How to survive a cash flow reversal

Before I get into a diatribe about cash flow reversal, I need to define what cash flow is. Cash flow is the cash that flows to your bank account every month from your rental income, after your expenses are paid. Cash flow is the safest metric to use when choosing an investment. Sure, there are people who invest for appreciation, but if you aren’t forcing the appreciation through renovation, you are merely speculating (that is a fancy word for gambling).

At this moment we are in some strange territory. A virus and the subsequent panic have set the stage for an economic reversal. Our recently booming economy is getting it’s ass kicked. Each day that our state is shut down just makes the problem worse. Small business, is the backbone of our economy. It is the small business that is going to have the biggest problems. Small business owners still have expenses to pay in order to survive, what they don’t have is an income to pay those expenses. Some business will survive. The number of survivals will equal the number of business entities that have sufficient cash or credit to keep paying their bills without an income.

The businesses that don’t survive will create two problems for real estate investors. First, they will close their doors and many commercial properties will become vacant. The owners of those properties will now be in the same boat as their former tenants. They will have expenses but no income, until they can get new tenants, and commercial vacancy rates will be high for a while. The second problem is that those closing businesses will lay off their employees. Those employees might still be able to collect unemployment but for how long? With big job losses there will be more people looking for work than there are employers looking to hire new workers. At some point, the employees won’t be able to pay their rent. That is when landlords will feel the pain of this virus.
Don’t lose hope, there is a silver lining here, but it will take me a few more paragraphs to get there.

Now let’s imagine a landlord who has a mortgage. That landlord must now make up the payment from the cash flow taken from their other properties or from their personal bank account. What happens when a landlord can’t afford to do this?
Before I answer that question, let me take you on another thought experiment. Imagine that you own 50 properties. They are all partially or fully mortgaged, meaning that you have a monthly payment on each of them. Now let’s imagine that 10% of your renters lose their jobs and can’t pay. Can you afford to pay five mortgages with no offsetting income? The real answer depends on how strong your cash flow is from the other 45 properties. What happens if you lose another paying tenant, or one more after that? At some point the landlord can’t afford to keep all of the properties.

When you are faced with a cash flow reversal, that is your cash flow turns from positive to negative, then you need to make some tough choices. Think of this as removing the cancer from a portion of your business body so that it doesn’t kill your entire body.
So how do we determine what to cut first and how to stop the spread of the financial cancer? If you only own one property, you need to get rid of it before it pulls you into bankruptcy. Bankruptcy, in my opinion is your worst option. Bankruptcy will keep you on the sideline for years to come, it has the highest and worst impact on your future. The only people who do well in bankruptcy are bankruptcy attorneys. If you own many properties, then you need to rank them and see which properties are first up on the chopping block. I would suggest that you rank your property based on which one has the biggest negative impact on your cash flow. My second criteria would be equity. I would look to dump the properties with the least amount of equity. My third and final criteria would be ease of sale. I would look to keep the properties that would easy to sell quickly if my finances don’t improve.

So how do we sell off the bad properties? The obvious answer for most people is the MLS. List the darn thing with an agent and hope your property is the one that sells faster than all of the other panic sellers. In a declining market, this might be the hardest way to sell a house. Not only will prices be dropping but you might not have enough equity in the property to be able to sell without bringing cash to the closing. There are few things more horrible than having to pay for the privilege of losing a house. Keep in mind that there will be taxes and closing costs involved in this process, and that agent you hired deserves to get paid.

A much better strategy would be to sell your house to another investor who can absorb the short-term loss without going bankrupt. If you want to get this monkey off your back quickly, just agree to let the buyer (investor) take over your debt. Don’t worry about the mechanics of how this works, we have lawyers who handle the paperwork and make it legal. Once the paperwork is all done, you can walk away from your bad debt. The only down side is that they loan will remain in your name for a period of time. The lawyer will make sure you are protected, so that if they new “buyer” fails to make your payments, you get the property back. You really have nothing to lose in this scenario.

I plan to do an entire class on this subject as soon as we are allowed to gather again.

To your success

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