Every real estate business should have a library of procedures. It’s exciting, I know, but it’s one of the most important parts of your risk mitigation procedure. You might be fine dealing with 2 or 5 or even 20 properties on your own. But when you hit 50, you’re going to need serious help, and you need to make sure you’re always hitting all the essentials.
Real estate is a game of risk and you owe it to your investors and yourself to make sure you’re managing the risk as best you can. One way I’ve talked about before is reducing your mortgage payments when interest rates drop and banking the difference. Thomas Beyer and I are in agreement that one should plan for 6% as a reasonable long-term interest rate. Thus, I’m an advocate of trying to bank the difference between your current rate and what your mortgage should be at 6%. You should do this to build up a reserve of 6 months rent (not just expenses) in a reasonable high rate savings account.
However, the important part is when and how you can tap into that money. There’s two times you’ll likely need access to those reserves: acute expense and chronic shortfalls.
You’re Puking Money Everywhere!
Expensive repairs and crazy tenants are just a part of the job. It happens to us all eventually. You have a couple months where things just don’t seem to stop. A couple big utility bills, a new fridge and a couple big emergency plumbing and now you’ve spent two month’s rent (never mind the cashflow). Now that you’ve gone on a shopping spree, and you’ve tapped into the reserves, it’s time to get back to reality.
I have a standing clause in my JV agreements essentially saying that any time we dip into reserves half the positive cash flow goes to replenish the reserve fund until it’s full again. We have also set a threshold where if we get down to (for example) 30% of the reserve fund it triggers a cash-call from the partners to top things up.
A Nosebleed of Cash
The other possibility can be a slow drain on your reserves. Sometimes rents drop or regular expenses (like mortgage payments or utility bills) increase, leaving you cashflow negative despite your best efforts.
Now you’ve got two options: long term treatment or radical surgery. In both cases you need to make sure you’ve accurately diagnosed the problem and that you’re not missing something simple to correct it.
Cut Off Your Nose
You can cut and run; sell the property, eat the loss and move on. But if you’re going to do this you’d better be damn sure you have hemophilia as well as a nosebleed. You risk tax implications, mortgage fees, negative equity and pissing off your JV partners. However, a smart investors knows where he is well enough to be able to tell when it’s better to cut and run, or to put a BandAid on.
Just Put Some Ice On It
The long term treatment is much better in my opinion. Get a solid idea of everyones personal goals, as well as the goals for the property. Do a solid analysis of the current financial status of the property and have a good idea of where the market’s going. Use solid, reliable, Canadian information like the Real Estate Investment Network and not two pounds of horse manure in a one pound bag.
Know how much money you’re bleeding and know how long your reserve fund will last. Do some projections of the market to know when you’re likely to be back above water. Make sure everyone understands what’s happening, when there will be a cash call and at what point you might consider radical surgery.
Be smarter about your reserves. Make sure there’s enough money there, but also make sure that you know when, where and how you can use it. You’ll sleep better at night.