If you owned this rental property, and a "get out of jail (practically) free" card, would you use it?
January 25, 2010 7:19 PM   Subscribe

How can I calculate the ROI on a rental property in a bubble busted area? Is this as poor an investment as I fear? How can I show my friend?

I am convinced this "investment" has turned into a bad one for my friend. He is emotionally attached and cannot see the situation clearly. I HAVE BEEN ASKED to help demonstrate this fact but can't quite figure out how to do it. I have tried several different online calculators but nothing I have found so far can account for the effects of the RE bubble bursting on this property.

The facts are as follows - he took a $150K loan in 2005 (20 years @ 7%, P&I payment is $1165) on a property in a highly bubble inflated area. Assume 20% down (there was no PMI on the loan). I assumed a tax rate of 30% for the mortgage interest offset.

Property taxes are $1570/yr. Insurance is $300/yr. The house is currently worth about $90K.

He is 5 years into the loan. The first 3 years the house was vacant. During the next 2 years the house was occupied for 18 months. The rent is $985/mo and it is questionable if the market will bear that. It is currently vacant. I would not assume an occupancy rating greater than 75%.

By my math in this first 5 years he has paid some $70K in mortgage payments (which does not even account for his time OR his remodeling costs) into this place for which he has collected about $18K in rents. So even when he does own the house free and clear, it will take many more years of collecting rent before it really breaks even.

My friend says he is thinking "long term" and that when the loan is paid off he has this cash flow "forever". I realize this is not exactly "wrong" but isn't this viewpoint way too narrow? The house is not in a great area (it was a manufactured home) and renting it so far has been problematic. He lives nearly 2 hours from the house. He will be 51 when the loan is paid off.

He currently has the opportunity to get out of this situation with very little consequence but he doesn't think he needs to. He doesn't see it as throwing money away but I can't imagine any business that would put this much money into something that doesn't break even under the most generous analysis and has no projected income until 20 years out.

He really doesn't have any "extra" money, and even if he did, this is crazy to continue as an investment plan, right? It is causing a huge strain his marriage, he has a 2 year old, they are making numerous sacrifices to keep this place, not saving any money currently, and I hate seeing this happen to them.

Is there a calculator/software or something that can help me show him how long the payback really is? Or some other way I can put it terms he can understand? Thank you so much.

throwaway email - crazyrental@gmail.com
posted by anonymous to Work & Money (11 answers total)
A lot of people that don't think about this crap have an easier time understanding cap rates. This joint has a negative cap rate right now. Maybe use that?

Or, the simplest, simplest possible explanation is that it costs him more to own this place than he gets by renting it, so what is he betting on? The upside in the real estate value? Because without that, right now this isn't an investment, its a slow money-incinerator, right? I mean, he borrows money (plus spends money on maintenance, whatever, ball it all up) to purchase an asset, then he rents the asset to other people for less money. Unless you think the asset itself is going to be worth way more money in the future, this is...a bunk strategy.

Maybe it would be easier to show him something like...if he is hung up on the idea that in X years he will own this house free and clear and it will kick off cash, show him how much cash a super-conservative investment would throw off after the same period of putting in whatever this place his costing him above what he's getting back in rent. E.g. a CD, munis. Show him a riskier portfolios too like equities or whatever, what the hell.

A lot of people get hung up on this idea that "once they own the house, MONEY JUST SHOOTS OUT OF IT!" which is true, and is awesome _if the tax advantages and leverage advantages of the house make it a positive-carry investment for you_. Otherwise, you need to look at the fact that big piles of money ALSO just shoot out money. So if he's looking at years of like...1400/mo going out the door against 700 coming in, he's 'saving' 700 a month in this house.

He's got 15 years on the mortage. If everything holds, he can either continue to put 700/mo into this house, or he can put 700/mo into some other vehicle. Lets say he puts it in the bank. 700/mo into a savings account is going to blow away owning a 90k house free and clear. He could just buy a couple more 90k houses in 15 years for all cash if thats the best cash flow at that point.

Which is how we get back to what his expectations on the RE market are.

Anyway, I think perhaps this will be easier to explain with a series of little examples, rather than a model. If he was the kind of dude who got models, he would not be in this deal.
posted by jeb at 7:36 PM on January 25, 2010

Is there a calculator/software or something that can help me show him how long the payback really is? Or some other way I can put it terms he can understand? Thank you so much.

Perhaps I'm not understanding you, but this is the wrong way to look at this. What's done is done. The money is spent, the losses are the losses. He bought it, it lost value, the rental market didn't hold up, but its not like...he gets a special prize if his investment eventually recovers. He needs to think about what it is worth now, what it costs now, what it will be worth in the future, what it will cost in the future. Whatever he spent in the past, he spent.

There's no technical reason why you can't go back and use your starting point purchase price and costs and then calculate an IRR with your assumptions at some point in the future, but there's also no reason to do that. I'm harping on this point because this is the kind of mistake people make all the time. People jump through all these emotional/mental justifications about how "in the long run, it will even out." Who cares? Think about it this way: if the market starts to recover, you will have the opportunity to buy at all the prices on the way back up, too. You get no additional utility from hanging onto your losers while they work themselves back up (quite the opposite usually), unless there are mitigating complications (tax issues, etc.)
posted by jeb at 7:46 PM on January 25, 2010 [1 favorite]

The house is worth $90,000. He owes upwards of $110,000 on his mortgage. According to the New York Times, he should walk away from his mortgage. There's really no reason for him to keep himself in penury to give the bank a $20,000 gift.

Then, if he wants, he can buy another house at a reasonable price and restart his long-term investing.
posted by alms at 7:48 PM on January 25, 2010

Mish has been a very vocal supporter of people walking away if they are underwater on a loan. You'll have to dig a bit, but at one point he he posted a quick and dirty cost analysis of when to walk away. You can start with this article. Googling Mish walk away should lead you to most of the rest.
posted by thekiltedwonder at 7:54 PM on January 25, 2010

One thing to keep in mind, also, is that manufactured homes are considered a depreciating asset with a limited lifespan which makes them difficult to finance as they age. Whereas you can get a mortgage easily on a stick-built house that was built in 1970, it's pretty difficult in many areas to do the same on a manufactured home.

I point this out as it means that when his mortgage is paid off the only real value may be in the land.
posted by maxwelton at 8:11 PM on January 25, 2010

Being underwater on the loan is probably not enough to persuade him, because it sounds like he believes that's compensated by future rent income.

which does not even account for his time OR his remodeling costs

Yeah, that's what he's not getting. Don't let him gloss over the costs of maintaining a rental property in calculating whether its profitable. His notion of infinite cash flow once the mortgage is paid off is premised on one flat-out wrong assumption (that costs end when the mortgage is paid) and one as-yet-unproven one (that cash can be made to flow at all, let alone profitably -- 1.5 years of occupancy out of 5 is a sign that something's not working).

Some permanent ongoing costs of maintaining a rental unit: management fees, advertising, cleaning/turnover services, carpet replacement, handyman, plumbing services, gardening, supplies, common area utilities, pest control, prorated capital improvements (i.e. the remodel, and setting money aside for other inevitable long-term costs such as eventual roof replacement, re-piping/re-wiring, etc.), etc.

Small-timers like to delude themselves that the maintenance costs don't exist in their brilliant business plan, because they handle it all personally. They fail to factor in costs of the DIY approach, such as:

* loss of income from not being able to use that time for a paid job, including time lost to muscle fatigue or injury
* the slower pace of an amateur's work means more days in which the place is vacant instead of producing income
* inadequate understanding of market conditions leading to prolonged vacancy or an underperforming income
* higher material costs because they don't have contractor discount
* additional costs from having inexpertly done enough repairs that some of them eventually need an expert to tear them out and re-do the work properly


Pinning down these costs is hard, and likely unnecessary. But plugging in a few broad guesstimates will help ground the discussion in reality. Though, ultimately, if the toll on his marriage and life hasn't motivated him to take action, then you may not be able to anything that'd convince him. Sounds like he's not operating on just reason. I've seen "investors" who are just too hooked on false premises to care what their real estate's truly costing them -- in dollars or in sense.
posted by nakedcodemonkey at 8:14 PM on January 25, 2010 [3 favorites]

alms, Roger Lowenstein says he should walk away from his mortgage, not the New York Times.
posted by yellowcandy at 8:48 PM on January 25, 2010

"Walking away" is highly dependent on the jurisdiction. In some states, the bank gets the property and is stuck with the tab, in others they can come after your other assets. Find out the laws of your state.

I think this is one of those situations where someone will ignore excellent free advice. Maybe if he pays for it, he'll believe it. The costs are easy to show, but the income side is where he's not in touch with reality. The problem is that the calculation is complicated by how long the house will last and the future rents. Assume fantasy numbers there and anything will work out, and assume fantasy numbers he will.
posted by a robot made out of meat at 7:46 AM on January 26, 2010

What others have said, above. Models are irrelevant. What's your friend doing, buy and hold on ... residential real estate? That's just nuts. The entire market has tanked and your friend is losing money hand over fist. If his negative cash flow hasn't convinced him I doubt a model or chart will.

He may remain convinced the property will appreciate and bring him a windfall, but that's bubble thinking. Today the only reason to hold RRE is for cash flow, because values are probably going to be stagnant for years (with a Y), perhaps a decade (with a D). If he isn't making money with an M, he shouldn't hold onto it.

It really doesn't matter what numbers you plug into the spreadsheet. Future earnings are not the way to think about this (that's how Tishman Speyer -- probably one of the smartest real estate outfits in the country -- got into trouble with Stuyvesant Town). Your friend has a mortgage to pay for. He's a lot better off talking to the bank about a short sale and getting out of this bad investment sooner rather than later.

Does your friend understand the terms sunk cost or opportunity cost? Because both of them sure apply here.
posted by dhartung at 9:57 AM on January 26, 2010

Mortgages for residential properties other than those occupied by the homeowner (that is, any rental property) are always recourse mortgages. That means they can and probably will, once they get around it, go after any significant assets of the mortgagee.

Anyone who doesn't understand this shouldn't be offering anyone advice on this.
posted by iknowizbirfmark at 5:55 PM on January 26, 2010

Sorry, that should be "assets of the mortgagor."
posted by iknowizbirfmark at 5:58 PM on January 26, 2010

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