Negative cash flow in lieu of principle only payments?
Investor · Molalla, OR · Member since 2013 · 7 posts · 0 votes
Negative cash flow in lieu of principle only payments?
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@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)
Hope that helps Nick.
17 Replies
@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)
Hope that helps Nick.
Please reconsider your purchase.
Does it seem alarming to you that the seller would offer such a finance deal?
Make a call to the IRS to learn if loans that do not charge an interest rate are legal and what the IRS will do if this is attempted.
In my opinion, all loans that call for a balloon payment should become immediately illegal. Such financing can set the borrower up for failure.
I would never recommend intentionally accepting a negative cash flow at any point. If the investment is not producing a positive cash flow, it is not an asset. It is a liability.
I would advise against assumptions, especially future financing. There are too many variables and too much time in your illustration.
Please reconsider your purchase. There are many others out there that are far better opportunities just waiting to be discovered.
- Real Estate Broker · Greenville, SC · Member since 2013 · 269 posts · 141 votes13y
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?
- Investor · Molalla, OR · Member since 2013 · 7 posts · 0 votes13y
Thanks for the feedback. There seems to be a little confusion in my example so maybe a few specifics would help. Obviously these are grossly oversimplified scenarios that don't include maintenance, vacancies etc, which would be present no matter how the house is paid for, but it may help illustrate my dilema.
Purchase Price 100,000 Market Rent $950
Scenario #1-Traditional Purchase, 20% down, 30 year fixed interest loan:
$100k-$20k down, Finance $80k @5%, PITI Payments of $690=CF of $260/mo
($20k invested, $3120 received =15.6%ROI year one. After 5 years, 78% of the original investment has come back to me and after 10 years 156%)
Scenario #2 (Which my original question is about)
No money down,PRINCIPLE ONLY Payments of $1000/mo. with the remaining balance ($76,000) due after 24 months.
First two years look something like this (Loan+Taxes/Ins.=$1250/mo, resulting in $300 negative cash flow for 24 months)
Total invested in 24 Months=$7,200 ($300x24 mo.)
Now I need to make some assumptions about future value and interest rates for a refi after 24 months. I realize this is where the risk is in this deal as no one knows where the value of the home or interest rates will be, but for the sake of illustration, I worked out a couple different scenarios.
If value of the home stays the same or increases, I owe $76,000 on a $100k+ home, putting this at less than 80%LTV, allowing for a refi at the market rate without putting additional money down. Understanding that the market interest rate will not be known, for this example I'm going to assume investment property 30 fixed interest loan will increase 2% from 5% currently to 7% to test the numbers. The new rate could be more, could be less after 24 months.
New Loan of $76k @ 7%=PITI of $764/mo, resulting in $186/mo. CF
After 5 years, I have $7,200 invested, have received $6,696 or 93% of my investment back. After 10 years I have received 248% of original investment (At 6% new interest rate, 5 year return would be 118% of original investment and after 10 years it would be 315%)
If value of the house drops, I would need to come up with additional money down in order to refi. For this example I am going to assume what I consider to be a drastic reduction in value of 24% (to keep the numbers easy) over the 24 month period (which I consider very unlikely but certainly possible). It would look something like this:
Owed $76k with a value now at $76k. I have already invested $7,200 in negative cash flow over the previous 2 years.
To refi, I need to be at 80%LTV meaning I need to put an additional $15,200 down
Now, total invested is $22,400.
With the same financing assumptions as above, new loan is
$60,800 @7%=$662/mo PITI which means $288/mo CF
In this scenario where value of the house drops 24% in the two years I am paying no interest, after 5 years 77% of total investment has been returned and after 10 years 123%
The appeal to me of this deal is that I am essentially able to finance my down payment INTEREST FREE, so I am able to preserve my current capital for other deals, and if bad things happen over the two year period, I eventually put down the money I was hoping to avoid having to put down, but I don't have to put it down all at once, and still receive similar returns.
It may also help to know that I am not and am not trying to become a full time investor, relying on current investment cash flow. I have a job that supports all of the above numbers and my investment goal is to create cash flow and equity about 15 years from now when I retire.
Sorry for the long post, but I'm still trying to work this out in my head as well. I appreciate the feedback so far, but I hope more specifics will lead to additional thoughtful feedback
- 13yDion DePaoliPro MemberReal Estate Broker · Northwest Indiana, IN · Member since 2011 · 2k+ posts · 2k+ votes
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.
- Investor · Molalla, OR · Member since 2013 · 7 posts · 0 votes13y
@Dion DePaoli, thank you for the thoughtful reply. I apologize for spelling the word wrong.
The structure of this deal, should I decide to do it, is the next part of my question. Since I am very ignorant in this area, my thinking may be flawed but my thought was that I would take title subject to a promissory note to the seller for 100k with payments for 24 months of $1000 and a subsequent balloon, all secured by the seller with a trust deed. Would that not be a workable structure?
- Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes13y
This seems like nothing to me but a speculation deal based on paying out money negatively for an extended period of time.
Just no way I would do such a deal. Too many other better properties and structures to go after than this type of arrangement. A tenant could trash your property thereby increasing the negative cash flow projections you have. So many bad things can happen there is too much risk.
- Investor · Molalla, OR · Member since 2013 · 7 posts · 0 votes13y
Isn't there a risk with any rental property that tenants trash it no matter how it is structured?Seems like even a deal with healthy initial cash flows would be subject to negative returns if the tenant trashes it.
- Investor · Molalla, OR · Member since 2013 · 7 posts · 0 votes13y
I fact that is another reason this deal may appeal is that rather than laying out lots of capital up front, I'm able to keep more cash reserves to be able to use in the event there are tenant or other problems.
Obviously I've been ignoring the fact that deals do exist where you put out no or little money and they are immediate cash flow monsters. I'm not suggesting this is an awesome deal, just possibly an alternative to putting out large capital up front
- Investor · Thermopolis, WY · Member since 2012 · 4k+ posts · 4k+ votes13y
@Nick Frankus Here is my two cents. When buying real estate you must look at your motivations and abilities. If you have the 20% to put down you can keep looking until you find a good deal, and buy it with conventional financing. If you do not have the 20% down you have to look for this kind of a deal because it is the only way you can afford to get into real estate. I have bought 2 houses at a negative cash flow because I was able to buy them with NO money down. In my case rentals do not cash flow well in my town, but will pay for themselves. I cannot afford to buy more properties because I lack the 20% down. For me the Sellers financed the 27K down at 2% interest for 5 years, I pay them $200 per month. I financed the rest, @4.5% on a 15 year mortgage so my payments are about 635$ a month, it rents for $825.00. I lose about $90 per month after taxes and insurance,(I gain over $500 per month off of principal owed). At the end of 5 years my mortgage will be roughly $61K and I will owe about a $17K balloon to the Seller so I can refinance at $78K and if the interest rate is 5% then my payments drop to $616 and I go to a $100 per month positive cash flow after taxes, insurance and bank payments. In 20 years total I own a home worth $111K with no money invested except $100 per month for 5 years. GREAT. However there are many dangers. First interest will most likely go up in 5 years, what if it jumps to 10%? If it does I am losing money again. While I have insurance what if it needs new carpet or a new furnace? That would have to be out of my pocket. What if I cannot rent the property? A property that puts $200 or $300 per month cash flow in the bank can afford to set empty a month or 2 but I must pay the entire payment each month it sets empty. I have the income to do this but if I had 4 properties like this I would not be able to afford it. The house in this example is in the top 30% of the market in my town so it rents extremely well and has appreciated in value about 3% per year. Buying rentals this way has greater risk because the margins are so close. (This house also sets next to the house I live in) Rentals do not seem like a great investment when they cost you money and time every month instead of putting money in your account. My exit strategy is clearly to resell to a home owner if things go bad. I do have other cash flow rentals, but none are as high a quality as this house. Hope this helps.
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.
- Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes13y
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.
- Investor · Dallas-Ft.Worth, TX · Member since 2013 · 74 posts · 18 votes13y
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. :)
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!
- Investor · San Jose, CA · Member since 2011 · 355 posts · 90 votes13y
@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.
- 13yRobert AdamsBusiness MemberReal Estate Broker · Henderson, NV · Member since 2009 · 1k+ posts · 373 votes
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.
The Adams Team at Rothwell Gornt Companies4.972 Reviews - Investor · Riverside, CA · Member since 2011 · 2k+ posts · 3k+ votes13y
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.
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