The Importance of Reserves

[Michael Manchester]

A good number of investors I work with, and even more who I interview, are looking to secure deals with as little money out of pocket as possible. In theory, that means they have more capital available to take down more deals and get rehab rolling. Some deals are truly strong enough that smaller, regional private lenders will actually go to 100% without the use of gap or transactional lenders. Those are rare - and more suited to flippers. Let me explain.

If you are going to turn a property in 6-12 months, then max leverage makes more sense to increase your cash on cash return. Yes, you are paying origination and interest on a larger loan amount, but with a good enough flip it shouldn't matter too much. Where the max leverage tends to trip people up is when they rehab and hold. 

Too many operators are dependent on every unit being on time with rent in order to service their debt. Too many people spend years building up a portfolio, following the rush of adding doors and finding the next deal, just to lose so much when all of a sudden they cannot service the debt. If you are dependent on every single unit being rented almost 100 percent of the time to be able to pay the notes on time, you are in a tough spot. You could have seven figures deposited into your checking every month - and still be broke in practice.

In my opinion, if you are really playing the long game you need to have true reserves set aside for each property - and when those reserves are depleted for any reason you need to STOP adding properties until you can build that safety net back. Just like having an emergency fund for your personal bills, it is crucial to have an emergency fund for every door you own. Build 3-6 months reserves into every deal you underwrite. Make sure you have that liquidity before you close, and put it in an interest bearing account and forget about it until you absolutely need it. 

I have investors come to me all the time in need of bail outs or restructuring and they have virtually no cash on hand. Good investors who are multi-millionaires on paper, but have to live week to week because they didn't plan for the unexpected. They chased it, and when you chase it, you always get bit. 

Please, as you plan the rest of your year, factor reserves into your plan and actually execute. I know this seems like very basic and simple advice but I see it overlooked if not outright disregarded all the time. Make sure you do everything you can to protect your investment. Just like insurance can protect you from damage, a simple debt reserve can insure against the unexpected. 

[Daniel Adu-Boateng]

I agree with this, but even on a flip. Things can go wrong and you still need reserves. When I first started out, all sorts of borrowers were getting 100% financing on flips but even those lenders have cut back. Now a days, 100% financing is for more experienced investors. Whether it’s a flip or buy and hold. @Michael Manchester