Real Estate Investing Basics

Protect Your Real Estate Investments & Finances with Strategic Reserves

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Private real estate affords investors considerable control over their investment, from how and when properties are bought and sold to how assets are managed. One of the trade-offs for this control is the cost of owning real estate.

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A way that investors budget for these ownership costs is through reserves, which include capital expenditures (aka CapEx) and other expenses. Investors should set aside a certain amount of money to cover these costs.

When budgeted for appropriately, these reserves can minimize or eliminate financial stress if an unexpected event occurs. That said, it is important to have the foresight to budget for reserves.

Related: Visualizing Cash Flow: How to Accurately Budget Expenses

The Fundamentals of Reserves and CapEx

budgeting-reserves

Reserves are savings—often a percentage of rental income—set aside by investors to cover future financial costs related to a property. There are different classifications of reserves. And it is a smart budgeting practice to use reserves for their specific classification, rather than as a general fund.

For example, strategic reserves often range anywhere from 10 percent to 30 percent, depending on a variety of factors. If an investor sets aside a total of 25 percent percent each month for reserves, a typical breakdown might be: 10 for for CapEx, 8 percent for vacancy coverage, and 7 percent for repairs and routine maintenance.

In real estate, CapEx refers to significant but occasional expenses related to owning a property, including replacing or repairing a roof, HVAC or plumbing system, paving a driveway, or replacing large appliances.

Most capital expenditures occur less than once a year, so when broken down by month, the amount looks more manageable. Routine repairs and maintenance are sometimes referred to as operating expenditures, or OpEx. Factors such as the condition and age of the property as well as investment strategy can impact the total amount of reserves and where they are allocated. This is especially true with regard to CapEx and OpEx.

Related: Investors—Yes, You DO Need an Ample Amount of Reserves. Here’s Why.

For a better assessment of how much money should be set aside in the reserves fund and allocated for each specific purpose, real estate investors may want to hire a building engineer to analyze the property. That way, investors can better determine the useful life of each part of the property and what the potential expenses are so they can budget more accurately.

Calculating which items will need to be replaced/repaired, when they will likely need replacement/repair, and how much it will cost to replace/repair them will lay the groundwork for establishing workable OpEx and CapEx funds that are within budget.

Additional line items might be included in reserves, depending on how the property is operated and owner preferences. For example, if an owner is managing a property themselves and, thus, not regularly paying a set fee to a third-party property manager, they may reserve a specific percentage of income each month for potential management expenses.

Keeping It All in Perspective

confident-investor

While budgeting for reserves and CapEx may seem like a way to chip away at profits and liquidity month to month, this process actually frees up real estate investors from worrying about how to pay for the unexpected expense.

CapEx and other planned-for expenses shouldn’t be viewed as a burden for owning property. Instead, investors should keep in mind that CapEx, when claimed as an expense and as depreciation, can be used as a tax advantage. Therefore, it behooves property owners to keep careful records of expenses like these. (They can come in handy at tax time.)

Knowing that these expenses are in the budget and accounted for not only serves as an insurance policy for property owners, but also can help formulate and enact a well planned, optimized investment strategy.

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Any tips you have for budgeting your reserves each month?

Share with a comment below!

Since founding Trion Properties, a private equity investment company that specializes primarily in value-add multifamily real estate investments and ground-up developments, Max Sharkansky has led the acquisition, renovation, and disposition of over $300 million in mismanaged and distressed assets. Max, along with partner Mitch Paskover, formed Trion in 2006 and successfully formulated a strategy of acquiring "diamond-in-the-rough" multifamily properties and creating value through renovations, creative rebrands, hands-on management, and the improvement of operating efficiencies. Max’s expertise of the marketplace has been instrumental in the firm’s success. Find out more about investing with Trion at Trion-Properties.com.

    Terry Lowe
    Replied about 1 month ago
    I don’t hold reserves by “line item” but I do know hot water heaters and washing machines last 10-12 years, dishwashers closer to 15 years, remodels, about 15 years, etc. Furnaces are a bit harder. The old ones from the 1950’s seem to last forever, and newer ones, 15-20 years. (I have them all serviced every year). We are very lucky about roofs in Denver, hail storms bad enough for insurance replacement come along every 10-15 years. I carry extra insurance with a low deductible for roofs. We take good care of our properties, and I save a certain amount each month. It all comes out In the wash, but I’m always sure to have enough for emergencies. After the 2017 hail storm, I had to replace 7 roofs in 4 cities! It was unprecedented, but I had great insurance, with low deductibles, and what could have been a personal financial disaster was easy peasy.... ( well sort of)! Take care of your properties and tenants, and they will take care of you.
    Wenda Kennedy JD from Nikiski, Alaska
    Replied about 1 month ago
    I agree. When I was appraising, we called these set-asides a "Sinking Fund Factor". The expected lives of new short-lived items are well known. But, hold on here. How long has that item been in service? Has it been well maintained or is it falling apart? How long is it going to last? Take the projected replacement cost and divide it by the number of months of remaining expected life. That amount is what you need to save each month, on a line-by-line basis. Do the same for other major expenses that have major payments -- like insurance. Make a spreadsheet. Think. What must you pay? What major expenses are you facing? What can go wrong? When are you going to need that money? This financial planning allows you to control many major purchases and repairs. With your money in hand, you can negotiate, catch things on sale or scheduled items/repairs when they are cheaper. Appliances can be purchased in bulk at deep discounts. Repairs/maintenance can be grouped. By planning that scheduling, you can save time and money. Emergencies are terribly expensive and they can kill your resources. A good management system looks down the road and prevents most nasty surprises.
    Alice Lawrence Investor from Brooklyn, New York
    Replied about 1 month ago
    What are your thoughts on reserves for property tax increases?