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Let’s Talk About Murphy — And His Critic, O’Toole

by Jeff Brown on February 18, 2013 · 6 comments

  
Murphy

Murphy’s Law — If anything can go wrong, it will.

BawldGuy Axiom: Murphy’s alive and knows where we live.

If you don’t plan ahead via very generous cash reserves — I call it a Sominex Account (Ambien for the whippersnappers.) — you’re beggin’ for problems down the road. If you’re not afraid of Murphy, flyin’ high ‘n fast, without a net, you just haven’t met the guy yet. Not to worry though, you will, as everybody gets their turn in Murphy’s barrel. Everybody. Ask any experienced investor about their ‘Murphy’ stories. Ask a bunch of ‘em, as their stories will eventually have you believing Murphy’s a real person. Listen to those stories as if they’re worth a million bucks — cuz in years to come they might be.

Besides appliances dying without permission, tenants’ kids breakin’ sprinkler lines, heating and A/C goin’ south, there are the really big ‘n nasty surprises. Like when interest rates go up enough that lenders begin searching in earnest for all those investors who took over their loans using the ‘subject to’ strategy. As sure as day follows night, they’ll do it — just like they did 30 years ago when rates rose then. ‘Course this time around they’ll be far better armed than last time out. Those with cash reserves will at least have a shot at comin’ out the other end of that bummer of a pipeline.

There are all kinds of reasons real estate investors want their cash reserves to be generous. Things happen in life that can spill over into the investment portfolio. It happens. It’s life — and it’s oh so predictable. I wish there was a formula, but there’s not, regardless of what you may’ve been told. The guy makin’ half a million a year, while livin’ on $80,000 doesn’t need as much as the young married couple with a couple rentals, who is just a vacancy or two away from a crisis.

But Everyone Needs Cash Reserves.

It’s my experience that far too many investors are somewhat to WAY low on the cash reserves. I’ve seen portfolios seriously savaged by one major cash hit that ended up knockin’ down domino after domino in a way that couldn’t have possibly been scripted in advance. Things happen when Murphy gets bored and you show up in his sights. Let me offer a perfect, real life example.

In SoCal, real estate values skyrocketed in both the mid-late 70s and 80s. From 1975ish ’til around 1990 or so, the median price for a home in San Diego went from about $25-30,000 to around $130-150,000. For most of that time, the vast majority, vacancy rates ran from virtually non-existent to 3%. It was a joke. There were years when, literally, I’d put a sign in the yard of a property with a vacancy on a Friday, show up Saturday morning with a dozen donuts, take a buncha applications, and leave. The unit typically remained vacant as long as it took the cleanup crew to get in ‘n out. Meanwhile, rents were goin’ up nearly as quickly as values were. It was a heady time, when vacancies raced to new lows, while rents and prices sought levels where the air was thin.

Then it happened — the S&L Crisis

Investors who think our most recent down cycle is the worst since — fill in the blank — didn’t live through the early-mid 80s and early-mid 90s downturns. They were different kinda economic hells, but brutal just the same. The former brought double digit inflation, 20% prime rate, 16.5% FHA interest, and investor rates just under prime. The latter though, brought with it one of Murphy’s special recipes. When the S&L crisis hit, San Diego, in my view, was the worst hit market in the country. Values fell by double digits, while rents fell even more steeply. Meanwhile, the vacancy rate went from a virtual nada to 15% — higher in many neighborhoods. Now, due to our 70s and 80s experience, the loss in values, however significant was viewed as a temporary irritation. Precipitously falling rents in a market where vacancies were off the charts, was generating real fear. But that wasn’t enough for Murphy, not by a long shot.

Two of the five biggest employers in the greater San Diego area locked their doors and left all their employees without jobs. It was like pouring gas on a raging fire. Vacancies got even worse at the speed of sound. This then caused rents to fall more precipitously. It was the perfect negative storm. Those with generous cash reserves muddled through, many much worse for the wear, but with portfolios intact. Nightmare doesn’t describe it. The only reason I didn’t lose anything was due to learning this lesson the hard way during the ’81 recession. Lost a property cuz I didn’t have nearly enough of a Sominex Account. Talk about sleepless nights. To this day my cash reserves remain beyond generous.

Let’s remember something about chart lines. They go both ways, up AND down.  For real estate investors of late, heck, the last few years, the perfect storm has been all wine and roses. Low prices, great locations and rent/price ratios, historically low interest, and plenty of inventory. However, sooner or later, your guess is as good as mine, the lines are gonna change direction. Things don’t stay good or bad forever, and this recent great run won’t be the exception. Whether it’s later this year, or three years from now, it’s gonna revert to whatever we’ll end up callin’ normal. Bank on it — pun intended. :) Also, those firmly ensconced in solid investment properties in high quality locations at current historically low — fixed — interest rates will be well positioned for normalcy, whenever it returns. Those with adequate skin in the game, cash flow, and generous cash reserves will simply go on living their lives, relaxed in the knowledge their portfolio is well positioned and sufficiently backed.

Whenever this run is over, those who’ve ensured their cash reserves have hit new heights will be happy they did. When the flips become routinely successful, and the long term properties are all cash flowing like ATMs, it’s ever so easy to ignore the buildup of your backstop — cash reserves. Don’t be that investor. Error on the side of too much. If you haven’t experienced it, fallin’ short of reserves when you need ‘em RIGHT NOW, isn’t an experience ya wanna live through. I know. Been there, done that.

Oh, almost forgot about O’Toole

O’Toole’s corollary to Murphy’s Law said, “Murphy was an optimist.”

Now that’s a truly scary thought.
Photo: shelby-dog

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{ 6 comments… read them below or add one }

Dennis February 18, 2013 at 6:53 am

Great advice, I was one of those that had to learn this lesson the hard way, one nice thing about learning the hard way is that the lesson (if you survive it or not) really sinks in.

My issue was feeling confident the cash flow was just going to keep rolling in like clockwork. I decided taking profits about 95% of my reserve would work just fine. Then there was a completely out of character shift in the neighborhood. A new landlord used the steam on the mirror test for tenancy. In 3 months I had a 50% vacancy rate, and then 75%. Thankfully that new landlord never got paid any rent, and the local police and L&I helped drive him out of the landlording business. Did I mention this all happened in January in a cold winter?

If I didn’t have a day job and some free and clear buildings I would be selling apples on the corner at least as a landlord.

This lesson taught me nothing is certain, everything we do has risk which must be managed.

Reply

Jeff Brown February 18, 2013 at 10:00 am

Back before we learned this lesson, Dennis, we were all geniuses, weren’t we? :) Man, did THAT balloon ever get unceremoniously popped.

Reply

Erion Shehaj February 18, 2013 at 9:43 am

Those who don’t learn from history are destined to repeat it. But an even scarier thought – the ones that don’t know history to begin with. That’s where experience comes into play for those that have been through it and listening comes into play for those that haven’t.

Excellent post!

Reply

Jeff Brown February 18, 2013 at 10:01 am

A serious point, Erion. As you’ve heard me say a myriad times, “It’s the answers to the question you never knew to ask that end up bitin’ ya.”

Reply

Brandon Turner February 18, 2013 at 10:18 am

Jeff – you always know how to make me feel guilty! (In a good way!) I know I’m one of those that have been guilty of acting like this perfect storm of low vacancy, high rent will never end! Besides having lots of cash reserves – do you have any other suggestions ?

Reply

Jeff Brown February 18, 2013 at 10:34 am

Hey Brandon — I learned the hard way (my favorite mode of education early on) that getting ‘insurance’ for the seemingly endless questions I didn’t even know to ask was invaluable. The moment I realized the value provided by the answers to those questions was when I attached myself to the mentors willing to put up with me. I began payin’ rapt attention to them in late ’79, and can trace my learning curve and resultant success to that one decision.

Most of us give lip service to the phrase ‘knowledge is power’, but few behave as if it’s true.

Reply

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