Are you liquid?

Like all parties my friends, this one will also come to an end. The clock is ticking, but I am not sure if it is 11:30 pm or 2:30 am. It is hard to tell if there is still a lot more fun to be had. I know that I am yawning a bit and thinking about hitting the proverbial hay. I will say that this party has been a blast so far! It started off with super cheap properties and a fair number of bad tenants. Food and drink were plentiful. We were breaking it down on the dance floor with the old school jams and wondering if there was a limit to the number of great deals that were available.

So much to chose from earlier on...buy and hold, flips, commercial, multi family!

Plenty of deals, plenty of beer!

Then we had a period of time where the properties were still fairly inexpensive and the tenants seemed to be getting better. Now don't get me wrong, there is still some food on the table. I am just saying that the pickings are more slim. You know what I am talking about. The cookie tray only has some dried out oatmeal raisin varieties. Perhaps a couple of mini tuna salad sandwiches left, but the roast beef is long gone. The giant chip bowl only has a half inch of crumbles left. You have to reach down deep into the cooler to find a beer. Hopefully it will be a flavor you like. Beware of drinking that chocolate double stout that you have never heard of with an ABV of 8.9%. You can try to justify it to yourself that it it will do the trick to keep the fun going, but it might be a sign that you may be staying too late at this party. It may be wise to start asking ourselves some questions. Did we just overpaying for a rental property? Because we overpaid, will we feel pressure of accepting a high risk tenant that will pay more because we feel like we need to juice the yield. Perhaps it is after midnight for this party. Rarely anything good ever happens after midnight.

Is the last of the chex mix symbolic? Sort of like purchasing an overpriced condo that barely cash flows?  All that dancing has made me hungry!

Just because you just finished a beer does not mean you need another.  Just because you finished a flip does not mean that you need to force into another flip if the margin is not there.

Not to be full of doom and gloom, but we are seven years into the current recovery and not everything seems hunky dory. Will we go 10 years between recessions? It could happen. It is fact that the US did go 10 years without a recession from 1991 to 2001, but those sure seemed like better times than we are experience now.

I am actually looking forward to the end of this party as it will be a signal that another party will be just around the corner within 6 to 18 months. However, when this party is over we need to be prepared to weather the storm and be in good position for the next shopping spree. Thus, the topic of liquidity.

I was recently captivated by an article that came out in the Atlantic Magazine that discussed how nearly half of all Americans are living with literally no savings. It references a 2013 Federal Reserve survey that asked how the participant would deal with a emergency situation that costs $400. A shocking 47 percent of respondents said that they would have to either borrow the money from friends or family or would have to sell something. I was certainly shocked by the findings. However, I also have some lower income tenants and can assure you that they would have provided the same response to the question based on their rent payment performance. Beyond being well written, I liked the article because it was a honest portrayal of a guy that by most accounts would be considered very successful. His story was a good reminder for me of the importance of maintain liquid assets in everyday life. Although we are living in a time of great prosperity, we can all agree it is not reaching all sectors of the population. We are living in a time of incredible debt levels between credit cards, student loans, autos, and home mortgages. If individuals are in debt, it is not surprising that they are not able to maintain much cash.

What can happen if we run out of liquidity:

This is just a short list of the challenges that may be faced:

• Every late payment situation with a tenant gets a little more stressful
• You could fall behind on loan payments, thus damaging your credit
• The bank may not renew your term loan, thus forcing you to sell during a down market
• The bank could freeze your line of credit
• You may be forced to fire sale a property to generate cash
• You will start delaying maintenance and CAPEX, which will make your property less attractive to better tenants. This will also erode credibility with your existing tenants.

Personal Liquidity

How much liquidity should you have? This a very personal question to say the least as it is a direct reflection of a person's risk tolerance and beliefs. I still consider myself to of the belt and suspenders variety.

Three months of living expense is a good rule of thumb, but two or more years might be the right call for a more conservative person. This is certainly a consideration when it comes to obtaining bank debt. When applying for a loan, part of the underwriting process will include an analysis of your personal liquidity. Although counterintuitive, banks want to lend money to people that do not need it. Banks love to lend to borrowers that are highly liquid because it directly correlates to a lower risk profile. When lending to low risk borrowers, the bank is not required to maintain as much reserve capital for the loan per FDIC guidelines. Without having to reserve much capital, the bank is then able to provide lower interest rates to higher credit quality borrowers.

Portfolio Liquidity

View your personal liquidity separate from your business / real estate investment liquidity if at all possible. Real estate investors that survived the last recession will state that you can never have enough liquidity. How much should you maintain per property? $1,000 per door in cash is the current measure I use. I figure that my aggregate reserve has to be large enough to cover a large event like the need for a new roof or HVAC system for one of my properties. Beyond that, I like to maintain an additional $2,000 per door in a relatively liquid vehicle like a index fund. Beyond that, having access to additional cash via a line of credit can be helpful to add another layer of security. A third layer of protection is to remain disciplined as far as continually maintaining and improving your properties. A new roof should not be a surprise event if you are diligent with the upkeep of your real estate.

Partner Liquidity

liquidity challenges are the most awkward when partnerships are involved. Consider the following:

• How exposed are you to the liquidity concerns of your partners? Certainly not an easy thing to talk about when things start going south. I advocate for good transparency between partners so that surprises do not pop up.  It is never easy showing your cards to other people, just it is better to do it on your terms vs. having to do it with your banker breathing down your neck.
• Perhaps two partners are providing full personal guarantees on a commercial loan, but one of the partners is much less liquid. Who is the bank going to call first?
• Why does your flip partner need your financing help with the project? Most likely it is because they have extended their capital into other projects. Even worst, they may not have any real assets that could be used for support in a crisis.
• When liquidity starts to become a problem with real estate investors, the game quickly becomes one of defining priorities. Which properties should be protected and which can we let fail? Which joint ventures are the most lucrative and which partners might we stiff?

Tenant Liquidity

It is important to consider your tenant diversification as far as liquidity. If you only cater to the low income population, you may need to maintain more liquidity for the leaner times. Having your rental income heavily concentrated with only a few large commercial tenants could be another reason to maintain more liquidity.

Conclusion

Party on my friends, but please heed caution.  I want to see you get home safe and live to see the next fiesta.