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Multifamily War Chest

January 31, 2020

I recently had a conversation with Neal Bawa about his “War Chest” strategy to protect multifamily assets that he owns from a US recession. The strategy is simply to closely observe US GDP growth and act in the event a quarter of 0% or negative growth is announced (a US recession is defined by two consecutive quarters with flat or negative GDP growth). Since we are at the top of the economic cycle, a 0% growth quarter is more meaningful than at other times.

Zero-growth quarters are not uncommon and data can sometimes be revised upwards after the fact. Nevertheless, when the US experiences a quarter of zero or negative GDP growth, “war chest” strategy calls for a suspending distributions and capital expenditures. We will notify investors and explain the situation – if the 0% or negative quarter was a fluke and the next quarter swings back into the black, the reserved cash flows will be distributed out to investors. If growth is zero / negative for another quarter, officially placing the US in recession, the suspension of distributions and capex is maintained: the goal being to build reserves equaling at least 2–3 months of debt service. This should provide enough cushion to weather potential negative cash flows caused by higher vacancy, lower rents, concessions, and collection losses during the recession.

As noted before, discretionary capital expenditures (not required repairs) and rent increases should also be postponed – in a recession, the main goal should be to maintain and even increase occupancy, as well as encourage longer lease terms. If market rents are falling in tough economic times, it may also be wise to quickly lower a property’s asking rents in step with the market, rather than stubbornly holding rents at their current levels. This will help maintain occupancy, encourage renewals, and avoid turnover. Once market conditions improve, any excess capital in reserves can be distributed to investors and normal property operations can resume. This sequence of events would be ideal in a recessionary environment as it avoids a capital call and forced sale – two very difficult events for an investment to overcome.

One objection sponsors may have to this war chest strategy is that an investment’s preferred return or IRR hurdle may compound while distributions are suspended, putting more strain on the sponsor’s promote. However, this is a minor issue – it much more important to forestall the possibility of a capital call or a forced sale, which could result in loss of capital. A sponsor’s concern should always be capital preservation first.

It is also important to communicate more frequently with LPs during a “war chest” / recession period. It is often said that investors should hear from you ten times more often when things are going poorly than when things are going well. Clear communication about a property’s performance and cash position during a recession will also keep investors more comfortable should the need arise for a capital call, since they will better understand its necessity, and hopefully see the light at the end of the tunnel. Even if a recession is mild, or avoided altogether, investors will appreciate that the “war chest” strategy keeps them informed and proactively deals with risks.