Rental property can be an excellent investment tool and it often is. However, there are certainly those times when a property goes bad. It may be an immediate downturn in the economy, a loan with bad terms, an area of town that goes south, tenants that trash the property, or maybe we just made a bad decision.
Whatever may have caused the problem with cash flow or the equity that simply vanished into thin air, it’s critical we keep calm and let cooler heads prevail. Stated otherwise, don’t get emotional and try to look at the facts and make an objective decision.
Of course, it’s always easier for someone on the outside to tell us to ‘stay unemotional’, but even then we need a simple approach to analyze the situation. When things are difficult, it’s certainly hard for all of us to think straight and make wise long-term decisions.
Over the years, I have developed a 4 quadrant analysis that has helped a lot of clients through some difficult decisions. I call it the “Problem Property Matrix”. Here is a simple representation:
The first rule in determining the best approach to take with a ‘problem property’ is that selling may not be the right approach. Keeping the property may make the most sense. Don’t be afraid to keep a property that has negative cash flow or be upside down. Let the numbers tell you what to do…NOT your emotions.
Let’s take each quadrant sequentially, and consider what the best approach may be with a property in different circumstances.
Quadrant 1 – Cash Flow and Equity. Obviously this is a property you want to keep unless you expect a dramatic change in the financial strength of the property and have evidence you should sell while ‘the time is right’. Nonetheless, count yourself lucky to be in this quadrant.
Quadrant 2 – No Cash Flow, but has Equity. This is the trickiest quadrant to analyze. On the face of it, if you have a property with negative cash flow, you might assume it is time to sell. However, this could be deceiving. Typically a property is in a negative cash flow scenario because there is a mortgage payment involved. Therefore, it’s important to consider how much of the mortgage payment is being allocated to principle and how much to interest. If the property has equity and the rental market in the area is generally strong, you should consider how much you are adding to equity each month with that mortgage payment. Hence, you may not be negative cash flow when considering the totality of the situation. View your rental property like a savings account that is growing tax deferred and run the numbers. Quadrant 2 could be a situation where you keep the property rather than sell.
Quadrant 3- Cash flow, but no Equity. This quadrant is a little easier to process intellectually. Even though you are terribly upside down in equity, you might want to say ‘Who cares! I’m cash flowing, so I might as well keep the property’. In fact, if you are in an upside down mortgage, selling could be disastrous. A sale could affect your credit or you could even end up with a deficiency judgment. This is a scenario where the bank comes after you for the balance on the mortgage. So in sum, if you are ‘cash flowing’, maybe you could envision a situation down the road in 5-7 years where the equity could turn around. In fact, as you slowly pay down the mortgage you’ll hopefully also have the market helping to increase your equity over time. Tow the line as long as you can in quadrant 3.
Quadrant 4- No Cash flow and no Equity. Obviously this is the quadrant where it’s time to get out…and fast. However, stopping the bleeding and getting rid of the property can be a challenge. Now again, if you are upside down in the equity, then there is obviously a mortgage or loan of some sort in place. Thus, there are really only 4 options: 1) a deed in lieu of foreclosure, 2) Short-sale, 3) foreclosure, or 4) finding someone to assume your mortgage that wants the risk or has some other crazy idea. Discussing the strategies of a short-sale or deed in lieu are beyond the scope of this article, but suffice it to say that both of these options typically damage your credit the least. When getting out of a property in quadrant 4, the goals are typically two fold: pay the least amount of money and limit the damage to your credit.
In summary, be pragmatic, objective and look for the long run wise decision. Don’t be hard on yourself if you are emotional or looking at the immediate or short-term situation. It is certainly typical to make irrational decisions in a crisis situation. Do your best to get a 3rd party to help you look at things rationally and don’t take it personally. Hang in there. Anyone that has invested in real estate on a regular basis has had to deal with a problem property before. You aren’t the first.
Mark J. Kohler is a CPA, Attorney, Radio Show host and author of the new book “The Tax and Legal Playbook- Game Changing Solutions For Your Small Business Questions” and “What Your CPA Isn’t Telling You- Life Changing Tax Strategies”. He is also a partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP and the accounting firm K&E CPAs, LLP. For more information visit him at www.markjkohler.com.