Where do you draw the line on cash flow with negative equity?

Question

So I'm talking with an off market somewhat motivated seller (he wants to liquidate to fund one larger single project in cash, his own retirement community) about a 4 plex in a grade B- -ish neigborhood.

I'll keep the analysis short...

Comps say the property has an appraisal value of $125k at its best, largely due to neighborhood.  It's probably one of the newer (1985 build date)/best looking properties in several blocks.

Assuming I'm the property manager, which I plan to be in the foreseeable future, this property would cash flow me around $800-$900 per month if I could get it for $150k.  He's at $175k right now.

I also think I could turn that $900 cash flow into $1100 with a few easy changes pretty soon after acquiring the property.

Even if I got it for $150k i'd be jumping in to $20k+ negative equity right off the bat.

But...

At what point do you respect the cash flow enough to be ok with the negative equity?

My current 'strategy' (I've yet to implement...) wants cash flow and plans to hold this property long term.

Thanks

Account Closed · Answer

Depends on several things...including the cap rate you use.  If the neighborhood is tough and the risk is higher, you'll want to use a higher cap rate to figure your return.  At 10% cap and a $150K purchase price, you'll need $1,250 in net income to justify the purchase--not including the mortgage payment.  If all you can get is $1,100 per month, it isn't worth more than $132,000--unless there are other factors that could increase the value over time. Determine the cap rate that seems reasonable for this property and then use...

APOD Formula:

Gross Income (Rents, Payments to You for Utilities, Laundry Income) - Gross Expenses (Property Taxes, Insurance, Vacancy (Rate) Expense, Maintenance, Utilities, etc. (not mortgage or interest)) = Net Operating Income / Cap Rate = Value

I'd also recommend considering the comps, future resale value, whether or not the property is up to code, how much remodeling is needed, whether or not it has tenants and how long it will take to get the rent to where you need it, whether or not you'll get the security deposits from the seller (if there are existing tenants), etc.--incorporating all these in as additions and deductions as appropriate.  The build date is helpful since you won't have to mess with RRP and lead disclosures.

Good luck!

Michael Le · Answer

One other way to view this might be the difference in monthly cash flow between the negative equity deal and the non-negative deals.

If you buy it at $150k you would be negative $25k in equity. On the other hand you would be ahead $400/m in cash flow vs the other properties. So that would take 60 months or so to make up the difference So after 5 years you would be even with the other properties but then you would start pulling ahead because of the massive difference in cash flow.

Jay Dewberry · Answer

When investing, I've found that you've got to take emotion out of the deal. If the numbers work for your particular strategy, go for it. Otherwise, one has to be able to walk away from the deal. As far as I know, there is no "acceptable ratio of negative equity to cashflow". The question is, and should be, does the numbers work based on my investment goals/strategy. If you've crunched the numbers and after all foreseeable expenses you're cashflowing $800+ per month, then the negative equity is not a big deal. On the other hand, if you feel you will need to sell this property in the foreseeable future for any given reason, that negative equity is going to be a problem.

Alexander Felice · Answer

I guess I would ask, are there no other deals around? Is every deal you look at either cash flow negative or equity negative? Are you forced to lose money in all situations?

negative equity doesn't matter, until it matters, then it might be the kiss of death.

Property management costs what it costs, doesn't matter who is doing it, you're paying for it. Make sure you included it in calculations.

I would find the correct comps, and offer what a property is worth, maybe you could overpay if you had a value-add or great cash flow situation but you're talking about overpaying by ~20% at 150k. Just doesn't seem necessary.

Michael Le · Answer

Negative equity wouldn't bother me too much if the cash flow is good. If after you bought that property and I came offered you $1mil for it, would you do it? You would likely say, Heck yeah! But what if I offered terms that I pay you $1 a month for a million months. I'd still be in negative equity but boy my cash flow would keep me plenty happy. I just have to understand I'll never be able to sell that property.

My only concern is whether your evaluating this property correctly. What are the numbers you are using that gives you $900-1000 in cash flow? Are you including insurance, capital reserves, taxes, repairs, mortgage, vacancy? And I know you say you will manage it yourself but you should really include that too.

Jay Dewberry · Answer

Hi Will. To answer your question, depends on your exit strategy. Like you mentioned, you want to buy/hold for long term cashflow. If you’ve run the numbers and it cashflows at $800+ per month, which is pretty good, I don’t see the negative equity as a major issue. However, if for some reason your strategy changes and you need to sell, then that negative equity would be of concern. Also make sure to run the numbers and take out for property management regardless of if you manage or not…unless you plan on managing for the next 30+ years. Just my quick thoughts. Good luck.