Investing in real estate without significant cash reserves is, shall we say, not recommended. An investor without reserves might as well send an engraved invitation to Murphy to come over and party. You’d think real estate investors would include this ingredient in their plans. The paradox I’ve observed so many times is that investors love that I insist upon it, but they’ve never incorporated it in their own planning.
The importance of a generous cash reserve cannot be overstated. I simply will not work with an investor who won’t set aside adequate reserves. It’s only happens rarely, but if they’re not willing to do so, I won’t take them on as clients. Period.
I’m talking about real reserves. CASH reserves. Enough to allow child-like sleep nightly. The rare exception to this rule in fact isn’t an exception. If your day job income is so abundant that your after tax savings are mind boggling, reserves might not matter in your case. I currently have a client who is a good example. He earns $3-400,000 after tax yearly. Since his investments up until now number only two properties, the worst case scenario would be to have both of them vacant for say three months. This would result in a negative cash flow equiailent of about 8-10 days of take home pay. In other words, he an handle this in stride.
The rule of thumb — have enough cash in your Sominex account to sleep like a kitten no matter what happens.
However, he’s about to pull the trigger on a tax deferred exchange, using both properties. This will result in the acquisition of roughly 6-8 properties. Though the numbers will show each property will break even or better, he’ll hear from me that relying on a break even analysis is folly. Murphy is alive and knows where he lives. Have you ever heard O’Toole’s corolarry to Murphy’s Law? He said, “Murphy was an optimist.”
Before we even begin the exchange process he and I will discuss in depth what could go wrong during his holding period. Having 6-8 properties now begins to have a real affect on your sleep patterns even if you’re making the money he is. Using the worst case scenario again, Murphy could cost him nearly a month’s take home pay. I will insist he set aside a cash reserve account of no less than $35-50,000 BEFORE we even begin selling his properties. This account will be used for the expressed purpose of securing those investments when Murphy decides it’s his turn in the barrel. And make no mistake — at some point in your investment life, it will be your turn.
My time in the business has allowed me to weather the ’74-75 recession, the terrible runaway inflation which immediately followed, which resulted in interest rates sounding more like shoe sizes for NBA players. That was followed by the late ’79 through ’83 so-called recovery. I still remember being grateful that a client who was in love with a seven unit building was able to secure an 11.75% loan! Nirvana was just around the corner. 
Then after the late ’80′s run-up came the double-barreled shotgun-ambush of the early ’90′s. Not only did San Diego get hit by the S & L crisis, but simultaneously lost a couple of the largest employers in the entire region.
In over 30 years I’ve only had two clients have serious problems with their investments. Both dipped into their reserves for non-emergency items. (One was for the new kitchen the wife ‘had to have’.) In both instances I was kept out of the loop until it was too late. They knew what my response would be.
A generous reserve account is not merely an option. In no way is it a luxury. How long can you go without sleep?
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Jeff:
A salient point the Kiyosaki disciples of today sometimes forget.
How much do you know about using qualified retirement plan money (IRA, etc) for REI?
I know little. My experience is in trust deeds with IRA money so I’m curious about what options there are.
I know what to do, and where to do it, but I always advise my ciients to bail from there plans. We take their money to better vehicles that not only produce much higher returns, but are literally tax free – for life.
And – drum roll – it’s not real estate.
Let’s get together for lunch. It’s silly living in the same city and not met yet.
That is some good advice, Jeff.
But even someone pulling down $3-400K after tax per year probably doesn’t sleep THAT good!
(I’m pretty sure his employer doesn’t just give him the money for showing up)
The sad part is that many investors have done well in spite of not following this advice… though none have weathered the big storms. Others watch and think “I can do that, too!” – and now we are seeing the bubble breaking in many markets. Breaking because speculators didn’t have the reserves you are preaching about.
Good post.
He sometimes loses sleep for a different reason. He has two great boys, both smart as whips, and both no doubt qualified to attend Ivy League schools.
You are so right about the speculators who haven’t had to face down any consequences arising from their inexperience. I have clients in Phoenix, and some have had Murphy follow them around a bit. Their reserves have made the difference. Now they’re preparing to trade to a different market.
Thanks for the kind word.
Murphy has been on my tail for a few years. Anyone having a poison pill that works for a BIG Murphy, I’m all ears!
I so agree with you Jeff.
I can attest to life without a sominex account and it is NOT fun. So heed the words of the master, guys.
Here’s one more mistake NOT to make. Be sure to do your re-fi’s BEFORE you go into acquisition even if the lender promises a “package”. Get yourself in the power position first, then buy. Borrow money when you don’t need it. Funny, my father used to say that! And plan for 70% LTV even if the lender tells you 80%. Like when you remodel your house, you count on 20% more than the contractor says. It’s the same with new acquisition. Plan on more than you think could possibly ever happen.
For instance, I forgot that even new houses can have long vacancies and that outfitting the houses with shutters cost nearly 2k each….there goes half the sominex accounts. New homes…who would have thought there wouldn’t be instant cash flow?
Expect changes to happen and if you get overextended, be sure your Karma is good with old invesor friends and relatives. Sometimes they can be Godsends with a bridge loan. Another emergency stategy is the IRA rollover for 60 days…will get you thru until the rent starts kicking in.
Don’t mean to scare you guys, but might as well let you know what happens when you don’t have the sominex account.
I rest my case.