Dec272012

The folly of negative-cashflow investment (redux)

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.

  1. Review rental rates and see if you can increase rates to limit the loss or make the property cashflow
  2. Sit down with your accountant and see if you need the loss for income purposes.
  3. 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.
  4. Some people don’t want to “give up” and think that holding it might make more sense.
  5. 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 advisor, 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.