3 Reasons We Should Embrace New Lender Reserves

[Joshua Ferrari]

Have you ever run out of gas? I’m not talking the figurative gas tank, but the literal one we have in our vehicles.

I had a truck years ago that frequently over-stated the amount left in the tank and one time it got the better of me. Embarrassingly enough I ran out of gas on the top of a mountain, while I was trying to propose to my girlfriend. It was such a pain to pull off to the side of the road, walk to the nearest gas station, spend a small fortune on a portable gas can, hike a bunch of miles up and down the mountain, spill half of that gas trying to get it into the tank because those spouts are designed so poorly, and on and on…

Even though quite a few people have experienced this frustration one time or another, it is a relatively rare occurrence. We’re collectively pretty good at avoiding it because it is so annoying and painful.

On a recent road trip back home, I almost ran out of gas again while driving and not paying any attention to my gas gauge. This got me thinking about the value of a full tank not only in our vehicles, but in our multifamily investments as well.

How painful, annoying, and potentially catastrophic would it be for a multifamily syndicator to run out of gas (cash) in their deal?

My point in this article is to share some perspective on why I believe embracing these reserve requirements will only make your business stronger.

1. Most of Your Competition is On the Sidelines

I had a conversation this week with a syndicator who has over 1000 doors under management. We discussed a current deal he has under contract. He wants Agency debt and has underwritten the deal with 18 months of principal and interest reserves required for a full leverage Fannie Mae deal.

Guess what… he is still projecting a 22.3% IRR, 2.09x equity multiple, and an 8.9% cash on cash return!

Does he have to raise some additional funds to do the deal? Absolutely. But he’s still able to offer great returns to his investors.

The point is, and I feel like it is important, this individual has embraced the reserve requirements while most people are in this “wait and see” mode that has come so pervasive of late. They want to wait for the reserve requirements to burn off before doing a deal.

This over-arching sentiment is simply an opportunity for those contrarian thinkers to capture great deals by embracing the current lending climate that has scared a lot of folks out of the market. Didn’t a wise man say something to the effect of ‘buy when the herd is selling and sell when the herd is buying’???

2. You’ve Got a CapEx Budget Anyway

What do we do as syndicators? We add value. There are two primary methods in so doing – 1. Better, more efficient management. 2. Capital Improvements. Part of the business plan is to improve the physical structure both inside and out; both functionally and aesthetically. This is done by investing money in the property.

Who says that must be done day 1? If you’re projecting a 5-year hold, could you wait twelve months to start the rehab? Or part of the rehab? Of course you can. The vast majority of time that is a very viable strategy.

Let’s say you have a $1 million budget for improving the property. And let’s also assume the COIVID-19 induced mandatory lender reserve is $400,000. Rather than raising $1.4 million in equity, you still only need to raise $1 million. You put $400,000 in the reserve and go to work with the $600,000 left over. It will probably take you a year to do all that work anyway. You just defer the lowest priority work until the lender reserve is released and you complete the capital improvements then.

You might even find out you can achieve desired outcomes without spending the full $1 million budget. There is opportunity here and it takes a very simple mind shift and doing things marginally differently.

3. Investors Will Appreciate and Gravitate Towards Safety in Uncertain Times

I’m a firm believer at a base level, and whether they will admit it or not, most passive investors’ biggest fear is losing their capital. No one wants a zero percent return, but I dare say most people could live with not losing their money.

The stock market can swallow up capital that is never to be returned. We invest in real estate because there is a tangibility and longevity to the asset class.

I’m of the mindset it is virtually impossible to lose in real estate as long as you can hold on long enough. Cash allows you to hold on.

Syndicators love leverage. The vast majority I’ve worked with want as much debt as they can possibly get. It makes perfect sense. Debt is cheap money, especially today. The more debt, the higher the projected investor returns. And the more debt, the fewer investors they need to go get, manage, and work with. Leverage through debt is what makes these deals work.

The flip side of debt is there are obligations with it. The greater the leverage, the more risk a syndicator takes on.

So how does one mitigate that risk?

Cash.

Cash on hand is the way to mitigate that risk. If you lever up and have a bunch of cash on the sidelines, there is plenty of “dry powder” to service that debt if times get tough.

Remember how much fun it is to run out of gas? Yep, no fun at all. Cash is the gas that keeps the syndicator’s deal healthy and insulated from risk. This means investors can sleep well at night knowing there are funds to weather any storms.

The Agency imposed mandatory reserves make a deal stronger. It should be presented to investors as a benefit and a reason to get involved in a deal now. I don’t need to spell that out here, I know you can connect the dots.

The moral of the story today is one that has been repeated over and over again throughout the ages – Cash is King. What may appear to be a draconian reaction to the coronavirus pandemic may very well be a big opportunity for the syndicator who embraces the new rules of the game.