Landlords With A Partnership In Property That is Losing Money.
Question
A partner and I purchased a 6-plex in Wisconsin a couple of years ago. The investment has lost a significant amount of money since its purchase, totaling almost $12,000 during the past 12 months. My partner has been unwilling to continue contributing his share of the negative cash flow and I’m unable to continue carrying the negative for much longer. There are 3 main problems. First, the variable rate loan interest rate, fixed for the first two years, just increased, meaning that the monthly payment will now increase and further increase our problems. Second, heating is provided by a central oil fueled system and oil prices have increased since we bought the property. Third, we can’t seem to keep the units fully rented. When does one call it quits and sell?
Answer
Unfortunately, investors, particularly new ones, often underestimate operating expenses and vacancy rates and fail to adequately take into account that a variable interest rate may significantly increase.
Whether or not a negative cash flow of the approximately $167 per month per unit calculated from your information is unusually bad depends on the terms of the purchase including the price paid, the loan to value ratio, the interest rate, the level of current rents and of market rents, and local vacancy rates for the type of property purchased. Many combinations of these items can result in significant negative cash flows, even more than you are experiencing, particularly during the first years of ownership.
Depending on the income levels and tax brackets of you and your partner, tax benefits of ownership, including depreciation, would often cover much of such a negative cash flow, assuming you each qualify to utilize your shares of the loss.
Regarding your specific 3 problems:
1. You should determine whether or not better financing is currently available and whether or not you can qualify for it. If the two of you have access to the necessary capital, you could also consider refinancing with a smaller loan with better terms by contributing additional capital of your own to the partnership or, possibly bringing in other partners to provide the capital.
2. While heating oil prices have varied greatly over the past decades (from around $1 during most of the 1990s to around $4 for the recent two-year period of 2012-13 in some areas), it should probably be assumed that prices are more likely to go up than to go down over the long-term future. Accordingly, your choices are to (a) raise rents to better cover the oil expense, (b) convert to a heating system that uses a cheaper energy source, and/or (c) convert to a system that allows individual tenants to pay for their own heating bills. The first option may not be possible in a competitive market and the other options may not be physically or economically feasible. Unfortunately, when the landlord pays energy costs most tenants see no reason to minimize usage, making option (c) the best solution if physically possible and economically feasible.
3. There are ways to minimize vacancies, including providing better quality for the price than the competition and doing better marketing. The former may require either lowering rents or adding amenities, but should be based on a comprehensive market survey. Either approach will, of course, cost money. Your options regarding the latter depend on what you are already doing and what other marketing tools are available in your area. Retaining existing good tenants should always be a priority, far ahead of increasing rents. The cost of a vacancy, including both fix-up expenses and loss of rents, is often never recovered even with reasonable increased rents.
Whether or not you should sell depends on a number of factors including (1) what price you can get, particularly whether you can sell for more than you owe or how much you can afford to put into a sale in order to close escrow, (2) how much higher you think the loan payments and oil costs might go, and (3) what your expectations are for future appreciation.
Finally, if the property cannot be sold because the current loan balance plus selling costs is greater than the value and funds to make up the difference are not available from the partners, there is also the option of letting the lender have the property. Of course, unless the loan is non-recourse (unlikely) or your particular state has an anti-deficiency statute that covers such properties (few if any states do) you will likely be at risk for a deficiency judgment in addition to credit record damage.
The bottom line is that you may have no options for avoiding catastrophe. However, I advise you and your partner to start by discussing the matter with the lender. You could see if they might be willing to take the property via a deed in lieu of foreclosure or if they have any flexibility regarding changing loan terms in ways that might help make the investment more viable for you and your partner. You should also discuss with your partner the possible implications of failing to meet his responsibility for his share of contributions needed to carry the negative cash flow. The implications include damage to credit records from a foreclosure and the likelihood of a lawsuit for the probable deficiency if the property is sold for sold after the lender forecloses for a price less than the loan principal balance plus ongoing interest and late charges plus the lender’s administrative and legal costs.