Owning rental properties is a great way to create passive income and long-term wealth, but unlike other investments like stocks and bonds, rental properties require more maintenance and run a higher risk of emergency expenses.
When a furnace goes or a dishwasher needs to be replaced, the expense should be covered by previous rental income rather than your personal account. This is why, when looking at a potential property, your analysis should include setting aside money each month for reserves. These reserves can be used for monthly repairs, larger capital expenditure items like a roof replacement, or money to pay fixed expenses like a mortgage, taxes, and insurance when the unit is vacant, or when rent is late.
With the major effects COVID-19 is having on the real estate market and the economy as a whole, having a strong reserve account is crucial now more than ever. We know having funds set aside for a rainy day is important, but how much is enough?
There are a few factors to consider when determining a reserve amount for a particular property.
- Age of the home. A newly constructed home is less likely to need any major repairs compared with a home built in the early 1900s. Therefore, you may not need to set aside as much.
- Condition of the home. Similar to above, if you purchase a property and complete a full renovation and update the major appliances and utilities, fewer reserves are needed than if the unit has appliances that are halfway through their recommended life span.
- Property location and market demand. Reserves aren’t only meant for repairs and maintenance—use them for vacancies too. If your property is in a market in which it may take 2 to 4 weeks to fill a vacancy, it would be smart to set aside a larger reserve amount than you would for a property located in a hot market that rents more quickly.
- Stage of investing career. Those in the accumulation stage who are actively buying properties may keep less in reserves so they can put more money to work by buying more rental properties. Investors who are in the preservation stage are keener to increase the amount of their reserves so they can decrease risk.
With these four factors considered, there are three ways to determine your reserve number:
Percentage of rent.
Many investors will simply set aside a percentage of the gross rent each month with no cap. This percentage typically ranges between 15% and 30% and depends on the factors considered above: 15% for new construction or newly renovated property in a high demand area and 30% for an older home in a weaker market. This isn’t always the best method though as rents may vary but expenses may stay the same. For example, a water heater will cost around the same to replace whether the one-bedroom apartment rents for $800 in a lower-income area or $1,500 a few miles into the city.
Three to six months of fixed monthly expenses.
Another way is to total up all fixed monthly expenses and set aside 3 to 6 months’ worth. This would include mortgage, taxes, insurance, and any other reoccurring expenses like property management, lawn care, or utilities. This method ensures you have ample funds should you have a nonpaying tenant or during tenant turnover.
Itemization of all major appliances and capital expenditure line items.
This is by far the most in-depth and time-consuming option but can be the most accurate. In this scenario, the investor lists out all of the major items that would need to be fixed or replaced such as a refrigerator, HVAC unit, roof, toilets, etc., and determines the remaining life of each item. They can then predict when each item will need to be serviced or replaced and set aside funds accordingly.
Although the amount in your reserves is specific to you and your portfolio, having cash on hand assures staying afloat during an emergency or market shift.
If you’re just starting out or don’t have much in reserves currently, don’t panic; now is a great time to begin to build that foundation. Start setting aside money each month; after all, small consistent actions are the key to wealth.