What is Negative Equity?

Whenever the value of any asset falls below the amount of outstanding balance of debt used to acquire the asset, you are dealing with a situation of negative equity. The value of negative equity for an asset can be calculated by subtracting the current market value from the outstanding loan amount. For negative equity to occur, the value of the asset must depreciate rapidly over the duration of its useful life.

Suppose Mr. X owns a house that was valued at INR 34 lakh at the time of the purchase. Let us assume that the purchase was financed by a financial institution with a 10% down payment. Therefore, the overall value of the loan becomes 0.9 x INR 34 lakh = INR 30.6 lakh. Consider the location of the house to be so remote that the city does not get developed in that direction. Also, the location suffers from frequent power outages and the entire real estate sector in that area has fallen out of favor from the real estate developers. In such a scenario, the house may rapidly depreciate in value so much that by the fourth year, the market value would be INR 15 lakh against an outstanding balance of INR 21 lakh. This scenario is a case of negative equity for Mr. X because the remaining amount of debt owed to the financial institution is greater than the market value of the asset. Similarly, for a business, a situation of negative equity arises when its total liabilities exceeds total assets. Read more to understand the causes, implications, determination, and management strategies of negative equity along with examples.

Causes of Negative Equity

Negative equity for a business is a result of numerous factors such as -

1. Higher dividend payments

   If a business continues paying huge dividends to its shareholders, it results in a reduction in its retained earnings, and ultimately a company’s equity. Dividend payments are a discretionary reward to a company’s shareholders and a company is not obligated in any way to pay dividends. A consistent decrease in equity through retained earnings can lead to negative equity.

2. Excessive amortization

   When a business amortizes intangible assets such as brand names and trademarks, it causes a decrease in asset value. Amortization is a hidden cost and its impact on equity gets higher over time. So, as a company owner, you need to keep an eye on your amortization expenses.

3. Heavy borrowings

   Equity = Assets - Liabilities

   Since higher debt levels can cause the liability to increase exponentially, at some stage, it may overshadow assets that can result in a negative equity scenario. Essentially, short-term borrowings must be used for working capital management and long-term borrowings must result in a corresponding increase in assets through investments and R&D.

4. Accumulation of losses

   A business may suffer losses over many years that can erode its equity over time. These losses reduce retained earnings and ultimately lead to a drop in the assets for a company. As a business owner, you must aim for profitability after some years of establishment or you could be faced with a tricky situation of negative equity in the long run.

Implications of Negative Equity on Investments

Negative equity can have serious implications for your business as well as other stakeholders. For an individual business owner, negative equity can translate to negative net worth because the assets owned by the proprietor will be less than his liabilities. This can refer to a not-so-smooth functioning of his day-to-day business operations. His regular expenses such as salaries and vendor payments may see a temporary halt that can lead to a bad reputation. Another implication could be evidence of financial mismanagement. For a business, a situation of negative equity refers to bad financial controls and lenient implementation of risk management policies.

Usually, there are red flags even before a business faces negative equity, but due to managerial oversight and aggressive business outlook, those red flags may have been ignored. A situation of negative equity that the company is in bad financial health and cannot meet short-term and long-term obligations. This can lead to a bad credit rating, loss of reputation, non-payment of outstanding loan balances, and eventual business closure. Financial institutions may hesitate or even stop extending credit altogether to an organization that has negative equity.

Negative equity also causes an erosion of equity and book value, and therefore, can cause panic among shareholders. Shareholders may not infuse additional capital into the business unless the business sees some sort of a turnaround and eventually experiences positive equity. Shareholders also may view the actions of management professionals with suspicion in case of negative equity which can cause a churn in the leadership team. Activities such as marketing and sales may be relegated to the background while financial control and management can be brought to the forefront for an early revival.

How to Determine If You Have Negative Equity

Essentially, negative equity occurs when assets owned by a business or an individual are not enough to meet liabilities. For instance, if your car’s market value is INR 14 lakh but you owe INR 20 lakh to the financial institution, you have a negative equity of INR 6 lakh. Determining negative equity is simple with the following step-by-step process -

1. Find the current market value

   You can find the current market value of an asset, e.g. car, through online portals or an independent valuation expert. You have to consider multiple factors while determining the car’s market value such as year of purchase/registration, usage, depreciation, current condition, vehicle history, current mileage, model, and market conditions to arrive at a definite figure. A car that has not experienced much wear and tear will have a higher market value than the one that has more wear and tear given that other factors for both the cars are similar. Similarly, an old model of a car will always have less market value than a new model.

2. Compute the remaining outstanding loan amount

   After arriving at the current market value of your car, you need to check your loan account statements and tally it with the amortization schedule to find the outstanding amount of your loan. The outstanding amount can be easily calculated by subtracting the EMIs already paid from the total payment required as per the amortization schedule. You may have to log in to your loan account portal, check your email, or visit your financial institution branch for a certified copy of your loan outstanding balance statement.

3. Compare the two values obtained in the above steps

   Now, you can easily determine if you are in a situation of negative equity. If your value in step 2 is more than that in step 1, you have a case of negative equity. The overall value of negative equity can be calculated by subtracting the value obtained in step 1 from that obtained in step 2.

For a business, the process needs to be repeated for every asset and if the overall outstanding amount is more than the overall current value of assets, the business has negative equity.

Strategies to Manage and Overcome Negative Equity

There are several strategies you can follow to manage and over negative equity some of which are mentioned below -

1. Avoid getting into it

   The correct strategy is to never reach a stage of negative equity because the recovery process is extremely difficult.

2. Consider refinancing options

   You can consider refinancing options for your loan at a lower interest rate which is fixed in order to avoid paying more during a high-interest rate environment. Though refinancing is an available alternative, the refinancer will check your enhanced financial control and risk management measures after you have experienced negative equity.

3. Delay asset liquidation and improve value

   If you are not getting the worth of your asset value in the market, delay selling the asset. Instead, try to enhance the value of your asset through upgrades such as changing the aesthetics of the real estate property or adding a value-added feature such as air conditioning to your commercial real estate.

4. Avoid or downgrade your next purchase

   When you are stuck in a negative equity situation, consider downgrading your next purchase to a more cost-effective alternative. You can also avoid making the purchase if the new asset or expense is not critical to your business operations. For instance, investing in new R&D during a negative equity condition is never advisable.

5. Negotiate credit period

   Negotiate with your vendors and try extending the credit period of the payments that you owe them. During that period, try collecting outstanding customer amounts to the maximum possible.

6. Faster repayments

   Repaying your borrowings faster can lead to a lower amount of outstanding balance in the future. Always endeavor to pay off debt over and above the EMI amount which is a good long-term strategy to manage negative equity.

Negative Equity in Real Estate vs. Automobiles

Let us see examples of negative equity in real estate and automobiles -

The above comparative analysis gives a fair idea of a negative equity situation for real estate and an automobile. Depending on the type of real estate and automobile, the value of asset improvement could be different which also affects the current market value. For a commercial property or an automobile, there is more likelihood of asset upgradation than a residential property or a personal vehicle. 

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