What Coronavirus Teaches Us About the Importance of Reserves in Investing
Over the past two years, economists and investors agreed we were nearing a recession. All of the indicators were there: inverted yield curve, slowing of GDP growth, decline in corporate profits, P.M.I. (purchasing managers’ index- measuring manufacturing), Cass Freight Index, Copper, Gold, EPU (Global Economic Policy Uncertainty Index), and overall business spending. When these indicators started to appear everyone started gazing into their own crystal ball to predict when it would occur, and what would be the tipping point. While most were accurate on the timing, very few predicted that a global pandemic would be the ultimate cause.
Today we know that the Coronavirus was the tipping point. It has created, and continues to create, an unprecedented impact calling into question the survival of millions of businesses across the country (and globe). It also calls into question the most vital lifeline a business has during recessions, reserves.
Note: In this article, reserves are defined as the capital businesses put aside to use only in a time of financial hardship.
Historically, reserves were calculated with an underlying assumption that financial hardship would be gradual over several months. Thus, reserves could off-set a portion of a business’ financial strain for a period of time while the business suffered a disruption. This underlying assumption is being challenged today; instead of a gradual disruption of business, there is an all out halt.
When it comes to apartments, the impact of the Coronavirus on tenants is threatening job security and tenants’ livelihood, inclusive of their ability to pay rent. The trickle down effects call into question an Owner’s ability to pay the apartment’s mortgage, insurance, taxes, utilities and all other operating expenses which keep the property functioning.
Regardless of the investment type, the amount of reserves needed depends on the size and type of the investment. In other words, the reserves needed per investment are directly linked to the holding costs (or expenses) of that investment. The more expenses, or higher cost to operate, the more reserves are needed. In addition, the more time the property’s income is on hold the more reserves are needed.
This common school of thought on reserves has the potential to destroy the commercial mortgage industry. Banks are acting swiftly to put safeguards in place to protect future investments. It is not uncommon for a bank to now require six months to a year’s worth of mortgage, taxes and insurance payments upfront. While this was also a request during the onset of the 2008 financial crisis, banks quickly loosened this requirement as the economy became more stabilized. Moving forward, it is possible banks will keep this lending requirement in place. At the end of the day, banks are not in business to own real estate.
During every hardship, there are lessons to be learned. It is apparent that today’s global pandemic is teaching some difficult lessons to both investors and banks. Regardless of how the banks react, if this crisis has taught us anything it is that the investors who had adequate reserves are in a lot better position to survive.