ADVICE Desperately NEEDED

General Real Estate Investing
1

I’m in great need of advice and I’m hoping the experienced investors and experts here can please help me figure what to do about my Predicament.

I am that completely inexperienced and ignorant “Investor” (“Rookie Speculator” is more like it) from California who back in June 2005 got caught up in the RE Frenzy, and after feeling like I was being left behind I jumped on the RE bandwagon and bought TWO ranch style homes in the Western Suburbs of Phoenix, AZ. (Litchfield Park and Avondale)

Of course, EACH house was supposed to go up $100,000 in a year but we all know how things turned out. Now, each house is worth $20,000 LESS than what I bought them for, and for the last 2.5 years my wife and I have been carrying these Two houses with a Negative Cashflow. The “Combined” Negative for both houses started at $1,000 per month, but about a year ago I paid off one $44,000 HELOC and the Negative Cashflow is now about $700 per month. We’ve also spent over $40,000 on the two homes due to Lost Rents, Negative Cashflows, Legal Fees, Maintenance, Utilities, Management Fees, Closing Costs, etc.

In addition, our W-2 AGI is over $150,000 and the CPA told us that there is a “Phase-Out” for Investor’s and that at $150,000 AGI we CANNOT take ANY Real Estate Investment Losses on our Tax Returns. He said we CAN carry the losses from year to year and when/if we eventually sell at a loss, then we can take the accumulated losses, but only something like $3,000 per year. So, there doesn’t seem to be any Tax Advantages for us. Neither of us are RE Professionals and with our jobs it’s not feasible for us to become one and get Tax advantages that way.

We put down $15,000 on one house and $25,000 on the other. EACH house started with TWO “Interest Only” Mortgages. EACH started with a 3 - 5 year Fixed ARM “Primary” Mortage, AND a HELOC, but again, we paid off ONE of those HELOC’s last year.

After the market turned down I initially thought that maybe I just had to change my strategy and outlook, and hold on to these two houses for the LONG-TERM, but now I’m starting to feel like we are just Hemmoraging Money, and who knows how long these prices will stay low. I’m thinking that any Profit we MAY make down the road will just be eaten up by the Negative Cashflow. Again, who knows how long it will take for prices to come back…5 years? 10 years? 20 years? maybe never? We’re also not paying down the mortgages with Interest Only, and of course, these loans are going to convert to higher interest rates.

Here are the Specific Details:

HOUSE #1

*4 Bed/2.5 Bath/2 car garage, 1975 sq. ft. waterfront on a small lake
*Purchase Price = $295,000
*Current Market Value = $275,000
*Downpayment = $15,000
*Primary Loan is 5.625% “Interest Only” 3-year Fixed ARM that converts July 2008, Balance= $236,000
*Monthly Payment = $1,300
*HELOC = PAID OFF (was $44,000 @ 11%)
*30-Day Tenant at Will Lease
*Rental Income = $1,150 per month
*HOA Dues Monthly = $36
*Town “Business License” Monthly = $28

House #2

*4 Bed/2 Bath/2 car garage, 1600 sq. ft.
*Purchase Price = $244,000
*Current Market Value = $224,000
*Downpayment = $25,000 Total ($15,000 was CASH to Seller)
*Primary Loan is 6% “Interest Only” 5-year Fixed ARM that converts 2010, Balance = $185,000
*Monthly Loan Payment = $1,030
*HELOC @ 10.25%, Balance = $35,000
*Monthly HELOC Payment = $350
*3 Months into 12 Month LEASE
*Rental Income = $950 per month
*HOA Dues Monthly = $36
*Town Private Fire Department Monthly Fee = $29

QUESTIONS:

A) Do we try to SELL Both Houses in this market (if we even can) and take a $100,000 LOSS? (From Commissions, Lost Market Value, Lost Rents, Negative Cashflows, Maintenance, Utilities, Management Fees, Closing Costs, etc.)

B) Do we try to SELL One House and take half of a LOSS, although still huge?

C) Do we HOLD onto both houses LONG-TERM and do nothing, just continuing the way we’ve been going, with the $700 per month Negative Cashflows?

D) Do we HOLD Long-Term, Refinance and ADD More Capital to boost our equity and try and make the monthly payments break even?

E) Anything Else?

I am really at a loss as to what to do.

Thank You so much for any advice you can give us.

2

I think you are in a perfect situation to do Seller Financing. Lots of people who used to be able to do Subprime can’t now. They still often have good incomes, they just can’t get a loan. In many cases, they are the ones who have been foreclosed on due to being victims of the ARM fiascos. They can’t buy now with foreclosures so soon on their record. Many would jump at the chance to buy if given the chance.

  1. Sell House #2 On owner financing. Offer to sell #2 for $250k with $10k down. You will carry the financing on a Contract for Deed/Land Contract for $240k for 30 years @7% interest and payments of $1596.73.

People will pay the higher price because you are offering them great terms. If you find a good buyer, but they don’t have $10k, get what you can, but at least $5k. Make sure you get a lawyer to set up a good L/O contract.

This will turn your negative cash flow to a small positive. When the HELOC gets paid off, it will become a huge positive.

  1. Sell House #1 - Sell at $295k with “95% Seller Financing” Get $14.5k down and carry the remainder on a land contract of $280.5k at 30 years @7% for a monthly payment of $1866.17. That is a nice, positive cash flow.

As an aside, even if your current loans have acceleration clauses, 99% of the time the lender will ignore it so long as they are receiving their payments. This is because so many lenders, especially those who did business in the Phoenix market, are so awash in foreclosures now that the last thing they want is another property on their books if the loan is performing.

Many sellers can’t carry their own paper. However, if you can, then their are huge profits to be made now. This is the way investers did business before the time of easy money and subprime loans, when mortgage rates were 16%, like when I started in the business. This is a great time to buy cheap and sell for great terms.

I would set each up so the buyers pay into an escrow account at a local escrow company, which will pay taxes, insurance and mortgage for the property. You can add the fee for the escrow service onto what the Buyer pays.

3

Thank You Salverston!

I really appreciate you taking the time to read and think about my predicament, and giving a thoughtful answer.

So, if I read you correctly it sounds like my best option is to SELL through this seller financing. The concept is very advanced and way over my head at this point, but I’ll make sure I learn all about it as quickly as I can. It sounds like I am actually going to be the long-term owner involved with these properties, but just that the Tenants will be paying toward buying them from me and taking them off my hands at some point way down the road?

As thorough as your answer was, I’m really hoping that in this very large community there will be several others with advanced experience like yours who will comment on my situation, and either concur with you, or maybe see things differently and offer another solution to take a look at from their perspective. It would be great to get as many opinons as possible, unless everyone is reading your message and saying you nailed it perfectly.

Thanks Again…I do appreciate it.

PeteF

4

Couple things in your post don’t add up. You say you have a negative cash flow of $700 per month, then, you say that your rental income has pushed your total income over $150K so you can’t take the passive loss allowance.

This does not compute for me. If you have a net negative cash flow, then you DON’T have a positive rental income that would push you over the $150K threshhold.

If this is what the CPA is telling you, then get another CPA. If you didn’t let the CPA compute your adjusted gross income to make a determination for you about your eligibility for the passive loss allowance, then why not? Isn’t that what you are paying a CPA to do for you?

Recognize that property you purchase with 95% financing will rarely cash flow as a rental holding in the first few years. Maybe you will reach some point in time ten years down the road, when your seconds mortgages are paid off, and rents have increased, and your ARM rates have dropped where these properties will generate a positive cash flow.

If you knew that the property would not cash flow as a rental when you bought it, what was your exit strategy? How long did you plan to hold them? How long can you afford to hold these properties with a negative cash flow? What was your plan B if your primary exit strategy failed?

If you paid off the HELOC on the second property, and raised the rents over time, would you at least get to break even cash flow in a couple of years? What if it takes your market 3 to 5 years to recover from the correction you are seeing now? Can you afford to keep the properties that long if you can at least make them breakeven cash flow.

As for the rent, $950 per month seems a bit low for a brand new 4BR house. Even $1150 for the other property seems low. That said, I am not in your market. I don’t know what a fair market rent is for your property.

The question is how long do you want to hold these properties with a negative cash flow? If you can’t or don’t want to, then sell. Sell with owner financing at the price you paid for them and charge a point or two higher interest than you are paying on your underlying notes.

If you don’t want to carry the notes, and you need a traditional sale, then you will have to discount your price. If the lenders will not short sale then you have to bring money to the settlement table to pay off your mortgage notes.

Either way, holding or selling will cost you money. You have to do some forecasting to determine whether holding for rental income or selling will cost you the least.

5

Pete is right with seller financing. It will become the new wave again. Many people can not quailfy for a mortgage. However it is very important you quailfy your tenant for seller financing. Try to get at least 3-5% down payment.

Keep in mind, most people need 10% down now. If there credit score is under 640, and can not go full doc probably looking at close to 20% with many banks. One thing is the interest rate. 7% is a give away. It is always negiotable but in todays market seller financing should be in the 9-11% range. Keep in mind the banks are charging rates in the 9’s. I would go lower than 8.5% really. However to get more cash up front you can say put 10% down and get 7%, 5% down is 7.5% , etc… make it a tier…

Also I woulds recommend contacting your banks. If you bought these with Non Owner Occuppied loans (investor loans) the bank will be more understanding when you tell them your negative each month and see what can be done with putting some of the negative to the back end of the loan till the home is sold, L/O, etc. Maybe ask for a 12 month grace period on having a smaller payment. Explain to the bank you have been carryiing this but it is becoming a financial burden now. Banks do not want to hear foreclosure so they may deal with you on that.

As for taxes. Put the homes in an LLC. Pass the tax losses to the company. YOU can carry a bigger loss. You will not be allowed to deduct the mortgage interest from your personal income but when you sell you will see advantages. Plus once you set up your LLC, you can start taking some business deductions that you normally will not…

Ex. I have a career but also my RE company. My company pays for many of my bills to lower its tax bracket, in fact I generally zero out the business income each yr and pay no taxes on my profits. I let the company pay my car payment (even though its in my personal name, the company can pay for an employee car), car insurance, medical bills, perscriptions, dinners, certain entertainment, trips, hotels, etc. Also in my W2 company I pay health insurance. Well I am allowed to have my business deduct that weekly fee I pay for insurance on my taxes as well for the business…

What you need to do is seach out an experienced REI CPA… Goto your local REIA club and ask for a referral…

Andrew

6

Thank You Dave T!

I appreciate your help, and you’ve asked some EXCELLENT questions which I will do my best answering.

Dave T - “You say you have a negative cash flow of $700 per month, then, you say that your rental income has pushed your total income over $150K so you can’t take the passive loss allowance. If you have a net negative cash flow, then you DON’T have a positive rental income that would push you over the $150K threshhold.”

PeteF - I was mistaken. I went back and looked at my tax return and it was just our Two W-2 Earnings that brought us to that phase out level.

Dave T - “Recognize that property you purchase with 95% financing will rarely cash flow as a rental holding in the first few years. Maybe you will reach some point in time ten years down the road, when your seconds mortgages are paid off, and rents have increased, and your ARM rates have dropped where these properties will generate a positive cash flow.”

PeteF - Is it EVER a good strategy to go into a RE Investment with a Negative Cashflow. Am I one of just a few that did it this way? How long do investors go with Negative Cashflows/

Dave T - “If you knew that the property would not cash flow as a rental when you bought it, what was your exit strategy? How long did you plan to hold them? What was your plan B if your primary exit strategy failed?”

PeteF - That’s the problem, I HAD NO Plan B. The Real Estate Agent I bought from was the son of my former co-worker who assured me that the houses would be up $100,000 in a year or two. He even gave me a spreadsheet showing how they will appreciate. One of the houses was even a house that He (the agent) owned. He had me sign a form saying that I knew it was his. I can see now that HE was bailing out and dumping the property on me. No one twisted my arm though…I went to him asking to buy two houses. I just wish he had given me better advice on the market. Either he was the dumbest RE Agent/Investor who had no clue, or he was a Crook and knew exactly what was going down, and he took advantage of my inexperience. He was a pretty smart guy so I can only conclude that he took advantage of me, and then he abandoned me.

Dave T - “How long can you afford to hold these properties with a negative cash flow? If you paid off the HELOC on the second property, and raised the rents over time, would you at least get to break even cash flow in a couple of years? What if it takes your market 3 to 5 years to recover from the correction you are seeing now? Can you afford to keep the properties that long if you can at least make them breakeven cash flow.”

Pete F - Yes, we could. The $700 per month Negative Cashflow payment is fairly easily for us to pay, and we could pay that indefinitely. It’s just that it seems like wasted money to me, like we just throwing $700 our month away. We’ve been doing it for 2.5 years and not getting any tax advantages. That’s why I felling desperate, at the thought of the loss, not because we need the $700 per month for something else.

Dave T - “As for the rent, $950 per month seems a bit low for a brand new 4BR house. Even $1150 for the other property seems low. That said, I am not in your market. I don’t know what a fair market rent is for your property.”

PeteF - This is what the property manager who I only hire to sceeen and select tenants told me the rents are in the area. I looked on some RE Websites for the area and the rents are in that ballpark.

Dave T - “The question is how long do you want to hold these properties with a negative cash flow? If you can’t or don’t want to, then sell.”

PeteF - I honestly don’t know. If I knew that years from now paying all that negative casflow would somehow benefit me then I would keep paying it. But again, it’s just seeming like wasted money out the window to me.

Dave T - “Sell with owner financing at the price you paid for them and charge a point or two higher interest than you are paying on your underlying notes.”

PeteF - So you concur with Salverston’s advice? How do you do this Seller Financing? I live 7 hours away from the properties so anything I do has to be done with a RE Agent/Property manager. Are they going to market and sell it just like a normal sale? Do I have to pay the typical 4 - 6% Commission just like I was selling normally?

Dave T - “Either way, holding or selling will cost you money.”

PeteF - Really? There is No Hope at all of profiting somehow down the road, or at least getting out of this situation sooner or later with at least breaking even?

THANKS AGAIN Dave T!

7

Thank You Andrew (yrush200)

I appreciate you taking the time to read my post and giving me thoughtful advice.

PeteF

8

Hi Pete,

Best of luck with your predicament…looks like you’re getting some good constructive options.

-Mike

9
[b]PeteF[/b] - Is it EVER a good strategy to go into a RE Investment with a Negative Cashflow. Am I one of just a few that did it this way? How long do investors go with Negative Cashflows/

Buying a negative cash flow property and hoping to profit from rapid appreciation is speculating – not investing. In my opinion, investing should put money into my pocket each month. If it does not, then I have not bought an asset, I own a liability.

There were several savvy folks who did make money speculating in some overheated markets. You now recognize that you came late to the party. I don’t think your real estate agent took advantage of you since no one could really predict when the market would turn down. You were just naive (perhaps a little greedy) and wanted to jump on the real estate bandwagon along with everyone else.

[b]PeteF[/b] - The $700 per month Negative Cashflow payment is fairly easily for us to pay, and we could pay that indefinitely. It's just that it seems like wasted money to me, like we just throwing $700 our month away. We've been doing it for 2.5 years and not getting any tax advantages. That's why I felling desperate, at the thought of the loss, not because we need the $700 per month for something else.

There are three benefits (or reasons) to invest in real estate.

  • Cash Flow
  • Appreciation
  • Tax Benefits

Never invest in real estate for the tax benefits alone. Buy and hold investors are not really purchasing the property, they are purchasing the cash flow. Since you have learned the hard way that immediate appreciation is not guaranteed, you need to have your property generate a positive cash flow during your holding period until such time as you take your profit from appreciation. Any tax benefit you may derive from the investment is just gravy.

Since you can withstand the negative cash flow for awhile until you pay off second mortgages and increase rents, rest assured that your $700 per month is not lost. Yes, when you can’t use a passive loss allowance on your tax return, the tax loss is “suspended” and carried forward to the next tax year.

When you sell the property, unused suspended losses are added to your cost basis and reduce the sale profit subject to capital gains taxes – they are never just “lost”.

[b]PeteF[/b] - So you concur with Salverston's advice? How do you do this Seller Financing? I live 7 hours away from the properties so anything I do has to be done with a RE Agent/Property manager. Are they going to market and sell it just like a normal sale? Do I have to pay the typical 4 - 6% Commission just like I was selling normally?

Depends upon whether or not you are willing to carry these properties with their negative cash flow until you can get them turned around. If you can, then you may want to continue holding because they will eventually produce a positive cash flow. Within five years, market prices may be back up to where they were when you purchased the properties and will just appreciate up from there.

If you need to cut your losses, then sell now. Sell with owner financing on good terms to get a quick sale. You may actually collect more money than your sale price if you sell with owner financing and carry the note for several years. If you want proof, just look at your amortization table for your own house. If you add up all the monthly payments you will make until your house is paid off, won’t you pay a lot more than the original purchase price?

Should you decide to sell, a real estate agent should probably facilitate the sale. Yes, you will pay the standard commission, so make sure you get enough downpayment from your buyer to cover the sale commission. If you sell with a wrap-around mortgage, require 10% downpayment, and don’t require any bank qualifying, you should be able to get a pool of ready and willing buyers who will probably pay $20K more than your loan balance. This alone will make the property marketing a lot easier for your real estate agent.

[b]Dave T[/b] - [i]"Either way, holding or selling will cost you money." [/i]

PeteF - Really? There is No Hope at all of profiting somehow down the road, or at least getting out of this situation sooner or later with at least breaking even?

I guess I should not have said that without further discussion. If you decide to hold for the long term, the negative cash flow will keep taking money out of your pocket. There may come a time when you can sell and recoup all that expense, but it is some time away.

If you sell now, with a traditional sale, you may have to discount your sale price to get a buyer – in other words sell at a loss. Additionally, a sale may take quite some time, and your holding costs don’t stop.

Selling to your tenant may mitigate that expense somewhat, but if you don’t participate in the financing, I fear that you won’t be able to break even if you need a sale within the next twelve months.