What to do about cash reserves for big apartment deal?

Question

Hi BP family! I'm preparing for my future goal of owning an apartment. I have a question about cash reserves. How do I handle ensuring enough cash reserves for an apartment when I don't have a large amount of capital? My plans for purchasing a large apartment would involve raising capital, leveraging a commercial loan and seller financing. I will contribute as little personal capital as possible. I'm scaling up outside of my current comfort zone so, relatively speaking, I won't have a lot of cash reserves in case something goes wrong; I'd love some feedback about how to overcome this challenge.

I recently purchased a duplex that needed rehab. I found more problems than I budgeted for and if I didn't have enough cash reserves (thankfully I do) then I would be in a bad situation right now. If this were 20 units instead of 2 and I had expenses proportional to my current costs, I wouldn't be able to cover them. Granted I've learned many lessons on this deal that I will apply to future ones, but even experienced investors run into unforseen problems. What strategy should a new apartment investor consider to protect himself?

Thanks for any comments from experienced large multifamily to help me prepare!

Jeff Greenberg · Answer

As a part of the raise you need to ensure that you budget for cap reserve, closing costs, funding the operating account, first years insurance, utility deposits, and other contingencies. Getting caught short at the last minute can ruin your day, and deal. A week before closing, I had a lender tell me that he wasn't going to give me the 80% ltv that he had put in the term sheet, but changed it to 75%. In addition to having to come up with 5% for the down, he also told me that I needed to have $1000 per door capex reserves in his bank at close. I had budgeted for $500 per door and had to scramble for both of these changes.

Andrew Johnson · Answer

Adam Ulery This can be a lender-specific question. I know my lender on a 20+ unit deal wanted to see 9 months of gross rents. Others might want to see 9 months of the mortgage payment! Or a certain dollar amount per door. I wasn't doing a rehab, the building was occupied, so that might skew it different than buying an empty property that needed $____ over ____ months to make it habitable. We had the 9 months so it wasn't a big deal. Is it capital just sitting around in a money market accountant making diddly squat? Yup. But if the roof implodes 20 years early (won't happen, but just for fun) I won't be scrambling around for money.

Abel Sng · Answer

@Jonathan Twombly Yep! Escrow is pretty common... closing on a $12.6M FNMA loan and we had to escrow 1.25x of PNA and 1x of all other capex. Additionally, escrowing around $300 annually per door monthly for replacement reserves. However, it's shocking to me that the lender would require $1k per unit for RR and not inform the borrower unless there was an abnormal circumstance. Normally this is disclosed at signing of loan application.Haha! You're totally correct on the seal and stripe! Luckily it's typically a pretty minor expense.

Jeff Greenberg · Answer

My two posts were two different deals. The first was done with a privately held bank (only 32 branches). I go into greater detail on a Joe Fairless interview. #424 Yes, gun to my head and 52k hard. PP 2.3milThe second was a private fund. PP 1.3mil 85% occupiedNeither of the deals qualified for conventional financing.

Jeff Greenberg · Answer

The maneuver that I really liked(not), was when the bank told us that they were going to hold back at close, the amount they estimated for the cap ex repairs. We could only gets this money after we did the repairs. So if you think about this. We had to come up with extra money since the bank was not giving us all of the money promised in order to close. Then we had to come up with the money to do the repairs. Then we had to show the bank that we did the repairs and ask for our money. Don't let yourself be caught short. You don't want to lose a deal at the last minute because you were short a 100k or so at the end.

Jonathan Twombly · Answer

@Adam Ulery If you're raising money for this deal from partners (an aside: be sure to speak to an attorney about how to do this properly and legally), you need to make this part of your capital raise. Banks are unpredictable in terms of what they order you to escrow at close for repairs (which in many cases you then have to do out of pocket and THEN get your money back from the lender to cover it). So one way to try to get ahead of this issue is to bring your contractor in during due diligence and have him give you a worst-case scenario read on the property. Raise money based on this worst-case scenario. If he can give you a written report, all the better. If the bank comes back to you with demands for more initial capex, you can at least try to push back with the report that you have prepared. It's a low percentage play, but depending on the bank, you might be able to negotiate.In my experience, for some reason, banks always want you to seal and stripe the driveways and parking lot unless they have been done recently. If you have driveways and a lot at the property, it's not a bad idea to get an estimate for sealing and striping so you can prepare in your capital raise for this item.

Jeff Greenberg · Answer

Since all of the appraisals (this was a portfolio of small properties) came in very good, I asked about the change. The way this bank does loans is this. The loan officer makes his calculations and presents a term sheet. Some time prior to closing he makes a presentation to the senior loan committee. They can accept the terms, turn the deal down or modify them. In my case, they modified them, and in addition to the changes above, also changed the amortization from 25 years to 20. They almost killed the deal, but it was strong enough to keep going.

Jonathan Twombly · Answer

@Abel Sng. This is very common with larger lenders, though some banks are worse than others. We've done most of our deals with CMBS (thank goodness we now qualify for agency debt) - and every lender made us escrow funds at closing, though one bank was much more demanding than the others, and we don't work with them anymore. In any case, it's something that you need to be prepared for so that you don't fall short of funds at the closing. But, fortunately, the banks don't spring this on you right at closing. They will give you some lead time. As soon as they have received their engineering report, they let you know what you need to escrow for so-called "immediate" repairs. Have never understood what is so immediate about a seal & stripe, but who understands the minds of bankers? :-)

Abel Sng · Answer

@Jeff Greenberg sounds like your lender held you a gun point! Hope you never use them again! How big was the deal? Sounds like you went through a local lender and not agency debt?