A Good Defense Is Your Best Offense: 3 Ways to Protect Your Portfolio during Turbulent Times

Note: We originally published this episode on November 11, 2020.

We often hear a lot about real estate success stories, but I don’t often hear much about being on the defensive to ensure that your hard work of acquiring a substantial real estate portfolio does not get lost during turbulent financial times.

I felt as though it is important to highlight the ways to strengthen the protection of your real estate holdings to ensure your properties are preserved for generations to come. This episode aims to provide some insight into some of the safeguarding techniques I implement against my portfolio.

Background

When starting off investing, landlords typically have worries at what I would consider the micro level (What if I get 2am calls for clogged toilets? What if a tenant destroys the property?). Worries tend to evolve to a macro level as your portfolio grows, and those prior worries are just realized as part of the business (What if there is a market crash? What if there is a surplus of rental units on the market?).

Now that we have created a sizable portfolio, these are my top worries.  As such, I have developed a three-tiered approach to diminish my uneasiness that I will discuss:

1. Vacancy: What would happen if I had to rent at a lower rate to get someone in my property?
2. Expenses: What would happen if I experience a lot of capex and repairs during a time of trouble?
3. Equity: Lastly, what would happen if I had to liquidate my real estate holdings?

We’ve been in a period of growth for the past decade, and it is easy to get caught up in the idea that real estate is infallible.

This presentation will address how I am able to counteract these worries so that I do not lose sleep over this (I can lose sleep on other things instead!)

Vacancy

• Vacancy is a profit killer!!!  Every month your property is vacant, you have to absorb all the costs (mortgage, taxes, insurance, repairs, etc.)
  • How low can my rent go?
    • Can I sustain a 10% drop in rents to be most competitive? What about 20%? How low can I go? In a time of crisis, I want to have the best property for the best price, so that my property is the one that the (presumably) smaller qualified renter pool will desire.
    • These are all considerations when I purchase a property, as well as if I cash-out refinance a mortgage.
      • During a cash out refinance, with all else being equal the interest cost will likely go up, as more is being financed.
• I consider this the first line of defense.  If I have a qualified tenant paying all or most of my expenses, I won’t have cash flow, but at least I will not have to reach into my pocket to pay property costs.

Expenses

• In times where rents are low and vacancy is high, Murphy’s Law would predict that is when several furnaces and water heaters will need replacing!
• We have a savings account that we maintain 6 months-worth of expenses per property.  At no point, does this ever dip below our designated number.  If it does, we refill using personal cash.  This is for emergency use only!
• You may have heard us discuss in previous podcasts, that our expenses tend to come out to 33% of revenues (taxes, insurances, repairs and maintenance).
  • Each month, we put aside 1/3 of our residual cash from rent collected minus mortgages (we don’t have escrow) into a reserve account to pay for operating expenses (expected expenses, and a little extra for CapEx).
  • In theory, at the end of the year, we should ‘end’ at our original 6 months’ expenses for emergencies.
• This is our second line of defense. The way to shield against expenses with less (or no) income coming in, is cash reserves.
• Clarification point:  This is only for our real estate portfolio.  My family also keeps 6 months of cash reserves for personal expenses as an emergency fund also.  These two emergency fund accounts (rental and personal) are in addition to our regular savings account.

Equity

• As some of you know, I have utilized the BRRRR method to grow my portfolio at a quick pace, and in a couple cases, I have recently cash-out refinanced several properties we previously did a cash-out refinance on as part of the BRRRR to extract additional cash to reinvest into additional assets.
• However, we have a rule that not asset-specific, rather portfolio-wide, we want our loan to value ratio to be at 65%.  This would warrant a 35% drop in value across the portfolio to become ‘under water’.
  • Do not squeeze every bit of equity out into cash! For example, some of our properties are at 50% LTV, so the average of the portfolio is at 65%.
• As we can see from the prior chart, historically, during the worst recession to date (which was caused by a housing mortgage crisis), assets dropped 3.8% in value in Colorado Springs, and 19.7% nationally.  In all other recessions, Colorado Springs values rose.
• Of course, past performance doesn’t predict future results.  This is my final line of defense.  This means if I am encumbered by vacancy to not be able to pay the bills and all my reserves are depleted, the economy would have to be in an even worse position than it was during the 2007 crash for me to walk away with nothing.
  • Assumed 20% drop in value (based on national average during ‘07) plus 10% selling costs, I would still have a 5% equity amount in cash from closing.

Final Thoughts on Reserves and Contingency Planning

• So what if you have NOMAD/House Hack properties with just 5% down? You may want to pump up your cash reserves to balance it out.
• What if you have 2 years of cash reserves and extra equity?  That may be too much, it’s important to understand your personal and market conditions, but this may be a little too conservative.
• Even in times of offense (building your portfolio), it is important to always ensure your defense (reserves, etc.) is strong.  Don’t overleverage your real estate both in terms of debt or operations!
• It is easy to get caught up in the excitement of your rental properties in good times, but you always need to make sure you are prepared to weather any bad times so that you don’t lose everything you worked hard for.

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A Good Defense Is Your Best Offense: 3 Ways to Protect Your Portfolio during Turbulent Times