Personal reserves vs. rental reserves

There are a handful of blog sites out there that feature what I call non-traditional advice. What is non-traditional advice? To describe, let’s look at what comprises traditional advice.

  • You should be paying out less than you earn on each paycheck.
  • Build up some small emergency fund. Later on, build up 3-9 months of income in savings.
  • Any extra cash you receive must first target any and all debt. Often home mortgages are put last in line, but still eventually targeted.
  • After paying off non-mortgage debt, max out your 401K, 529 plans, IRAs, and any other tax deferred vehicle.
  • Investments should target mutual funds to avoid taking on too much risk.
  • Never buy individual stocks.
  • Only buy real estate if it’s cash only, and still profitable and you are willing to learn how to be a landlord or hire a property manager.
There may be variances, but that is what most people on TV and radio talk about when they give financial advice. Well, there is a whole body of web sites that focus on wealth building using different principles than what’s listed above. People that stumble onto them are shocked when any of the above points are called into question. Heck, I saw one site where the blogger posted his net worth worksheets for several years, and one of the comments hastily stated was that the author’s posted debt was flat out “stupid.”
Pay note, the man had a net worth of over $1 million, was cash flow positive on the order of $15,000/month through a combination of business income, rental income, and other means. If needed, he could sell everything and pay off his debt, and be debt free, but then he would be asset free and cash flow free as well. But none of that seemed to matter to the debt-is-evil commenter.
Cash vs. stocks to store reserves

One thing I have noticed that several sites are talking about is that cash reserves are dead money. The principle point is that cash reserves are either in checking accounts that yield no interest, or savings accounts that yield little interest. Either way, the money is expected to suffer bad losses over the long term due to inflation and taxes.

While the point is sound, in my opinion, we need access to some amount of liquidity. My rental properties are currently 75% occupied. If that dropped down to 25% through the loss of two tenants, my cash reserves in place would cover the cost of the rental mortgages until new tenants are found. My property manager could call me tomorrow and tell me there are major damages caused by a tenant who was just evicted. The unit needs to be repaired before it can be shown to new potential tenants. These are items of risk I must be ready to handle on short notice, and I was already geared up to handle before I bought them.

It’s possible I could stash that money in other places, like dividend kings that have a solid history of growth. This would probably have a longer term benefit to my cash reserves, but it introduces short term risk. Let’s assume that instead of keeping my reserves in cash, I instead invest it in one of my current stocks like Vanguard Natural Resources (VNR). VNR is currently yielding 9+%, so it would definitely outpace the interest of my savings account. When that emergency call comes and I find out that my units are currently vacant, it appears I need to withdraw $1500 to pay the monthly mortgage. It’s possible that VNR could be in a down cycle, causing me to lose money since the time I invested the money there. I may have gained some money in distributions paid out on a monthly basis, but it could be entirely offset if VNR is in a downcycle. This would be the time when I should be BUYING, but instead circumstances require I SELL. That is the short term risk I would be taking on if I stored my money there.
This makes the cash used to back my real estate investment no longer a reserve, but instead an investment of its own. This introduces systemic risk, which I don’t need at this point. Mortgage debt is fixed, except for taxes and insurance, which is just a piece of the monthly payment. This means that my reserve cash doesn’t have to compensate for inflation. Repairs can rise with inflation, so my reserves should probably rise as well in the future, but not as fast a real investments. Just enough to reasonably cover my rental units.

Or a HELOC to bail you out

One of the articles I spotted addressed this issue squarely and had a solution: open a HELOC (home equity line of credit) on one of your properties, possibly your primary residence. That way, when there is no panic, you don’t draw the money. But if something goes haywire, you can easily pull money to deal with the situation. As soon as the situation permits, perhaps through recovering rental income or distributions paid on the VNR stock I mentioned earlier, you could repay the outstanding balance of the HELOC and get back on track.

This is a strategy that could work, if you have the fiscal and psychological makeup to handle it. It would require that you not be tempted to use the HELOC for other things, like buying toys. It also means you might pay some amount of interest charges, but the advocates of such a plan would say that is washed out by the opportunity costs in not investing your money in a real wealth preserving vehicle.

To be fair, the articles visit the concept of risk. Essentially, they point out the likelihood of using your reserves, and showing that in the long term, investing the money has a bigger payoff. But in my opinion, you can’t serve both long term and short term needs at the same time. My portfolio needs a certain amount dedicated to the short term, and that is what my reserves are for. The sacrifice is their lack of long term growth.

Or an EIUL to borrow against

One avenue I have evaluated and may yet pursue, is to buy a small EIUL using my cash reserves. In the span of five years, I could fully fund a cash value life insurance policy, and whenever I need the cash, I can borrow against the surrender value of the policy. When things are restored to balance, I can then start to pay back the EIUL and eventually put everything back on track. Since the borrowing costs of an EIUL are around 0.1% (yes 1/10%), it sounds like a good plan. That’s even better than the current 4% rates on HELOCs.

If you are not aware, $10,000 at 4% incurs a monthly interest charge of $33. At 0.1%, that interest charge be just $0.83. Like the difference? To be fair, even the $33 isn’t much.

Of course, in the first five years, my total amount of accessible money would be less than what I started due to the front loaded expenses, but the estimate I have already previewed shows that by the end of the sixth year, I would have caught up and passed my initial cash outlay. In 15 years, my cash value will have doubled, providing an internal rate of return of around 5.6%. Assuming I make it to retirement age, and have been able to effectively pay back any loans, the fund should yield around 7%. Not bad for an emergency reserve of liquid cash, ehh?

Cash reserves protect you from financial and emotional disasters

After reading a story about how a couple got stuck between a rock and a hard place, and ended up taking out two loans against their 410K, I knew where the story would end without reading. They would hate debt with a passion and vow to never take on another nickel of debt.

This is a common story I see in many places. The real problem this couple suffered was two-fold:

  • buying more than they could afford
  • not having adequate cash reserves to handle life’s bumps in the road
People like Dave Ramsey and Suzie Orman are always banging the drum on setting aside emergency funds and cash reserves. They are right! When something critical hits you like replacing a roof or paying for a new truck because they one have just died, and you have no cash reserves, panic ensues. Your need for cash NOW will cause you to make rash decisions like taking on bad debt, such as payday loans or 401K loans. These are expensive and come with onerous requirements.

Bad Debt

Payday loans have high expenses, a side effect of buying ultra-convenient money. The lenders realize the people coming to them are panicing and willing to pay the fees. Many states have clamped down on payday loans to make them not as outrageous. Emphasis on “as”. However you feel about them, you can be sure that people with wealth building plans don’t use them. They are only sold to people in critical need of money and lacking cash reserves.
401K loans have a heap of issues as well. For one thing, they come with short time windows. 401K loans must be paid back in five years. That’s just the beginning. If you leave your job, the loan becomes a permanent withdrawal you can’t repay, including the harsh penalties. This means you have to pay income tax + 10% penalty on the balance of the loan. Ouch! This is another reason I don’t like stockpiling money in a 401K. It forces people to hunker down in their current job, even if a better prospect opens up, due to not wanting to lose any money, especially if their funds haven’t recovered yet from the 2008 downturn.

Good Debt No Longer an Option

Suffice it to say, once people dig their way out of such a dire situation, they hate ALL debt with bitter angst. The emotional scarring is pretty strong. At that point, the thought of taking on debt for cash flowing assets like real estate is off the table. Just how bad does debt taste to these people?

Imagine this: what if Space Mountain at Disney World was suddenly up for sale for $100,000 with a promise to pay to you a piece of every ticket sold totaling $25,000/year? Your favorite bank will write you a note for just 10% down financed at 3.0%, 30-year fixed with no closing costs. Would you take it? I would, but these people would turn it down in a heartbeat because of the evil debt involved.

What used to be intangible fear of a potential risk has just become real and crystalized in their minds as a permanent fixture.

Ask them if they would consider taking a reasonable mortgage with plenty of cash to cover the risks. They will quickly reply, “It happened once, it will happen again. Not for me!” I don’t know any financial instruments that work to build retirement when all you have is fear.

The Real Lesson

In this situation, the lesson this couple should have learned is to take a serious look at spending habits. Either cut back until enough cash reserves can be built up, or look at creating a new stream of cash flow. They could create some side business or buy a cash flowing asset. With reserves available, they would have been able to buy the new roof, replace the truck, and then start rebuilding cash reserves without the shock. The reserves would also help protect them emotionally, because they would not be driven into such a troubling loan. They would instead be hit with a more annoying loss of reserve funds that must be rebuilt. That’s why this is the most important step. After taking a dent in reserve funds that is much easier to recover from, it’s not so hard to entertain the chance of buying rental property. 
But sadly not for this couple. The shock of what they suffered has pushed the idea of real estate off the table. It probably means they will focus on paying off all their debt, including their home, and eventually saving something in their 401K. Most people 55-64 years old have less than $88,000 in retirement savings with their home being the principal source of equity. Go ahead and calculate what 4% of withdrawal of that will be, and tell me how you would survive on that. Pretty grim, ehh?
They may own their home free and clear, but what good is that when it doesn’t generate a single nickel of revenue? Free and clear rental property would be a much better place for such equity at the time of retirement. You think this couple experienced a major panic today? Wait until they figure out they can’t retire, but must instead start their new career saying, “Welcome to Walmart.”

Cash reserves – important piece of any investment plan

Just today I received notice my company would deposit $75 into my bank account within five working days. This was compensation for five t-shirts I bought for the Nashville Java Users Group when we attended the DevNexus conference back in March. I basically asked Jeremy if I could hand him $75 in cash when I arrived, and of course he said yes! This required that I float the cost of this until I get compensated.

Back in 1999-2000, at my old company, the travel department got downsized by a huge amount. It meant there were backlogs of expense reports not getting filled. When your corporate credit card doesn’t get paid, they suspend it! (BTW, this impacts YOUR credit rating, not the company’s). Of course, I only discovered this when it came time to book a trip. I had to pay for the trip myself, because my card was delinquent. From that time forward, I paid cash up front for my trips, and had to wait sometimes 60-90 days to get compensated. Even when new memos came out, telling people to not do this so that our trips woud be properly covered by the insurance policies supplied by our creditor, I wouldn’t consent, because I had already been burned once and wouldn’t suffer that again.

The key requirement in both these circumstances is you must have enough cash on hand to front these expenses. Maybe $75 isn’t much, but are there times where you felt you didn’t have that much wiggle room in your paycheck-to-paycheck budget? I certainly have. It’s the key reason that the last time I cashed in a major chunk of stock option from my current job, I didn’t immediately apply to the debt on our town home. Instead, I decided to pool some liquid capital and wait for the next allotment of stock option to pursue that debt.

This extends to the realm of whatever business you plan to run. One vital component to success is having enough cash reserves to handle shocks of this kind. Business expenses, especially investment real estate, are very bursty and never smooth and average. If you investigate the reason people were getting foreclosed on properties over the past decade, you will find that many suffered from lack of cash reserves that were critical when Murphy dropped in with bad circumstances like being out of work for 6 months. People that get behind, rarely catch up. I’ve heard the same for renters as well.

As Jeff Brown often says, Murphy is still alive and knows where we all live. It is better to assume that he will show up periodically rather than hope that he won’t. If you plan to get into investment property, you need to right amount of cash reserves so a panic doesn’t ensure when things bad happen. You should have a minimum of 6 months of total cost of expenses and mortgage expenses, and count 50% vacancy in there as well. 12 months is even better. If you start with 6 months of cash, consider routing any extra rent into that reserve until you are up to 12 months, before actually working on reducing the debt. With that much in easy-to-reach cash reserves, you can weather many storms and actual pursue a solid investment plan.

Cross posted from http://blog.greglturnquist.com/2012/05/cash-reserves-important-piece-of-any.html.

I am not a licensed financial advisor nor an insurance agent, and cannot give out financial advice. This is strictly wealth building opinion and should be treated as such.