Negative cash flow in lieu of principle only payments?

Question

I have a seller willing to carry owner financing with no money down, principle only payments with a 2 year balloon. The payments she is willing to take would result in a negative cash flow when rented for the 2 year period until the balloon.

The purchase price is pretty much right at current market value. I'm wondering if it is worth paying market price now and negative cash flow for two years, then could refi then, potentially being at a 20% equity position. I would then be in a cash flow position without having to put the 20% down all in one chunk.

Does this make any sense or am I just being silly?

Dion DePaoli · Answer

The idea of a "principal" (please use the right word) payment would suggest the instrument is a form of installment contract. Perhaps a lease option or something. You are paying a portion of the agreed purchase price down and then owe the rest, it is simply spread over time. The seller has a right to grant that agreement. Whether that agreement structure allows you to take title is a separate question. There is a minimal amount of interest that the IRS will force onto the Seller in most cases either way you set this up, it is referred to as Unstated Interest. So the idea of conveying to you and then receiving final payment in the future creates this situation. There is more detail to this and a tax professional should be involved. If interest need be applied, it is a couple points ahead of prevailing market rates and is updated and available from the IRS. The idea that subject property has negative cash flow is not bad on its own merit. Investors purchase assets that have negative cash flow for various reasons. I don't think your thinking here is bad or flawed. The structure of your deal is making you cash negative not the property. Conventionally, the property seems like it would cash flow just fine. So, I think the analysis you make, I am paying the downpayment over time opposed to now, is proper. The question is, what utility are you getting from the money that you don't pay upfront over time. If you are putting that capital to work, then you might even be offsetting the loss altogether. If you're not doing anything with that capital to generate return then the only supporting argument you have is, I just simply want to keep my capital. Then don't make investments would be the answer. It is true, cash in our hand today is more valuable than in the future but not unless it is working.

Mehran K. · Answer

@Nick Frankus What makes you think that the property will be at 20%equity in 2 years? What happens if cannot refinance? Do you have the income to support the negative cash flow? Why pay full price to lose money every month? Some rules I follow (doesn't mean everyone has to) Never a loan with less than 5 year balloon Never a property that doesn't cash flow Never betting on appreciation (speculating) No deal for me! Hope that helps Nick.

Aaron Mazzrillo · Answer

I'd go for the principal only payments, but with one or more 12 month extensions. Let's say I can get the seller to agree to $1,000/month for 24 months, $1,100/month for 25-48 months, and $1,200/month for 49-60 months. All with no-prepay, you'd be at $64,400 in payments over the next 5 years. Quite a lot of progress towards being free & clear. At any time you are able to acquire a loan, you could refinance and pay off the seller. HOWEVER, I'd certainly get a substitution of collateral clause thrown in there so I could walk that mortgage to another property. Never pass up the opportunity to borrow money at zero interest. One of my very first deals had no payments for 5 years, and zero interest. That property cashed flowed over $500 on the day I closed. It was a huge help in getting me to where I am today.

Michael Smith · Answer

Never heard of a principle only payment... Are you sure the seller didn't offer an interest only loan with a balloon? If there is an interest rate and the payment is not enough to cover the interest due than the principle balance will actually increase - this is called negative amortization. Make sure you are negotiating with the seller to get terms that actually make sense for you and won't leave you high and dry in two years if you can't refinance before the balloon. Also, as Mehran K. said why would you pay full market price for a deal that doesn't even cash flow?

Robert Adams · Answer

Sounds like you are trying to play the appreciation game...you are banking on the fact that it will appreciate...well what if it doesn't? that is the question you should be asking yourself. Be cause if it doesn't your negative cashflow will further increase your losses. I am also assuming you can't get traditional financing and that is why you are having the owner carry the loan. Will you be able to get a loan in 2 years? What is your exit strategy? How do you plan to pay off the balance in 2 years? If you don't have answers to these questions you may find yourself giving the property back to the owner in 2 years and all that negative cash flow will go straight to the owners pocket. Based on what you have stated so far I would not do this deal.

Michael D. · Answer

@Nick Frankus , I don't know why you're getting so much negativity on this. I think it's uncalled for. The financing terms proposed are wonderful, and anybody should be happy to take them. Think about it this way: If you had $24k right now, would you rather put it down on the house and have a 6% mortgage, or keep all that money in your pocket and pay no interest for two years. I think the answer is obvious. The REAL question here is whether the house is worth the price - and that's what you need to figure out. These JUICY financing terms might be offered to mask an inflated price. This is the real danger here - that the easy money cons you into taking a deal that's no good. As @Rob K pointed out, $100k for a house that rents for $950 probably isn't the best deal in the world. I think I'd disagree on the magnitude of that error though. Suppose expenses are on the lower side - maybe $400/mo. That would leave $6600 per year in income, which makes a 6.6% cap rate. Too low for my blood, and I'd pass - but not too low for everybody. I'm just saying - the deal is probably priced on the high side, but the terms are clearly AWESOME - the opposite of what some people seem to think.

Ali Boone · Answer

Whewwwww I'd be careful banking on hypothetical scenarios. The word "balloon" is enough to scare me out of any deal, especially when it's only a 2 year balloon. Always be careful investing based on crystal ball assumptions!

David Weiss · Answer

I agree with the others, I'd look for another deal with long term benefits like this one but with positive cash flow instead of negative. This one has too much risk, there are too many ways for you to lose your investment. For example, if you lose your job, a positive cash flow property maintains itself, but you could end up losing your investment while hunting for a new job. Fortunately, this is not the only seller in America willing to OF with $0 down. :)

Joel Owens · Answer

I understand investors with little capital trying to make something out of nothing. I see these types of deals not work out more times than they do. The investor ends up negative cash flowing and then doesn't realize the gains on the back end like they predicted. During the last run up that ended in 2005,2006 investors were holding a bunch of these properties and trying to time the sell off for maximum profit but they had no cash flow but tax losses. Some did really well and exited before the crash, some did okay selling some but being brought down with what they were left with when the market crashed, and others lost everything and couldn't exit the market at all. These types of plays are generally speculative. A seasoned investor might make a small portion of their portfolio this type for a yield play but not a big portion of it. I just wouldn't want to obligate myself to a monthly payment in the hopes that it turns into something down the road. I want the property to make fiscal sense going in and if the other predictions happen down the road it's icing on the cake. Having said that I see investors make what I deem to be crazy investment decisions everyday.

Rob K. · Answer

Paying $100,000 for a house that rents for $950 is a good way to go bankrupt. I would read up on the 50% rule. In my market, I wouldn't pay more than $40K for such a return. I would suggest finding a deal with better returns. You might have to buy in another city, but it would be well worth it.