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Cashflow Negative RE Investors F’d

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Do you know anyone in a cashflow negative real estate investment who had been lording over you the fact that the condo/townhouse/house they purchased two years ago has appreciated so and so many thousand dollars? Kicking yourself because you didn’t think to jump onto the real estate bandwagon? (By cashflow negative I mean the mortgage payment they have is more than the rents they’re getting, so they are losing money on a cash flow perspective) While I don’t, I do know one guy who had been counting his eggs before they hatched and currently has something on the order of 5-6 condo/townhouses in cash negative positions banking on appreciation to bring him the big bucks. US News and World Report has an article about the slowdown so you know that the slowdown has been going on for probably half a year now, but what does that mean for your real estate friend?

If you bought a house before or in the beginning of the housing boom, you could make your money in one of two very popular ways. The first is to buy a distressed property, fix it up, and then sell it for more (flipping) and if you want some television entertainment there are tons of shows about this sort of thing. The second way is to buy a house, rent it out, watch it appreciate and then sell it. Along the way, if you’re cash flow positive you put a few extra bucks in your pocket, if you’re cash flow negative then you lose a little now but you can think of it as an investment in the future.

The problem is that ARMs are getting reevaluated upwards and so those folks who have negative cash flow properties will be in trouble. After the initial fixed payment period is up and the mortgage payments increase, a cash flow negative position becomes a much bigger cash flow negative position. Couple that with slower appreciation rates and all the incentive for being cash flow negative has evaporated. So you’re adding a large class of home sellers who see themselves as being on the edge of a cliff… add them to those regular sellers (leaving the area, upgrading, etc.) and those former buyers who bought too much house and you’re looking at a balooning group of sellers. Just to throw some gasoline on the fire, you can add home builders who are throwing in crazy incentives to buyers just to unload inventory.

Am I writing anything groundbreaking? Nope, but in case you were wondering why everyone is fearful of a housing burst… that’s why. To steal a line from a friend, Burst burst burst burst!

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6 Responses to “Cashflow Negative RE Investors F’d”

  1. Todd says:

    You have described the classic bubble scenario. I’m not sure everyone must sell but those who do might be in for a surprise. Real estate markets are local so the scenario you describe may be more realistic is some areas than others. The only people who will be impacted by the “cash flow” negative situation are those who must sell now. If you can weather the storm real estate will continue to be a very good long term investment. On the bright side if you have some cash there will likely be some great deals to be had in the months to come. We already are seeing less buyers and a tighter rental market (driving average rents up) We had so many buyers and condo conversions in the past couple of years that renal inventory is down. Thus rental prices will go up and the scenario you discussed will cause real estate price will go down until equilibrium is reached. That may take a few years and there is money to be made in the gap.

  2. Khyron says:

    Be careful using the word “flipping”. Some of the professional investors I know, in MD in particular, are staying away from it because it has confused people. “Flipping” was targeted in a Federal government investigation; basically, “flipping” is about committing appraisal fraud to sell a home for more than its post-rehab value. What you are describing, Jim, is rehabbing. See this for a distinction:

    Strategy #3 – Wholesaling vs. “Flipping”…

    Sherman is the head of a REIA in Bowie, MD that obviously became very popular in the last few years, and still is. I am a member of that REIA. His course materials go into even more detail about the difference between “flipping” (both the illegal type and the legal type which is better called “wholesaling” in the commercial RE world) and rehabbing. See the problem? Best to stay away from that word; its meaning has been confused through overuse.

    Moving on, I agree with everything else you said.

    Peace!

    [Edited URL into link]

  3. Dus10 says:

    Well, depending on how long someone has held the properties, they may be well served to refinance and hold. If they have held onto the property for two years, and they can refi for 0.5-1.0% less than their current rate (which could be possible, given ARMs), then they could put themselves in a near cash-neutral setting.

    I bought my home almost two years ago with a 2/1 ARM, and we are looking to refinance, and we may likely drop by 0.5%. That coupled with an ever-so-slightly lower principle, we will be saving about $60/month. If you extrapolate that over six properties, that could be make/break…

  4. prlinkbiz says:

    I agree with above that cash flow negative does not always mean effed. However, the speculators are being flushed out right now, and the real investors are moving in.

  5. Matt says:

    The folks buying real estate with the intention of selling it later at a profit without having added their own value in the middle are going to be in trouble. But that’s what happens to speculators…sometimes they win, and sometimes they lose. And if they can’t afford to lose, they shouldn’t be playing.

    Despite having just sunk a lot of money into a house with my fiancee, I’m not worried. We don’t plan to sell. The Greater Fool Theory didn’t drive our decision, and in fact we both felt this house would be worth every penny of its current price regardless of the condition of the market. Our time horizon isn’t the next year, or the next 5 years, or the next 35 years…it’s the rest of our lives. And our kids (if we ever get around to having any) can worry about the resale value after we die.

    Most of the people who really lose a lot in the bust are going to be people who were gambling, rather than buying or investing. And the risk of serious loss is the price of gambling.

  6. Justin says:

    I think this is the reason that the richest people I know have always told me to make the money when you buy a place. As far as having negitive cashflow and talking about the appreciation that they are getting… that seems a bit, well, stupid. It is possible to make quite a bit of money by rehabbing but simply sitting there with negative cashflow? That goes against every bone in my body. I want more money every month not less. Rich Dad books talk about always having an exit strategy but sometimes the parachute just doesn’t open. Just looking at the future value of money equation will tell you that a negitive cashflow with only appreciation as your plan for making $ is not smart.

    Matt makes a good point in his comment; he knows what he wants to do with his house and will be much better off for it.


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