the coming ‘rent control’ era takes root. I suspect the rush to the exit door will be epic.
Reminder:
*The REAL return is what counts!
*Economic data understates inflation and overstates growth, so if you don’t ACCURATELY factor-in true inflation, actual rental yields are all just bullshit.
*Price keeping-up with inflation is NOT being compensated for risk exposure, nor is it building REAL wealth. It’s merely tracking inflation.
Class dismissed.
If rent control takes hold in Orange County, it will ruin the value of the affected properties, but it would increase the rent from those that avoid it. San Francisco has this same problem. Each rent-controlled unit takes one away from the free market, and since no additional supply comes to market, as new renters start looking for properties, they bid up the few remaining market rentals.
Homeowners Could Spend Up to $9,000 Every Year in Hidden Costs
When purchasing a home, it’s important to consider the extra or hidden costs. Many homeowners are blissfully unaware of just how much these additional fees can costs on top of their mortgage. Zillow and Thumbtack recently released a study that found homeowners can pay more than $9,000 in hidden and home maintenance costs every year.
Zillow and Thumbtack calculated several unavoidable, hidden costs like property taxes and insurance, as well as some commonly forgotten maintenance costs like yard care and carpet cleaning to help buyers be more prepared for additional costs associated with homeownership. Data for this study was taken for the entire nation and across 15 metros.
“Home buyers too often fixate on the sticker price or monthly mortgage payment on a house, and don’t budget for the other expenses associated with ownership–which can add up quickly,” said Amy Bohutinsky, Zillow CMO. “For example, new buyers can get really excited about having a backyard of their own for the first time, without budgeting for how they plan to maintain that space.”
According to the study, homeowners pay an average $6,042 per year in unavoidable hidden costs, nationally. This includes homeowners insurance, property taxes, and utilities. Homeowners in the Boston metro have the highest property taxes and can expect to pay $9,413 annually, the highest amount of all the markets analyzed. Meanwhile, in Phoenix, homeowners pay an average $4,513 for these same additional costs.
Those that prefer to outsource when it comes to cleaning their home or doing yardwork, instead of using the do-it-yourself method, still find themselves spending an equally comparable amount on additional expenses, the study found. Thumbtack users visit the site to request help for house cleaning, yard care, gutter cleaning, carpet cleaning, and pressure washing. On a national level, these tasks add up to an average $3,435 per year. In San Francisco, homeowners will pay the highest amount in the metros reviewed at $4,653 per year, compared to Denver homeowners who pay around $2,782 for the same projects.
“Maintaining a home is time consuming and costly, and in some regions hiring help gets you more bang for your buck than in others,” says Jon Lieber, Thumbtack chief economist. “As we know, this winter was especially harsh in some parts of the country, and in the aftermath, homeowners can face a lot of unexpected expenses to keep their home in top condition. It’s imperative for buyers to consider these inherent maintenance costs when budgeting for their big purchase.”
You don’t have the typical maintenance items buying new, but it’s worse! You get to spend tens of thousands landscaping your new backyard in the first year!
“…is ‘busting’ many an LA/OC landlord these days who did not understand the consequence of price.
Just wait till the coming ‘rent control’ era takes root. I suspect the rush to the exit door will be epic.”
It almost makes you want to invest in Section 8 housing in the high desert.
Not too familiar with the high desert trends; is that where the poor are being pushed out? I did take a trip to Joshua Tree several years and noticed a lot of people pushing shopping carts in Apple Valley. Really surprised me.
Water…
I actually think that is a not a bad idea…
The main difference between a cash-flow positive investment and a cash-flow negative investment is how much the buyer is able to put down. If you have 50% down, then the property will probably cash-flow. If you put 0% down, probably not.
If you can get the property at a good price, but don’t have the down payment, but do have extra income to cover the monthly loss, then it can still make sense to buy. With amortization and rent covering most of the expenses, your monthly cash-flow-negative payment is essentially buying the home at a discount. As rents and property values rise, you can refinance into a better position. It all depends on the price.
The person cited in the article that sold their home in 2011 could have cash-in refied, dropping their monthly payment. With rents and property values rising the last four years, it would be interesting to see where they would have stood financially. Many simply didn’t have the funds to cash-in refi at the time, so it wasn’t an option. So they could either continue to pay interest at elevated mortgage rates or default.
Just because a property is cash-flow-negative, that doesn’t mean that it’s a bad deal, just that it isn’t as good a deal as one that’s cash-flow-positive. If it’s too negative though, it probably means it’s overpriced. But a few hundred a month can still make sense once you consider amortization, rent, rent growth, and appreciation. Once all the cash-flowing properties are gone, investors will need to sharpen their pencils if they want to grow their business.
Negative cashflow real estate investments are a huge risk, and back during the housing bubble, people either didn’t realize this risk or didn’t acknowledge it. Thousands of speculators who bought in 2004-2006 believed they had a can’t-miss bargain and ended up in the same circumstances as the owners in the article. The vast majority (probably all) of these speculators didn’t have the cash available to save the properties, which is why we had so many foreclosures. Only through interest-rate bailouts were any of them able to survive.
I agree. Negative cash flow investments can be risky, but the devil is in the details. Taking today’s property as an example: the monthly expenses are $1922. Of this, $571 is property tax, $220 is mello roos, $137 is homeowner’s insurance, $227 is HOA, $346 is property management, $277 is maintenance and reserves, and $144 is vacancy and collection loss.
The cash flow is ($540)/mo. after amortization. If you manage it yourself, then the cash flow is ($194). Amortization will rise by $30/mo. after a year, and $174/mo. after 5 years. With rent increases, this property should be cash-flow positive with amortization after about five years for a self-managing owner. There is also the potential tax benefits to consider.
I don’t like the mello roos and the HOA fees. This takes a big chunk out of the profit, but the amenities are higher in this area because of these fees, which means rents should be higher so its probably a wash.
Overall, I think this property is a little too expensive as an investment. I would like to see it payment neutral after putting 20% down. The high expenses (~2k/mo.) make this an iffy investment.
My main concern would be carrying the ~1200/mo. The amortization is nice, but that is a large chunk of money for one investment. Self-managing drops this to $860/mo. Vacancy and collection loss is not likely in this area. There is no getting around the maintenance reserve, but this can be put in upfront into a property management account. So, the real monthly out of pocket is $439. After 20% down, that seems pretty steep.
But it is a prime area that will always be rented and rents should rise faster here than other areas. Mello roos will sunset and prop 13 limits the property tax increase to 2%/yr. The mortgage is fixed at a relatively low rate.
It is a 30yr loan, however. This investment would make a lot more sense if this was a 15yr loan, but then the out-of-pocket expense would be around $1500/mo. Over 180 payments that works out to 270k + 130k down = 400k to buy a rental in a prime OC neighborhood, that is currently priced at 659k. Not bad, but definitely a long-term investment.
Russ- I suggest you read up on the definition of cash flow. This is a good book that I can recommend:
http://www.amazon.com/Every-Estate-Investor-Financial-Measures/dp/0071603271
+1 Good call.
Thanks. I’ll take a look at it.
Kind of echoes what I was saying, doesn’t it?
“… However, the presence of an occasional negative cash flow doesn’t mean that this is a fatally flawed investment; you make up the loss in other years or through other of the “four returns.” [cash-flow, appreciation, amortization, or tax shelter] The potential for a negative cash flow, however, does bring an important point front and center: If you make your projections and judge the overall investment to be worthwhile, you can anticipate the negative cash flow and take it in stride. If you don’t make your projections, your can get blindsided.”
Working my way to cash-flow analysis section…
Reflating Housing Bubble Provides Baby Boomers Retirement Savings
Senior home equity nears $4 trillion as home values rise
Home equity, and mortgage debt of homeowners 62 and older, has reached 189.67, its highest level since Q1 2007, according to the National Reverse Mortgage Lending Association/RiskSpan Reverse Mortgage Market Index, a quarterly measure which analyzes trends in the home values.
The RMMI is updated quarterly and tracks back to the start of 2000.
The $63.5 billion increase in senior home equity in the first quarter was fueled by an estimated $61.6 billion increase in the aggregate value of senior housing and a $1.9 billion decline in senior-held mortgage debt.
“As the economy recovers and the amount of housing wealth held by older homeowners continues to grow, home equity is an increasingly valuable resource America’s seniors can use to help fund their longevity,” said NRMLA President Peter Bell.
The first quarter of 2015 was the twelfth consecutive quarter in which the index has risen, and the $3.96 trillion estimated aggregate value of home equity owned by seniors is now just 1 percent below its peak level of $4.0 trillion in Q4 2006.
The current senior equity levels represent a 34% recovery since the post-Recession trough reached in Q2 2011, when senior equity levels had fallen to an estimated $3.0 trillion.
Housing Experienced a Supply and Demand ‘Conflict’ In May, Economist Says
This is how economists will spin the dramatic decline in home sales when mortgage rates rise
The housing market experience experienced a “conflict” between supply and demand in May as increased home values resulted in sales, which subsequently increased supply – but at the same time, lack of affordability and economic uncertainty reduced demand, according to First American Chief Economist Mark Fleming.
The market capacity for existing-home sales increased by 0.3 percent month-over-month and 12.5 percent year-over-year in May, while rising interest rates and a slight jump in unemployment countered equity-enhancing home price appreciation, according to First American.
Still, given current market fundamentals, the housing market is underperforming, Fleming said.
“Our Existing-Home Sales Capacity model’s analysis of the fundamentals that influence capacity indicates that the market is experiencing both tail and headwinds,” Fleming said. “The net effect is a very modest tail wind. The appreciation in home prices, for example, is helping to improve the U.S. housing market, with recently released data showing declines in the levels of negative and insufficient equity. As a result, true market values are beginning to meet or exceed the expectations that homeowners have for the value of their properties, encouraging them to sell and, therefore, reduce pent-up supply in the market today.”
The rising interest rates and slight increase in unemployment counter the financial benefit of home price appreciation, thus reducing market capacity for existing-home sales, Fleming said. Additionally, increasing mortgage finance costs not only put homeownership out of reach for first-time buyers, but also makes moving unaffordable for existing homeowners to move.
Opinion: The housing market, any way you look at it, can’t lose
http://www.marketwatch.com/story/the-housing-market-any-way-you-look-at-it-cant-lose-2015-06-19?siteid=yhoof2
At some point both the economy and the housing market will recover. Are you ready for it?
Strange things can occur at inflection points. Current norms are no longer valid predictors of future prospects. As prices start to breach the surface, and underwater properties become salable again, supply will rise dramatically.
Normally, this would drive down prices, but since the floor was set back in 2006, prices won’t fall. As incomes rise further into the cloud strata, demand will rise into this rising supply. This will result in rising sales volumes at more or less static prices.
As the underwater backlog is worked off, supply will thin and prices will resume their ascent. As houses become less illiquid, consumer confidence will rise, and with that rise in confidence there will be a rise in spending.
Once full industrial capacity is reached, then prices will rise. Rising prices result in rising inflation, which the Fed will blunt by raising rates.
Consensus is for one .25% rate hike this year in December, and Fed funds rate at 1.75% by end of 2016. I think the Fed needs to be certain that once they put their foot on the gas, they don’t have to take it off. The recovery is the most important thing. Prematurely tightening and then having to reactively loosen policy again, will only result in economic chaos.
Contrary to what Yellen is saying, it matters just as much when the tightening starts as the path it takes. Once tightening begins, a steady hand on the tiller can make the ship sail smoothly. Remaining the harbor of accommodative policy is better policy than heading out before the seas have calmed. Once a strong direction is established, some wind can always be taken out of the sails by raising rates. If you drop the sails entirely at the sign of the first favorable gust, you lose both the momentum and your ability to steer.
I would hold off on rates until wage growth is 3.5% and inflation is 2.5-3%, then tighten steadily at .25% every 6 months. The economy will have difficulty chewing much more than that. With the strong dollar, problems in Europe, Japan, and China, I don’t see these conditions existing before the end of next year, maybe the following year. Inflation is currently less then 1% and wage growth is ~2%. These are the conditions when the Fed would normally loosen policy, not tighten it. And discussions of raising rates are foolish.
It’s best to think of affordability as a rubber band..
Sometimes it gets stretched farther than other times, but no matter what it always snaps back.
If we assume a 25 bps Fed Funds Rate is baked into the 10Y UST today (2.27%) and therefore the 4% 30-year mortgage rate, then a 150 bps rise by late 2016 could mean mortgage rates around 5.5%.
On a $1M mortgage in Irvine that would increase the net monthly cost $400+ and increase the minimum income required by $40K+! Gulp.
Which is why I don’t think the prediction for 1.75% by year-end 2016 is feasible. If incomes rise by 5%/yr then rates can rise by 0.5%/yr, or 2 rate hikes of 25bp.
Unless the Fed is predicting wage growth of 15%/yr, then this timetable will result in falling sales volumes or rates reverting downward like 2013.
We did see that kind of wage inflation in the 1970s. But, before the Fed wreaks the economy with that kind of tightening shouldn’t we see the same 1970s level of inflation first?