One of our rental properties is "underwater". By that I mean that we owe more on the mortgage than the property is currently worth. This is of course not a good situation to be in. My wife and I are in good financial shape overall and most of our rental assets have significant equity. So we plan to hang on to the property for the time being and 'ride it out'. But that may not work best for everyone. If we were losing a lot of money on the property or couldn't afford the liability then it might make better sense to just dump it now and take the loss. Theres a few potential options for dealing with an underwater rental property. Everyones situation is different so what will work best depends on the details.
What are the options?
The way I see it there are only a few options for a rental that is underwater. In brief the list is :
1. Sell it at a loss.
2. Keep it.
3. Improve the property to increase the value.
4. Lease option sale
5. Sell it as a short sale.
6. Let the bank have it.
7. Bankruptcy
Selling at a loss. If you own a property that is underwater then you could sell it and take money out of your own pocket to pay the bank off in full. For example say you own a rental worth $100k fair market value and your mortgage is $120k then you could sell the property for the $100k and then take another $20k out of your savings to pay the bank off in full. If you don't want to be a landlord and never wanted to then this may be a preferable option for you. Pros: You get rid of property, no doubt or risk of further loss, credit isn't harmed. Cons: It costs you $20k.
Keep it. If you own an underwater property you can simply keep it and continue to rent it. Eventually the value of the property will exceed the debt and it will not be underwater. How fast that will happen is anyones guess. In some cases it may take as long as the term on the mortgage. If the property is only underwater by a few thousand then it could have positive equity within a year or two. If you bought the property with the intention of using it as an investment from the start then this may be your preferable option. Pros: Credit isn't harmed, not selling property for loss, potential future gains on property and rental income. Cons: Risks involved with renting property, tied to property.
Improve the property. This option is not likely to work in most situations. But its worth a look. Simple improvements like a coat of paint or some basic landscaping may improve the resale value of a property. Or if you're particularly handy yourself then you may be able to put a lot of labor into the property and cash in on your own hard work. Pros: lower loss/ risk. Cons: not often feasible, more work required.
Lease option sales. If you find the right tenant / buyer you may be able to negotiate a lease option. This deal is structured so that a tenant will rent the property for a given period of time and then they have the option to buy the property after the lease is over. This can be a positive thing for a potential buyer since they may need some time to improve their credit or increase their savings. The owner may benefit if they structure the deal to make sure that the sales price is an improvement on the current fair market value or if it at least gives you enough time to pay down the mortgage gradually to get out from underwater. Generally I'm not fond of lease options as they seem structured to exploit the tenant/buyer. But if you structure the deal in a way that its fair and positive for both parties then it could be a feasible alternative. Pros: reduces risk, ok for credit. Cons: option may fall through.
Short sale. A short sale is when you sell a property for the market value and the bank takes a loss on the mortgage. In order to do a short sale you have to get the bank to agree to it. Banks may favor a short sale since it could be a little cheaper for them compared to dealing with foreclosing and selling the property themselves. Short sale of a property will hurt your credit but may not be as bad on the credit as a foreclosure. Pros: Not as bad as foreclosure, no financial loss, gets rid of liability. Cons: Credit is damaged.
Foreclosure. I think the last resort is to just let the bank have the property. You should try a short sale before foreclosure, but if a bank doesn't want to do a short sale then a foreclosure may be the last option. A foreclosure will trash your credit. Its not a positive thing for you, the bank, or anyone involved. You should avoid a foreclosure if at all possible. But you have done everything else possible and a rental negative cash flow is dragging down your finances then allowing the bank to take the property may be the only thing left to do. You do have to be careful if you have a assets though since the bank could come after you for the difference. You may also have a tax liability on the unpaid portion of the mortgage. Pros; Get rid of property without financial loss. Cons: Credit is trashed, worse option in general.
Bankruptcy Depending on the situation it may make better sense for you to declare bankruptcy than to simply allow the property to go into foreclosure. The bank will end up with the property either way. If your finances are in really bad shape and you are letting the house go into foreclosure, then you may be a good candidate for bankruptcy. Of course bankruptcy is something to avoid if at all possible. Pros: Finances wiped clean. Cons: Credit trashed.