I feel like I read Forum posts constantly talking about how important or unimportant reserves are. Are they really necessary? Why not apply that cash to whatever I purchase, giving me the ability to purchase more? I see it on BiggerPockets and other business forums I frequent. The fact is that people new to business underestimate the importance of reserve accounts – just like I did.
For those of you who don’t know, I purchased my first investment property earlier this year. It’s a multi-family located about 400 miles away from where I currently live (you can read about my due diligence process for investing at a distance here) and will be a cash cow… after I replace the roof.
Yep, you read that right, not even four months into my investment, I find out I need to replace the roof. I can hear you calling me “rookie,” which I may deserve, but not so fast!
Being a finance/accounting guy, I spend hours building and enhancing financial models (sometimes just for fun) and understanding how different variables affect overall outcomes of cash flow, return on investment (ROI), internal rate of return (IRR), net operating income (NOI), etc. Inclusive in every financial model I build is a “Capital Expenditure” section, which breaks out all the property’s components into estimated remaining life and cost to replace such components. My estimates were developed based on various contractors that I had inspect the property during my due diligence period. I determined the monthly amount needed to be set aside for capital expenditures, and I have appropriately accrued based on my estimates.
I knew the roof was an upcoming project, as in needing to be replaced within the next four to five years. It’s a mansard roof and had a few shingles missing on the vertical portions, which my contractors told me not to fret over. I figured I could get by with repairs or a patch job, which would hold me over until I decided to replace it.
I took these expenses into account, and the property was still a sweet deal for my desired hold period. I went through with the purchase and have been sitting pretty ever since. Until last week.
Where I Went Wrong
I thought I did everything right, my due diligence was extensive in nature and I was confident about the purchase. Sometimes, though, there are things that you just can’t predict regardless of whether you have done no deals or hundreds.
What I didn’t account for was my insurance dropping me from their policy because shingles were missing from the roof. I can understand their concern – who wants to insure a place when the roof is missing shingles and, as a result, subject to a higher risk of requiring a large insurance payout?
They sent notice that if repairs weren’t done within 20 days, they would be terminating my policy. To mitigate their concerns, I needed to provide visual evidence that the repairs had been made. If 20 days was not enough time, I would have the option to reinstate the policy after repairs were completed.
My truly awesome property manager contacted various roofers around the area and had them provide me with estimates. As I was receiving the estimates, I noticed they were quoting me on a full re-roof job. That’s not what I wanted, so I called each of them to discuss.
Each of them said something similar to, “the roof is in such bad shape that a repair really isn’t worth it, and you should just go ahead and do the re-roof.” I have no idea whether it’s true that a repair wouldn’t suffice, or if the contractors just wanted a bigger job with more profit involved. In either case, the message was clear: nobody was simply going to repair my roof. This meant I had to replace it, and 20 days isn’t nearly enough time to get such a job completed. So now I was racing against the clock.
Luckily, the property’s roof is a mansard, which is inherently more expensive to replace (that’s sarcasm, people). How expensive? About 7-8 months of the free cash flow the property is on track to generate. Lovely.
Again, I did account for the capital outlays; however, I had expected the re-roof to occur in or around 56 months.
The Importance of Reserves
When I purchased the property, it had nearly tapped me out in the cash department. I figured I could take on the extra risk of having limited reserves because I’m young and have a solid monthly income. The plan was to stash away my income from both my W2 job and the rental property for a month or two and call that my “reserves.”
But a new roof requires a bit more than what I had planned as reserves. As I said, the expenditure will amount to 7-8 months of the property’s free cash flow, and since I have not yet owned the property for that amount of time, I need to tap into the small reserve account I was building up.
I’ll admit I consider myself lucky here; my side CPA business has taken off and allowed me to bank extra cash quickly. It allowed me to roll those earnings into the roofing job and still keep my financial goals intact. If I didn’t have my CPA business, I wouldn’t be under financial strain, but I’d certainly be sweating.
If I didn’t have the money for the re-roof, I’d have to wait a couple more months for the property to generate enough cash for the project. By that time my insurance company would have dropped me, and I would be at the mercy of a new insurance company my mortgage provider decided to stick me with, likely costing more and further digging into the cash flow the property generates.
Reserve accounts give investors the ability to adapt to changing situations quickly. I have certainly learned from this experience and will always keep a good sized reserve account on hand just in case something unforeseen happens.
Don’t neglect your reserve accounts, and don’t buy properties that completely tap you out in the cash department. I was lucky enough to lean on the earnings generated from my side CPA business. I’m still excited about the property, as even with the surprise capital expenditure, the IRR over my hold period is still fantastic.
I can’t tell you how much to keep in reserves, but in the future, I’ll be sure to keep at least as much of the cost of a new roof.
Investors: Have you ever found yourself in a situation where you were glad you had some reserves on hand?
Let us know your experiences in the comments section below!