I have been receiving the same question from a lot of people lately …. “What do I do with my upside down home?”
Having purchased a home when the market was booming in 2004 through 2006, many homeowners find themselves “Upside Down,” meaning they owe more money on the home than they can net from its sale.
So I decided to commit a blog post to this very hot and important topic. While many people write blogs on short sales, foreclosures, loan modifications and forbearance, I have yet to come across a model that will allow people in this situation to execute an analysis with the sole function of determining their best solution to an unfavorable situation.
What Options Does A Homeowner Have
We have given the same advice to homeowners in the Tallahassee real estate market for the past 17 years. Everybody who wants to get rid of a home has four options:
- Sell the home
- Stay in the home
- Lease the home
- Abandon the home (give the home to the bank)
While this seems to be pretty simple, we often find that some homeowners have not considered that they might not be able to sell their home without bringing money to the closing table (after all, don’t we buy real estate because it is a “great investment?”).
How To Decide What To Do With An Upside Down Home
If somebody finds that they owe more on the home than it is worth, and they have to move for any reason, than it appears that they really are limited in the options that they have. Unfortunately, many people when faced with such a large decision simply say “Well, I’ll just rent it out until the market returns.” With this in mind, I decided to build a financial model in order to determine what this “wait time” will really be and when the homeowner will finally be out of this investment.
For this model to be realistic, we have to make some assumptions. If you are using this model to help you make the same sort of decision, you would need to replace my assumptions with your real world specifics. For the purpose of this model, my assumptions will be kept very simple, yet in-line with what we are seeing with clients.
Real Estate Model Assumptions
“Jim” has owned his home three years. He has it on the market for $158,000 (down from $168,000) and currently owes $140,000 on the home. We have told him the value is dropping daily, and currently he can sell it in the $130Ks and should lower his price accordingly. Here are his specifics:
If he sells it today, he can expect to bring $17,150 to closing. This is a tough pill to swallow considering he was expecting to sell the home and collect that amount at the closing table. So Jim is considering “Leasing it out” until the market turns.
The property management company has told him he can lease it out for $1,050 per month and Jim knows that his mortgage payment is $1,239 per month (PITI). He’s thinking that is less than $200 per month difference, which is a whole lot easier to stomach than $17,150 at once, at closing.
Unfortunately for Jim, there are other expenses associated with leasing a property. When added to the formula, we get the following information:
What our model shows is that during the first few years, he can expect to invest nearly $500 (before taxes) into keeping his property, which is just less than $400 per month after taxes.
Now that we have this, we make a few more assumptions:
- The Net Operating Income (NOI) will rise 4% per year over the long run
- The property will depreciate 10% in 2009
- The property will depreciate 5% in 2010
- The property will depreciate 0% in 2011
- The property will resume appreciating indefinitely at the 50 year average of 4% in 2012.
These assumptions allow us to build a table to determine how long Jim has to invest in the property before he can afford to either sell it for no cash out of pocket or sell it and recoup his investment. But we also have one other option for Jim to consider:
Lenders Are Taking Notes For The Deficiency
It is most likely that we can negotiate with the lender to work out a note for Jim for the $17,150 difference (short sale) in selling the property. This would mean Jim would not have to bring the money to closing, rather he could “owe” it to the lender. We will assume that we can work out a 30 year repayment plan, at 0% interest for Jim. That would equate to $47.64 per month for the next 30 years.
Real Estate Model Graph
We can now graph or chart out all of Jim’s options to help him make an informed decision. While none of his decisions result in him getting money now for selling or leasing his home, at least the model provides for an accurate portrayal of what Jim should expect over the next 30 years:
From the real estate model graph, we have discovered the following:
- A) Jim’s initial plan of “I’ll just lease it out until the market turns will be a longer commitment than Jim expects. If Jim has deep enough pockets, he can lease the property out for thirty years (or more) and then sell it for a handsome profit. Unfortunately, to do so would require Jim to commit a negative cash flow through the year 2028 (this is a VERY conservative analysis) and have invested roughly $56,127 out of pocket before the cash flows begin to go positive. But Jim can expect to walk away with over $248,000 at closing in the year 2037.
- B) If Jim chooses to have us work a short sale with the lender, most likely we can negotiate a deal where he pays his negative balance ($17,150) over the next 30 years. The green line on the graph shows that he will have paid back the entire $17,150 by the year 2037. This is a safe decision and only requires him to pay $48 per month.
- C) The final point on the chart “C” shows that Jim’s first “walk away” point, where he won’t have to pay money at closing is in the year 2019. By then, he will have invested nearly $45,000 in negative cash flows. It is important for Jim to understand how long of a commitment he will have to make if he is going to just “lease it out until the market turns.” I have often found that the people who choose this decision are really choosing to not make a decision!
How To Decide To Lease Or To Sell A Home
Ultimately, the decision seems to be based upon how much hassle Jim is willing to endure and how deep his pockets are. If he will commit to more money and a long-term, he can turn this into a positive investment. If he simple wants it to “go away,” he should do the short sale and expect to make a small payment each month for the next thirty years. Regardless of the route that Jim takes, he will remember 2008 as a very tough time to need to sell a home with no equity.
The Model Numbers Which Support The Graph
| Net From Sale | Net From Leasing | Cumulative Sale | Cumulative Lease | Short Sale Payment | |
| 2008 | ($17,150) | ($4,590) | ($17,150) | ($4,590) | ($572) |
| 2009 | ($25,080) | ($4,590) | ($29,670) | ($9,180) | ($1,143) |
| 2010 | ($28,299) | ($4,425) | ($37,479) | ($13,605) | ($1,715) |
| 2011 | ($25,836) | ($4,254) | ($39,441) | ($17,859) | ($2,287) |
| 2012 | ($19,006) | ($4,076) | ($36,865) | ($21,935) | ($2,858) |
| 2013 | ($11,832) | ($3,891) | ($33,767) | ($25,825) | ($3,430) |
| 2014 | ($4,296) | ($3,698) | ($30,121) | ($29,523) | ($4,002) |
| 2015 | $3,623 | ($3,497) | ($25,900) | ($33,021) | ($4,573) |
| 2016 | $11,944 | ($3,289) | ($21,076) | ($36,310) | ($5,145) |
| 2017 | $20,691 | ($3,072) | ($15,619) | ($39,382) | ($5,717) |
| 2018 | $29,885 | ($2,847) | ($9,497) | ($42,229) | ($6,288) |
| 2019 | $39,551 | ($2,613) | ($2,677) | ($44,841) | ($6,860) |
| 2020 | $49,716 | ($2,369) | $4,875 | ($47,210) | ($7,432) |
| 2021 | $60,407 | ($2,115) | $13,197 | ($49,325) | ($8,003) |
| 2022 | $71,652 | ($1,851) | $22,327 | ($51,177) | ($8,575) |
| 2023 | $83,482 | ($1,577) | $32,306 | ($52,754) | ($9,147) |
| 2024 | $95,931 | ($1,292) | $43,177 | ($54,046) | ($9,718) |
| 2025 | $109,031 | ($995) | $54,985 | ($55,041) | ($10,290) |
| 2026 | $122,821 | ($687) | $67,779 | ($55,728) | ($10,862) |
| 2027 | $137,337 | ($366) | $81,609 | ($56,095) | ($11,433) |
| 2028 | $152,622 | ($32) | $96,527 | ($56,127) | ($12,005) |
| 2029 | $168,718 | $315 | $112,591 | ($55,813) | ($12,577) |
| 2030 | $185,671 | $675 | $129,859 | ($55,137) | ($13,148) |
| 2031 | $203,530 | $1,051 | $148,393 | ($54,086) | ($13,720) |
| 2032 | $222,347 | $1,441 | $168,260 | ($52,645) | ($14,292) |
| 2033 | $242,175 | $1,847 | $189,530 | ($50,799) | ($14,863) |
| 2034 | $258,886 | $2,269 | $208,087 | ($48,529) | ($15,435) |
| 2035 | $269,241 | $2,708 | $220,712 | ($45,821) | ($16,007) |
| 2036 | $280,011 | $3,165 | $234,190 | ($42,656) | ($16,578) |
| 2037 | $291,211 | $3,640 | $248,555 | ($39,017) | ($17,150) |
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