Caught Off-Guard by COVID-19? Prepare Yourself for the Next Black Swan—Here’s How

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A black swan is an event that is so far outside of the norm that it cannot be reasonably anticipated by markets and investors. I think it’s fair to characterize the COVID-19 pandemic as such an event.

I have my thoughts on what the outcomes may be, but I need more data on the ground before I consider approaching any prognosticating. For now, let’s say that while the type and timing of a black swan event cannot be anticipated, the notion of such an event occurring at some point in the future can certainly be rationalized and should be prepared for.

In other words, while we do not know what black swan will emerge, where, or when, we can assume that it will happen, and we should make an effort to be prepared.

In today’s article, I’d like to address what it means to be prepared for a black swan event.

How to Prepare for Unforeseen Events as a Real Estate Investor

Realistically, there are many moving parts to this, but at the bottom of this pile is a cold, hard reality that everything comes down to a super simple acronym—LLBP.

Preparedness for a black swan event includes three hurdles:

• L (Liquidity): This helps you survive the black swan.
• L (Location): This helps you recover from the black swan.
• BP (Business Plan): This helps you protect from the downside and achieve long-term prosperity.

I’m not sure how everyone else tackles this, but I’ll share with you what my team and I do for each and every acquisition so as to prepare us to survive, recover, and prosper following a black swan event.

Liquidity—Immediate Survival

9 Months of Debt Service Reserve

Automatic to our underwriting model is a nine-month debt service reserve. Important to note here is the fact that most of the time, the lender requires some amount of reserve. However, up until a month ago, lenders were happy with one to three months’ worth of reserve.

From what I’m hearing, Fannie Mae is now requiring up to 18 months of debt service reserve for the deals in the pipeline to offset the risk of the eviction moratorium, with an average requirement of 12 months.

This new requirement was one of the primary reasons deals have fallen out of escrow in the last week.

Say you were a syndicator prepared to escrow two months of debt service, and the lender just changed their terms—you now have to escrow 12 months of debt service. Even if you could raise more money in time to close, your projections for returns took an insurmountable hit. Many had to walk away from deals.

An interesting side note on this situation is that because my company always has nine months of debt service in reserves, we are taking a minimal hit to our underwriting. This helps us be competitive in a market where 75 percent of buyers have been sidelined.

General Reserve

In addition to the debt service reserve, automatic to our underwriting is a $1,000 per unit general reserve.

Construction Floats

On larger repositioning projects with more moving parts, we also like an additional construction float. This is also liquid, and if the black swan necessitates adjusting our construction plans to tap this liquidity, we have this bullet in the chamber.

To give you a sense of these numbers, our last acquisition of Sun Crest Apartments required a total equity raise of $4.2 million. The reserve items I mentioned above totaled almost $600,000, while the debt service on the deal is under $40,000 per month.

Some other reserves we typically have included:

• Replacement dollars for 25-50 percent of the HVAC units, depending on the DD.
• Replacement dollars for 25-35 percent of the hot water heaters, depending on the DD.
• Plumbing reserve of $50,000-$200,000, depending on the DD and mechanical layout.
• Cost overruns for all of the CapEx projects.

Perspective on Liquidity—It’s Not Easy

There are a couple of points here, one of which is something you’d expect, while the other may be quite surprising.

As you would expect, all of these reserves are certainly a strain on the underwriting, which frankly, is the reason so many syndicators are quick to drop the reserves in order to prop up the forecasted returns. Lots—and I mean lots—of value-add is necessary in order to accommodate such reserves. But you knew that.

Something surprising, on the other hand, is how often I get pushback from investors for insisting on this level of the reserve. Specifically, new investors who haven’t had experience with us complain that having this much equity sit idle impacts investment returns too much.

Sam and I typically report to our partners on a monthly basis, but since the outbreak of COVID-19, we’ve sent out weekly updates.

I haven’t heard anyone complain about the excessive reserves lately—go figure.

Ladies and gents, I don’t sleep very well in general. This is because I am an old neurotic Jew who worries about everything. But, I take some comfort from knowing that all of our assets carry “too much idle equity which negatively impacts projections of return…”

Related: The Essential Importance of Cash Reserves in a Crisis

Location—Short-Term Recovery

CBRE’s most recent Weekly Market Update projects the following for multifamily:

• The average vacancy in Q4 to rise from 4.1 percent to 5.7 percent.
• The sharpest drop in rents is forecast in Q3 at 3.4 percent.
• Early-stage new construction has stalled.
• Rent increases are currently 0 percent.

The reality right now is that the economy is taking a hit, and the only questions are how bad and for how long. Where liquidity facilitates our staying power for the duration of the downturn, your location likely has more to do with how long it takes you to recover.

Let’s not overcomplicate things—all of this is rather logical. There is reason to think that a city that was growing its employment base by 3 percent per year prior to the pandemic is likely to recover sooner than a city that was growing its employment base by 1 percent.

Similarly, if rents take a hit as an outcome of the pandemic, a city that was growing rents at 8.5 percent prior to the downturn is more likely to return to positive rent growth sooner than a city where rents grew by 2 percent.

WhiteHaven invests in Phoenix. Below are some stats for Phoenix MSA, according to Colliers International:

• MSA Population: 5 million
• Population Growth: County has been the No. 1 growth county in the U.S. for three years running. Phoenix is the fastest growing city. Population expected to double in 10 years.
• Job Growth: 3.2 percent, which places Phoenix in the top five employment markets
• Rent Growth: 9 percent year over year
• Occupancy Rates: 95.2 percent
• Average Rent: $1,185
• Inventory Under Construction: 16,200. According to the report, “Despite sustained new construction, Phoenix’s apartment deficit is still expected to hit 32,000 by 2020/2021.”

There are more unknowns than knowns at the moment, but I feel pretty good about our chances of recovery at a faster pace than many other municipalities. So much so that we are aggressively making offers while so many buyers are sidelined!

Related: How to Reduce Vacancy During an Economic Downturn

Business Plan—Long-Term Competitive Advantage

The purpose of a business plan is to drive risk-adjusted returns. In order to do this, the business plan needs to synergize (a) that which will drive growth, with (b) that which will minimize risk exposure.

The thing to understand here is that in times of economic downturn, there is always a flight to quality. This is true in any market. As this relates to multifamily properties, when rents deflate and concessions escalate, tenants find themselves able to afford to scale up on the quality of their apartment.

So, when Class A begins to take a hit and starts discounting rents, this results in two things. First, those tenants who could only afford Class B yesterday, now all of a sudden can afford Class A, and they relocate. And, secondly, this competition from Class A in-turn forces Class B to discount their rents as well in an effort to keep occupancy up, which forces Class C to discount theirs, etc. It’s a race to the bottom.

So, how do we address that in the business plan?

Value-add for so many apartment syndicators has become something I call “lipstick on a pig,” consisting of painting the cabinets, refinishing the countertops, flooring, paint, and fixtures. In total, costing anywhere from $4,500 to $6,000.

We made the decision early on to go well beyond that. We replace cabinets, install granite countertops, install washers and dryers, build new offices and gyms, etc. We can only afford to do this because we focus on extreme value-add repositioning opportunities, where we can pencil lifting rents by $200-$400 per month. But the end result is that we end up owning uncommon quality rentals in the submarket. In fact, when our Class-C tenants go looking at Class B because they think it’ll be nicer, they realize that it’s not.

So, our business plan facilitates higher rents than the competition because our product is something no one else is offering. But, even more importantly, our business model essentially creates a subclass of property. These are Class-C transitional locations but Class-B units with Class-A finishing surfaces, which serves as sort of an insurance policy for the downturn when there is a flight to quality.

It is now too late to prepare for this black swan—it’s already here. But, if this helps any of you in the future, remember LLBP—liquidity, location, business plan.

How are you preparing to weather the financial storm caused by the COVID-19 pandemic?

Join the conversation in the comments below.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.