COVID-19: Everything Changed but it Stayed the Same

This post was originally published on April 21st, 2020:

It’s been quite a while since my last blog post, but as you know the whole world has been dealing with a whirlwind of change and uncertainty due to the COVID-19 pandemic. I have been busy for the last 5-6 weeks pivoting my business, and adapting my personal life to the “new normal”.

On March 12th, 2020 my partner and I sat down in Conference Room T (Troegs Brewery in Hershey) for our bi-monthly “state of the business” meeting. The first item on the agenda was to discuss this weird virus that seemed like it might get serious. We discussed everything below (and more) and came to two conclusions: #1 - we weren’t going to let this thing stop us and #2 - we were going to come out of this stronger than ever.

PERSONAL/BUSINESS CASH FLOW AND CASH RESERVES

All real estate investors (and all business owners, for that matter) should begin and end their thoughts with cash flow and cash reserves. I have preached these concepts to anyone who will listen until I was blue in the face, and situations like this show why they are vitally important.

Pre-pandemic, I was making a consistent $2,000-$3,000 in rental cash flow per month. I also get paid an acquisition fee through my partnership which pays for marketing plus my time that I spend finding and buying deals. My wife has a very good, (WFH friendly) office job at a large corporation, and her salary pays all our living expenses with room to spare.

We have, to put it mildly, very healthy cash reserves. I performed a stress test (nerd alert) to project how long our cash buffer (including a few unused lines of credit) could last in three different scenarios. First, I categorized all our rental units into High Risk (strong probability they won’t be able to pay due to COVID-19 shutdown), Medium Risk, and Low Risk (they can work from home, or work in an essential industry such as health care). 20% of our units are High Risk, 33% are Medium Risk, and 47% are Low Risk.

Scenario 1 would assume only the High Risk tenants can’t pay rent, and can’t get evicted. Scenario 2 assumes both High and Medium Risk don’t pay. Scenario 3 assumes NO ONE pays rent.

For all scenarios, I’m assuming that I can’t get access to any other capital and can’t get mortgage forbearance from any lenders. Also, it would be naive to assume that I would only need to make mortgage (PITI) payments, so I’m assuming a normal amount of maintenance and even property management fees for all units.

In Scenario 1, we’d still make a little cash flow and be able to sustain indefinitely. In Scenario 2, we’d be able to sustain for 49 months (over 4 years!). In Scenario 3, if zero tenants paid, and zero mortgage companies would allow forbearance, we would survive a whopping 18 months.

Going forward, our strategy regarding cash management remains the same as it always has been. We use a mixture of our own cash and Other People’s Money (OPM) for offense, and use cash flow/cash reserves for defense. What does that mean exactly? I’ll give you a few examples:

• - Smoking hot deal comes up, but we need to close fast. Do we use cash reserves, just this once? NO. I’m using hard money or private money, and paying those lenders a handsome return.
• - Need to pay for a rehab? I’m using hard money or private money.
• - Market tanks, and I lose money on a flip, or get a low appraisal on a cash out refinance? If I need to bring money to the table to pay off a lender, I’ll come out of cash reserves.
• - Tenants don’t pay due to eviction moratorium? And/or they lost their job due to COVID-19 shutdown? This is what cash reserves are for.

This is how I sleep at night. Plenty of cash reserves to cover all but the most apocalyptic scenarios.

OUR MISSION STATEMENT AND STRATEGY - THE SAME AS IT ALWAYS WAS

Alright, we never had an official mission statement. But I think we always had an unspoken understanding of what it was. It’s very similar (probably identical) to thousands of other real estate investors’ strategy:

“Find and acquire residential properties in fantastic locations and add value.”

It’s so simple yet elegant! Sure, the execution gets a lot more messy and complicated, but everything I do can be boiled down do that one sentence.

OK, let’s break this simple sentence down into pieces, and determine how COVID-19 should affect each piece:

“Find and acquire residential properties in fantastic locations and add value.”

“residential properties in fantastic locations” - Gotta start with this one, because it’s the backbone. We aren’t buying commercial, retail, or industrial properties which can be more affected by an economic downturn. We’re buying places where people live, in highly desired locations. In fact, in nearly all the Central PA sub-markets we invest in, there is a shortage in the supply of housing and it hasn’t been able to keep up with demand for years. That supply vs. demand dynamic hasn’t changed from COVID-19.

Could COVID-19 cause a slowdown in housing appreciation? Of course. But Central PA home prices are already low and affordable, and the local market has proven to be less susceptible to volatility than higher priced markets. They might go down 10% or 20% in a worst case scenario, but that’s not the end of the world. More on market price uncertainty later.

“Find and acquire residential properties in fantastic locations and add value.”

“Find” the properties. Uh-oh, Realtors can’t list or show properties due to COVID-19. I guess I’ll just stay at home and watch “Tiger King” while eating Cheetos.

Just kidding.

If you really want it, you can find a way. This includes making offers sight unseen, doing video walk-throughs with the seller, or bypassing the MLS entirely by dealing directly with the seller (my preferred method).

Before the pandemic, my marketing goal for the year was to spend $3,000/month (on website, list subscriptions, ringless voicemails, text messaging, direct mail, etc.) to acquire one deal per month. When it became apparent that the pandemic was serious, I considered cutting back on that budget for about 5 seconds, but then decided against it. Why? Multiple reasons:

• - I figured I could handle the negative cash flow for a long time (see cash reserves above!)
• - Marketing is an investment and a pipeline - dollars invested now will result in deals in 2-6 months
• - I know* a lot of my competitors are running on much tighter margins, with less cash reserves (I keep going back to that!), and that they will be cutting back on their marketing. Now, motivated sellers will receive 2 or 3 letters per week instead of 20. This increases my response rate drastically.
  • *How do I know? I know the ridiculously high prices that they’re paying! At those prices, their profit margins must be razor thin.

In short, I’m 110% all-in on marketing and finding deals. In fact, I think this could be a great opportunity to weed out some of the competition that was overly ambitious in the prices they paid for properties. Plus, more sellers could become motivated due to the probable economic downturn that’s coming due to the shutdown.

“Find and acquire residential properties in fantastic locations and add value.”

“Acquire” the properties. Oh, no! This has got to be impossible during a shutdown! How will I get money? Title companies probably aren’t even working! Time to go play Call of Duty…

Kidding again, obviously. It’s times like these where it pays to have built a network and a team. I’ve have connections with dozens of commercial lenders, and the one we’re working with now continues to close loans for us within a week or two of the initial request. I’ve had multiple private/hard money lenders back off on lending since the COVID-19 shutdown, but I had several backups lined up who have stepped up to the plate. Sure, it’s gotten harder, but the bottom line is financing is not a problem.

There’s some title companies that are not performing closings. But I know several (the ones that I work with) that are still conducting closings as long as the buyer and seller come in at different times, and sign documents in different rooms. We’re still making it happen!

“Find and acquire residential properties in fantastic locations and add value.”

This is the magic, the glue, the not-so-secret sauce that makes it all work. Without adding value, we’re speculators. If you don’t always add value, then there will be certain market situations that you should NOT buy in. If you always add value, then you can always be a buyer. Let me explain.

The beauty of adding value to a piece of real estate is it allows you to acquire an asset at a lower cost basis. At the time of writing, the SPY ETF (tracks the S&P 500) is trading at around $270 per share. What if you could buy it, right now, at $200? Would you consider that to be risky, or safe? If you were presented with this option, how much would you buy at the lower price?

Buying an asset for less than what it’s worth reduces your risk. If you took the proposition above and SPY fell 20% to $216, you’re still up $16.

It’s because of this concept that I’m a full time real estate investor. I believe that finding and buying assets at a great price and adding value is worth my full time attention.

The stock example above is obviously oversimplified. In real estate, it takes some serious work to find great deals, then you need to estimate the rehab correctly, and execute the rehab within budget. If you screw something up, you might end up paying market value for a property when you add in the cost of rehab and holding costs. That’s happened to me once or twice. But the 8 or 9 value-add deals that went well more than made up for that.

The other complexity introduced by real estate is time. It takes time to add value. The longer it takes to complete the rehab, the higher the risk. Let’s say I buy a $50k property, plan to rehab for $50k, and plan for $20k in holding/closing costs. When I bought it, maybe I figured it’d be worth $150k when it’s all done. So, I’d be buying an asset for $120k that would be worth $150k. If I putz around and take 12 months to do the rehab, that gives the market a whole year to completely shift. Maybe it was a hot sellers’ market when I bought it, but who knows what could happen in 12 months? Did anybody expect a global pandemic 12 months ago???

So maybe the market would drop in that 12 months. Let’s say it drops 20% - now I’ve paid $120k for a $120k asset. I broke even - but I still didn’t lose money.

Now, if you’re focused and tackle the project like a professional, you’ll crank out a $50k rehab in 2 months. Real estate - 99.999% of the time - will not fluctuate very much in only 2 months. Maybe the market DID drop a little, and you sold the property for only $145k. Big deal - I’ll take that $25k any day. (by the way, we just sold a flip with very similar numbers to this example)

Back to my point about how you can always be a buyer if you add value. If you’re paying market prices, and you think the market is about to tank, you probably shouldn’t buy right now. As soon as the market goes down, you’re in the red. If you buy a great deal and add value, your investment is protected in all but the worst scenarios.

My plan with COVID-19 is just to keep buying and adjust my offers accordingly. If the market DOES go down, I’ll just adjust my offer prices down. Maybe the offer becomes $40k instead of $50k, since my re-sell value is $140k instead of $150k. And if the market drops while I’m holding/rehabbing the asset? Well, we’ve built in such a large profit buffer (i.e. protection against risk) that it would take an immediate and catastrophic market plunge of 20% or more for us to break even or lose money.

I should note that the thought process is the same for rental properties, but the exit strategy is just different. Instead of selling, the planned exit strategy is a cash out refinance. The danger of a market drop with a rental is that if you get a low appraisal, you might not be able to get all of your investment back - just most of it. In this case, this is why we always invest some of our own cash into each deal, plus maintain healthy cash reserves just in case we need to come out of pocket to pay back short term debt.

SUMMARY

The bottom line is while I’ve had to shift many of my investing tactics, the overall strategy remains the same. Find and acquire residential properties in fantastic locations and add value! It’s a recession-resistant philosophy.

I believe it’s times like this, when things get uncertain and scary, that the best businesses and business owners come out of the storm better and stronger. It takes some guts, confidence, persistence and a little bit of ingenuity to make things happen when everybody else thinks it can’t be done.

“Out of adversity comes opportunity” Ben Franklin

“Buy when there’s blood in the streets, even if the blood is your own” - Baron Rothschild

“Be fearful when others are greedy, and greedy when others are fearful” - Warren Buffett