How Much Should You Budget for Reserves and CapEx?
You may or may not have experienced this firsthand, but I am certain you have all heard the horror stories from buy and hold investors. You have a rental property that is cash flowing wonderfully, and then all of a sudden the HVAC stops working. It’s going to cost $4,500 to get it back to working order.
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In this article, we are going to go over what exactly reserves and CapEx are and how much you might want to have set aside for these scenarios.
What Are Reserves and CapEx in Real Estate Investing?
Reserves are just savings that you have set aside for the day when your property goes vacant. It really isn’t a matter of if it is going to be vacant, it is a matter of when. Every tenant will eventually move out (or get evicted).
In this situation, it is very wise to have money set aside to pay for the mortgage (if any), insurance, and taxes that accumulate on the house. You will also need to factor in electricity, water, trash, and any other utilities your property may have that you need to keep the place functional until your next tenant moves in and takes over.
Short for capital expenditures, CapEx refers to large items in the household that need to be replaced over time. Think things like water heaters, roofs, and HVAC systems. Typically these aren’t things that need to be replaced every year, but every five to 10.
How Much Should You Set Aside for Reserves and CapEx?
It is pretty typical for banks to require six months of reserves in a savings account when they loan on a house. So, if you are going through a traditional lender, you might need to consider this.
To calculate this number, take your mortgage with interest, add in your taxes and insurance, and multiply by six. Boom! There’s the amount of reserves that you should have set aside.
As for CapEx, this will vary on a case-by-case basis. You will have to ask yourself:
- Has the roof been replaced recently?
- When was the HVAC updated?
- Have I replaced plumbing?
Basically, what condition is the house in when you begin to rent it out? This will determine how much you want to have set aside.
How Do I Save for This?
It is a great idea to factor these expenses into your monthly cash flow analysis. When doing it this way, it makes saving up for these expenses more manageable, because you break it down month by month. The funds come out of the rent you’re collecting.
For even more on this, check out my article about all of the things that I factor into a cash flow analysis called “How Do I Know If a Property Is a Good Investment? (With a Buy & Hold Example!).” It goes into a lot more detail about cash flow analysis that isn’t covered in this article.
Don’t think of these items as cutting into your bottom line. Think of putting aside this money as protecting your investment when things go wrong and need to be taken care of.
Everyone is going to approach this differently, and there are really no hard and fast rules to help you determine the right amount to save. You just need to do what makes you comfortable and helps you sleep at night—instead of worrying about the possibility of something going wrong in your investment property.
Do you have money set aside for unexpected property expenses? How much? How did you arrive at this number? If you don’t, what’s your plan in the event of unforeseen circumstances?
Leave a comment below.