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What’s That Underperforming Property REALLY Costing You?

by Ken Corsini on September 12, 2012 · 11 comments

  
underperforming property

I was out of town last week and had an opportunity to meet a number of different investors on my trip. One conversation in particular stuck with me because I believe the scenario is common to a lot of people. Many investors that are in the market today for investment properties were the same ones that were buying properties either during the real estate frenzy of the mid-2000’s or on the front end of the recession (before prices had truly bottomed out). Many of these investors have either lost houses due to the tremendous drop in value or are hanging on to one or more properties that simply aren’t performing.

The investor I spoke with had purchased three properties in the same market back in 2007 and has done everything in her power since then to try to make them “work.”  I stood there and listened as she explained how she had refinanced this house and that house and moved money here and there … all in an effort to get these properties to a place where they at least break even. When she got finished telling me about all the shenanigans she had pulled to get to this point, I simply asked her, “Why?”  Why go through all of those motions just to try to feel good about properties that she had no business owning.

Now I’m not saying somebody with a bad investment needs to let it go into foreclosure, but I do think it makes sense to take a hard look at underperforming houses.  This is especially true when the bad investments are preventing someone from making new investments . . . as could be the case if you’ve got money tied up or have maxed out your conventional financing ability.

Are Your Underperforming Properties Holding You Back?

As was the case with the investor I spoke with, she wanted to invest in properties right now, but the 3 she had purchased were holding her back. Amazingly, while the houses were essentially break even in terms of cash flow, she was only slightly upside down on them. Being that she was in a market with little upside potential, I couldn’t help but wonder why she hadn’t dumped them yet in favor of better opportunities?  I suppose when you’ve put enough time and energy into something to make it “work,” it’s not easy to let go – especially if letting go feels like defeat because you might need to come to the closing table with more money out of pocket.

The question I posed to her and that I would pose to other investors in similar situations is, “What is the real cost of holding that underperforming property?”  While it didn’t feel like it was costing her anything, in actuality it was costing her a lot of missed opportunity.  While she sits idly by, other investors are scooping up properties at tremendous discounts and locking in at interest rates we may never see again in our lifetime.

So many investors forget to factor opportunity cost into their buying scenarios, but I think it’s a crucial metric to consider.  A simple example of this is an investor that chooses property “A,” yielding 10% versus property “B” that could have yielded 12%. In this example the investor actually experiences an opportunity cost of 4%, as the greater yield could have been achieved through the alternative investment.

But what about the opportunity cost of sitting on a non-performing investment property? What could that money (or financing) be doing if it was invested in deeply discounted, high cash flow property with appreciation potential? I would submit that there are a number of investors in a position to sell previously purchased assets at or below what was paid for them, reinvest those funds and end up making much more money in the long run. Why? Because there are unbelievable opportunities to buy properties that produce great yield and have the potential to gain 50%-100% over the next 10 years.

While many investors think the best course of action is to sit tight on subpar investments, maybe it’s time to analyze the true cost of inaction. Perhaps it makes more sense to take a slight loss now in favor of much higher returns from the kinds of deals and interest rates that investors have access to right now.

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{ 11 comments… read them below or add one }

Dale Osborn September 12, 2012 at 10:59 am

There is a certain fear that keeps people from taking action like you are talking about. I can see your point very clearly about dumping the duds and getting into a better deal to make more in the long run. This basically happened to me when I was still in the military stationed in Germany.I had some funds saved and had put it into a 4-year CD at 8% interest. While in Germany interest rates for CDs went up to 16.5%. I did not want to pay the $900 penalty for early withdrawal so did not pull it out and relock it at the 16.5% interest rate. Of course, hindsight is always 20-20!

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Kyle Hipp September 12, 2012 at 11:39 am

Maybe I am missing something. I have a property that I bought in 2007. I get $100/m cashflow. I bought it with 10% down and the market value for a timely sale is roughly what I owe. I have transitioned my strategy to a 15 yr mortgage bt this one remains at 30yr fixed. If I were to sell I would prolly have to bring cash to the table and would lose the $100/m. Possibly trigger a tax hit with my depreciation schedule as well.

The only advantage I see would be that it would be easier to get another property with conventional financing but I would have used some of the money for that down payment to sell this home. Also I could get 4%ish on a 15 year fixed with conventional and prolly 5% – 5.5% on a 15 year ammortization with 5 year baloon. The interest rate spread is negilible and doesn’t compensate for the $100/m loss from selling the other property.

I definately agree that everyone must analyse this on a regular basis but I don’t see droping an under performing property as neccessarily wise given the array of optuons at everyone’s feet. I can see some scenarios where options are limited such as don’t meet any lending standards but then you still have other avenues and private lenders. The one I would see is that you don’t wanna invest more in the property and sell to save that investment. Please fill me in further if I am missing a key point.

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Ken Corsini September 12, 2012 at 4:10 pm

Kyle – I think your situation comes down to financing. If you were maxed out or couldn’t qualify for another conventional loan, I think it could make sense to sell the property (even at a slight loss) in favor a of different investment property … one that could spin off a lot more in cashflow and/or upside potential (especially if you use a hard money to refi strategy that requires very little net out of pocket).

However, it sounds like you have the ability to continue getting additional conventional loans … which probably makes it unnecessary to liquidate the subject property.

There is no one size fits all scenario. The point of the article was to point out that there are SOME situations where it does make fiscal sense to liquidate a subpar investment in favor of a better investment.

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Kyle Hipp September 12, 2012 at 6:01 pm

Ken – I completely agree. We can’t get caught in a loss aversion rut. It is easy to look at another person’s situation and tell them what is best because you take out all the emotion. I find it best to wake up in the morning and look at where you are like the past 10 years never happened. You just find yourself in this situation and now must make the best decision for a prosperous business moving forward. Your capital growth and liquidity need to be understood which gives you a list of your options then your decision on how to move forward depends on your financial goals.. Great post Ken!!!

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Nathan September 12, 2012 at 1:18 pm

Maybe I misunderstood the scenario… but from what I read, the investor was slightly upside down on properties that break even… and your advise to her was to sell? So you’re telling her to spend cash to receive $0 return??

If she was losing money and spending $10,000 would save her $150 a month… I would understand it.

If she had reached her maximum number of mortgages and was missing out on tremendous deals which would justify the investment in the deal plus the cash out to sell, I might understand it. Personally I would go portfolio loan or private money first.

Holding on to a break even property isn’t a bad thing. In 30 years you own it and during that time you’re generating additional tax shields. Why were you advising her to sell?

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Dale Osborn September 12, 2012 at 1:52 pm

The recommendation is to sell – take the funds and put them to better use. By doing this it would end up in a better position than just plodding along happy with not rocking the boat. If you take a look at my comment above, you can see I missed an opportunity by not stepping out of a low CD and putting it into a much higher CD. The end result is what counts.

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Ken Corsini September 12, 2012 at 3:56 pm

Dale – you are dead on.

Nathan – I advised her to sell SO THAT she could invest in higher yielding investments. I’m not saying that every break even or upside down deal needs to be liquidated in order to chase other deals …. BUT, there are DEFINITELY scenarios where it makes sense to take a slight loss on a deal now in exchange for moving money or financing ability into another investment.

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Kyle Hipp September 12, 2012 at 4:14 pm

Dale and Ken- I agree completely in your CD scenario but this is a leveraged investment which doesn’t seem to provide anything but a loss of capital at close.

Are you guys talking about someone who paid cash, lets say $150,000 and now it is worth $130,000 and never had much for cashflow. Cause in that case I can see selling for a $20,000 loss plus commission and then plowing the $110,000+ into better properties. But in a leveraged house where the person owes about what the property is worth, selling to get another, better investment doesn’t seem like it helps much.

Ken Corsini September 12, 2012 at 4:22 pm

Kyle – the simple answer to your question is “it depends” … on a lot of different factors like:

* If leverage was used, how much?
* Even if selling for a loss … is there equity that can be pulled out? How much?
* Can the investor get additional conventional loans or are they maxed out?

I can’t tell you at what exact point it makes sense to stay put vs liquidating … every scenario is different and every person has to make this decision for him or herself.

Nathan September 12, 2012 at 4:38 pm

Sorry Ken, I misunderstood your wording… to me, “upside down” means you owe more than a property is worth. In that case, you don’t have under performing equity which could be used some place else, you have no equity… it would take case to get out of the situation.

Sounds like you meant to talk to people about sunk cost. If the $100,000 you put into a property is now worth only $70,000, you may still want to sell and take the $70,000. What matters now is how best to use $70,000… not that it was once worth $100,000. The moment you spent the money, made the choice to buy, that investment became a sunk cost. It can’t be undone so ruing the past is pointless (i.e. waiting to break even). All you can do is make the best choices based on where you are today.

The same applies to people who buy stocks… “I can’t sell at $20/share… I bought at $35/share!!!”… sure, and keep holding it and next year it will be worth $10… the question isn’t what you paid or once had, it’s what you can do to maximize what you have now.

Frank November 14, 2012 at 7:05 pm

This is a great post. With the myriad of options available to some investors, this can make sense indeed. However emotion can be tricky and just like we cannot be emotionally attached when we buy, we need to keep the separation once we own. It is not always easy especially if you have your own sweat equity in the deal. Each situation indeed tends to be unique but this is a viable strategy for sure. Good post.

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