Reserves - How much cushion do you need?
Rental Property Investor · Andover, MA · Member since 2017 · 126 posts · 67 votes
Hi All,
My goal is to purchase a multi family rental in 2018 and house hack it. I'm curious to know how much you all budgeted for reserves when you purchased your first deal? Would you take your 401k into consideration?
Dan
Your reserves should be 6 months of PITI per investment property. Reserves can be stock, bonds, cash and yes up to 50% of your 401k in most cases.
Reserves is not your HELOC or Credit Cards like several foolish investors tell me. Those things are "credit" and credit can be frozen when markets get messy re: 2007-2008.
Good luck.
Initially, typically 6 months of operating expenses @Daniel Ortiz. I also setup bank accounts for each property (separate from rent collection). These accounts are titled RMVITC-Property Name (Repairs Maintenance Vacancy Insurance Taxes Capital Expense). Each month rent is collected, I deposit those monies originally calculated in my analysis, into those RMVITC accounts. That way, taxes are due, no problem. Received an insurance premium bill, no worries. Tenant moves out, have a month of vacancy, I don't sweat it because the funds are in my RMVITC accounts.
Congrats on setting your goal and good luck finding a deal.
The lender will require you to have 6 months reserve for investment properties. So, take the prospective mortgage payment (PITI) and multiply that by 6. That is the reserve that will be required. And Yes, you can use your 401K to satisfy this reserve requirement.
As you add to your portfolio, the lender will require you to have 6% of the loan balances of the total, and then 6 months reserve for the subject property (the one you are buying at the time).
So, that 401K will really come in handly as you add up properties. Keep in mind, the 401K portion that the lender will base your reserves on is the portion that is available for loan or withdrawl. This is not usually your balance. Most employers will limit how much you can withdraw or take out a loan against. Most commonly, it's $50K.
While the lender won't require it (because the 401K will satisfy their reserve requirement), you may want to start out with SOME liquidity for repairs and/or unexpected items that could pop up like the HVAC going out, or a leaky roof. Also, your rent cash flow should account for a capex to build this reserve so it isn't all funding that you personally need to save for each one.
Also, I would highly recommend a home warranty for anyone starting with minimal liquid reserves. The home warranty can assist with those bigger ticket unexpected items like HVAC. Try Old Republic Home Protection. They are pretty good.
Another way to look at this is to have 5% to 10% of the value of property for your reserve number. Like others have said, lenders will require enough funds to cover the mortgage for 6 months. Also look at the condition of things that will need to be replace and what life expectancy is left on the equipment. You should be putting away 10% cap ex, 10% repairs 5-10% for vacancy each month from rent. Look at how fast your savings will grow basis on what you put away each month. This is a numbers and risk game. What are you comfortable dealing with? The first year may be slim but you shouldn't have to feed your reserves after up and running.
@Daniel Ortiz risk tolerance is one factor as others stated, but age is also a factor. I looked at your profile and you are a young man with great educational credentials and excellent future earning potential. I think it is ok for you to run with lower reserves and keep credit available for large expenses. When you are young, you have time on your side. If you were 45 years old and just getting into investing, I would tell you to have a much larger cash reserve. My advice when you are young is stretch yourself thin and as you get older, bank more cash and pay down properties.
Do not get a home warranty. Warranties are like gambling. The odds are stacked in favor of the house. Worse yet, fighting with warranty companies can be a nightmare.
We too are looking at house hacking a multi family property in 2018. We were told by our lender, that because we are looking at getting an FHA loan, that we only need 3 months PITIA as reserves for the property we are purchasing. Under a conventional loan you would normally need 2 months of PITIA for the property you are purchasing AND 2% of the UPB (unpaid balance) of any other rental properties you have, up to 4 properties. If you have more than 4, a larger percentage and 6 months of PITIA would be required. We only have 2 other properties at this time, so if you have more, you may be required to have more than the 3 months for reserves? There are lots of opinions on how much you should have, but I would check with your lender to know exactly what the minimum is you'll be REQUIRED to have to close.
What is the property? If everything in it in new, then $5k is good to start. If the mechanicals, windows, doors, etc are old, then $15k
Like several others have said the "standard" says your reserves should be 6 months of PITI per investment property. Reserves can be stock, bonds, cash and yes up to 50% of your 401k in most cases.
However a lot depends on the property and the part of the country you are in. In some areas 10K is plenty in some areas it is not. I also recommend running everything out of one account. This is crucial when the tax man cometh. Transfer your reserves into the account and conduct all you business from that one account.
Everybody has their own strategy - here's what I do:
Property Tax Reserve - this is simple...take your estimated property tax and divide it by 12. Plan to pay from this reserve twice per year.
Repair Reserve - 10% of gross rents. This can be a revolving account depending on when repairs are made
Capital Expenditure Reserve - this equals my depreciation expense every month on my rentals (i.e. - if you have a stove with a 7 year life, you will be completely reserved for a new stove in 7 years)
"Vacay/NoPay Reserve" - I take the vacancy rate in the rental property area (most national real estate sites have estimates) and multiply it by gross rents. I add 5% of gross rents to that as a legal reserve for evictions, etc.
You will be under reserved for about the first two or three years mostly because of the capital expenditure reserve amounts. Eventually it will catch up to itself if you don't pay yourself during that time. You could also add to that balance every month to start, or get a line of credit to borrow against just in case.
My reserve funds sit in a business savings account - this is a revolving account and I will usually net current month activity against reserves (if I have a repair reserve of $20, and I paid out $10, then I will record the repair expense of $10 and add $10 to my reserve).
I should also add that I use project based accounting....so I can track each property individually through my accounting reports.
The warranty cost around $450 or so (annual premium) at the time, and $60 per visit when we called out the trades for repairs. We did not purchase it when we bought the house, but sometime after renovations since we decided not to replace the HVAC, oven and cooktop. I did not actively include it in my budget up front since it is a relatively low cost and honestly something we decided on after the fact. After the first year we did not renew.
Hi Andy,
Great info! Definitely something to consider. It makes sense that you didn't include it in your analysis due to the warranty being an afterthought, however if I ever were to consider purchasing a warranty (and if you plan to use it again in the future), I think it might be beneficial to treat it as an additional operating expense just as you would budget for property management for example. Sure, $450 annually and $60 per visit doesn't seem like much, but lets say you are cash flowing $200/mo. The $450 fee and a few visits later is already cutting into your cash flow by 25% (approximately $50). I'm sure the warranty has its time and place!
Dan
Initially, typically 6 months of operating expenses @Daniel Ortiz. I also setup bank accounts for each property (separate from rent collection). These accounts are titled RMVITC-Property Name (Repairs Maintenance Vacancy Insurance Taxes Capital Expense). Each month rent is collected, I deposit those monies originally calculated in my analysis, into those RMVITC accounts. That way, taxes are due, no problem. Received an insurance premium bill, no worries. Tenant moves out, have a month of vacancy, I don't sweat it because the funds are in my RMVITC accounts.
Congrats on setting your goal and good luck finding a deal.
Hi Jay,
That's a great tip (RMVITC), gonna have to write that one down! All of the great feedback I've been getting has made me realize I should probably reach out to my mortgage broker to see what she thinks. Turns out for 3 and 4 family's, the lenders my broker works with actually require 6 months PITI, so you nailed it.
Don't want to get too off topic from the forum, so if you'd like to connect feel free to PM me. But I have a question for you regarding bank accounts. How many bank accounts do you typically set up for each property? Lets say you own a two family property. I assume you'd open one account for RMVITC of the property. Do you then open two additional bank accounts, one for unit A and one for unit B (for a total of 3 accounts)? On top of that, would you also need to open accounts specifically for interest bearing security deposits for each unit (adding an additional 2 bank accounts for a total of 5 total for the property)?
Great blog by the way!
Dan
The lender will require you to have 6 months reserve for investment properties. So, take the prospective mortgage payment (PITI) and multiply that by 6. That is the reserve that will be required. And Yes, you can use your 401K to satisfy this reserve requirement.
As you add to your portfolio, the lender will require you to have 6% of the loan balances of the total, and then 6 months reserve for the subject property (the one you are buying at the time).
So, that 401K will really come in handly as you add up properties. Keep in mind, the 401K portion that the lender will base your reserves on is the portion that is available for loan or withdrawl. This is not usually your balance. Most employers will limit how much you can withdraw or take out a loan against. Most commonly, it's $50K.
While the lender won't require it (because the 401K will satisfy their reserve requirement), you may want to start out with SOME liquidity for repairs and/or unexpected items that could pop up like the HVAC going out, or a leaky roof. Also, your rent cash flow should account for a capex to build this reserve so it isn't all funding that you personally need to save for each one.
Also, I would highly recommend a home warranty for anyone starting with minimal liquid reserves. The home warranty can assist with those bigger ticket unexpected items like HVAC. Try Old Republic Home Protection. They are pretty good.
Hey Cara,
Really enjoyed your feedback, thank you. My lender just got back to me so you are 100% correct, she informed me that I need 6 months reserves. She specified for 3 and 4 family properties, so I asked what about 2 family. I assume its the same, but we shall see.
I never knew that bit about being required to have 6% of your total loan balances in addition to 6 months reserve for the subject property. Now I'm beginning to see how difficult it might be scaling your real estate portfolio and how valuable your 401k becomes.
Will definitely include CapEx into my expense calculations.
Interested in finding out more about home warranty's. If you find any articles that do a good job explaining them in detail, please feel free to send this way! I'm gonna see what I can dig up.
Thanks,
Dan
Another way to look at this is to have 5% to 10% of the value of property for your reserve number. Like others have said, lenders will require enough funds to cover the mortgage for 6 months. Also look at the condition of things that will need to be replace and what life expectancy is left on the equipment. You should be putting away 10% cap ex, 10% repairs 5-10% for vacancy each month from rent. Look at how fast your savings will grow basis on what you put away each month. This is a numbers and risk game. What are you comfortable dealing with? The first year may be slim but you shouldn't have to feed your reserves after up and running.
Hi Jim,
Thanks for providing feedback! How did you determine your CapEx, Repairs, and Vacancy rates when estimating expenses?
Dan
@Daniel Ortiz risk tolerance is one factor as others stated, but age is also a factor. I looked at your profile and you are a young man with great educational credentials and excellent future earning potential. I think it is ok for you to run with lower reserves and keep credit available for large expenses. When you are young, you have time on your side. If you were 45 years old and just getting into investing, I would tell you to have a much larger cash reserve. My advice when you are young is stretch yourself thin and as you get older, bank more cash and pay down properties.
Do not get a home warranty. Warranties are like gambling. The odds are stacked in favor of the house. Worse yet, fighting with warranty companies can be a nightmare.
Hi Joe,
I appreciate your kind words. I've worked hard to get to where I am, and couldn't have done it without the support of my parents. Part of my "why" is to be able to repay the favor for them giving me the opportunity to get to where I am today.
Being younger may allow me to take on more risk, but at the same time I'd hate to find myself underwater. I originally wrote this post because the underlying question I am trying to navigate through is whether or not I will be in an opportunistic position in 2018 to achieve my goal and begin my journey as a real estate investor. Between school and now working full time, I've been renting apartments for the past 7 years or so, and quite frankly I don't think I can sign my name at the bottom of another lease knowing what I do now about REI.
Interesting thought on the home warranty. My dad is the same exact way..."why buy a warranty? Something always seems to break the day after the warranty expires"! This may call for a new forum post eventually.
Dan
We too are looking at house hacking a multi family property in 2018. We were told by our lender, that because we are looking at getting an FHA loan, that we only need 3 months PITIA as reserves for the property we are purchasing. Under a conventional loan you would normally need 2 months of PITIA for the property you are purchasing AND 2% of the UPB (unpaid balance) of any other rental properties you have, up to 4 properties. If you have more than 4, a larger percentage and 6 months of PITIA would be required. We only have 2 other properties at this time, so if you have more, you may be required to have more than the 3 months for reserves? There are lots of opinions on how much you should have, but I would check with your lender to know exactly what the minimum is you'll be REQUIRED to have to close.
Andy,
Great advice - I did just that and contacted my mortgage broker. I wonder if it differs from state to state. My lender told me that for BOTH a 5% convention w/ or w/o PMI AND for the 3.5% FHA I would be required to have 6 months PITI in reserves. Sounds like my lender is asking double what yours told you. Do you know whether or not it differs from state to state? Or maybe lender to lender?
Dan
What is the property? If everything in it in new, then $5k is good to start. If the mechanicals, windows, doors, etc are old, then $15k
Todd,
I don't have a specific property in question, it was more of a general question to determine how much money I should be looking at having in reserves. I agree with your thought process in that besides from my REQUIRED reserves, I should really be basing any additional reserves on the "health" of the property prior to making the purchase.
Dan
Like several others have said the "standard" says your reserves should be 6 months of PITI per investment property. Reserves can be stock, bonds, cash and yes up to 50% of your 401k in most cases.
However a lot depends on the property and the part of the country you are in. In some areas 10K is plenty in some areas it is not. I also recommend running everything out of one account. This is crucial when the tax man cometh. Transfer your reserves into the account and conduct all you business from that one account.
Jimmy,
6 months of PITI per investment sounds just about right based on what everyone else (including my lender) has said! Do you use one account to handle all of your business for a property, including tenant's rent and security deposits etc? I was always under the impression security deposits needed to be held in a separate account since it will be gaining interest, and that the security deposit and any interest it gains must be returned to the tenant if none of it is to be used deducted for repairs etc. Unless that is just a Massachusetts thing?
Dan
Everybody has their own strategy - here's what I do:
Property Tax Reserve - this is simple...take your estimated property tax and divide it by 12. Plan to pay from this reserve twice per year.
Repair Reserve - 10% of gross rents. This can be a revolving account depending on when repairs are made
Capital Expenditure Reserve - this equals my depreciation expense every month on my rentals (i.e. - if you have a stove with a 7 year life, you will be completely reserved for a new stove in 7 years)
"Vacay/NoPay Reserve" - I take the vacancy rate in the rental property area (most national real estate sites have estimates) and multiply it by gross rents. I add 5% of gross rents to that as a legal reserve for evictions, etc.
You will be under reserved for about the first two or three years mostly because of the capital expenditure reserve amounts. Eventually it will catch up to itself if you don't pay yourself during that time. You could also add to that balance every month to start, or get a line of credit to borrow against just in case.
My reserve funds sit in a business savings account - this is a revolving account and I will usually net current month activity against reserves (if I have a repair reserve of $20, and I paid out $10, then I will record the repair expense of $10 and add $10 to my reserve).
I should also add that I use project based accounting....so I can track each property individually through my accounting reports.
Hi Ed,
The step by step approach is really helpful. Appreciate you providing insight as to how you manage your reserves. How did you determine your allocation percentages?
Dan
@joe splitrock
A warranty is like gambling in the same way insurance is. I had an unexpected HVAC problem at my second house the first month I owned it. It took almost all $5000 I had in reserves. I have increased my reserves now. I didn’t think to get a home warranty but to call it gambling seems to imply that it’s always a bad idea. The warranty gives predictably and outsources the risk (and the need for higher reserves) to a professional. I could see that being useful to a newbie.
@joe splitrock
A warranty is like gambling in the same way insurance is. I had an unexpected HVAC problem at my second house the first month I owned it. It took almost all $5000 I had in reserves. I have increased my reserves now. I didn’t think to get a home warranty but to call it gambling seems to imply that it’s always a bad idea. The warranty gives predictably and outsources the risk (and the need for higher reserves) to a professional. I could see that being useful to a newbie.
@greg smith - for the record...I love the casino!!! Haha although I must say my new found love for REI has postponed me from going to the casino while I live frugally and save for a downpayment. I don't know enough about home warranty's specifically, but if they are anything like other warranty's, then I'm sure there's is a time and a place for it.
Dan
Initially, typically 6 months of operating expenses @Daniel Ortiz. I also setup bank accounts for each property (separate from rent collection). These accounts are titled RMVITC-Property Name (Repairs Maintenance Vacancy Insurance Taxes Capital Expense). Each month rent is collected, I deposit those monies originally calculated in my analysis, into those RMVITC accounts. That way, taxes are due, no problem. Received an insurance premium bill, no worries. Tenant moves out, have a month of vacancy, I don't sweat it because the funds are in my RMVITC accounts.
Congrats on setting your goal and good luck finding a deal.
Hi Jay,
That's a great tip (RMVITC), gonna have to write that one down! All of the great feedback I've been getting has made me realize I should probably reach out to my mortgage broker to see what she thinks. Turns out for 3 and 4 family's, the lenders my broker works with actually require 6 months PITI, so you nailed it.
Don't want to get too off topic from the forum, so if you'd like to connect feel free to PM me. But I have a question for you regarding bank accounts. How many bank accounts do you typically set up for each property? Lets say you own a two family property. I assume you'd open one account for RMVITC of the property. Do you then open two additional bank accounts, one for unit A and one for unit B (for a total of 3 accounts)? On top of that, would you also need to open accounts specifically for interest bearing security deposits for each unit (adding an additional 2 bank accounts for a total of 5 total for the property)?
Great blog by the way!
Dan
I typically setup just one RMVITC bank account per property, but that's just me. Now, I do track income & expenses per unit. And I don't self manage, so I don't handle the security deposits. If you are self managing, definitely check into your local/state laws on what is required (i.e. holding security deposits in an interest bearing account could mean the tenant receives a portion of that interest when they move out).
Initially, typically 6 months of operating expenses @Daniel Ortiz. I also setup bank accounts for each property (separate from rent collection). These accounts are titled RMVITC-Property Name (Repairs Maintenance Vacancy Insurance Taxes Capital Expense). Each month rent is collected, I deposit those monies originally calculated in my analysis, into those RMVITC accounts. That way, taxes are due, no problem. Received an insurance premium bill, no worries. Tenant moves out, have a month of vacancy, I don't sweat it because the funds are in my RMVITC accounts.
Congrats on setting your goal and good luck finding a deal.
Hi Jay,
That's a great tip (RMVITC), gonna have to write that one down! All of the great feedback I've been getting has made me realize I should probably reach out to my mortgage broker to see what she thinks. Turns out for 3 and 4 family's, the lenders my broker works with actually require 6 months PITI, so you nailed it.
Don't want to get too off topic from the forum, so if you'd like to connect feel free to PM me. But I have a question for you regarding bank accounts. How many bank accounts do you typically set up for each property? Lets say you own a two family property. I assume you'd open one account for RMVITC of the property. Do you then open two additional bank accounts, one for unit A and one for unit B (for a total of 3 accounts)? On top of that, would you also need to open accounts specifically for interest bearing security deposits for each unit (adding an additional 2 bank accounts for a total of 5 total for the property)?
Great blog by the way!
Dan
I typically setup just one RMVITC bank account per property, but that's just me. Now, I do track income & expenses per unit. And I don't self manage, so I don't handle the security deposits. If you are self managing, definitely check into your local/state laws on what is required (i.e. holding security deposits in an interest bearing account could mean the tenant receives a portion of that interest when they move out).
Hey Jay,
Sounds like a great strategy, thank you for sharing. Will definitely be sure to validate how I’m supposed to handle security deposits in my state..,but I think the separate interest bearing bank account is the correct path.
Dan
Everybody has their own strategy - here's what I do:
Property Tax Reserve - this is simple...take your estimated property tax and divide it by 12. Plan to pay from this reserve twice per year.
Repair Reserve - 10% of gross rents. This can be a revolving account depending on when repairs are made
Capital Expenditure Reserve - this equals my depreciation expense every month on my rentals (i.e. - if you have a stove with a 7 year life, you will be completely reserved for a new stove in 7 years)
"Vacay/NoPay Reserve" - I take the vacancy rate in the rental property area (most national real estate sites have estimates) and multiply it by gross rents. I add 5% of gross rents to that as a legal reserve for evictions, etc.
You will be under reserved for about the first two or three years mostly because of the capital expenditure reserve amounts. Eventually it will catch up to itself if you don't pay yourself during that time. You could also add to that balance every month to start, or get a line of credit to borrow against just in case.
My reserve funds sit in a business savings account - this is a revolving account and I will usually net current month activity against reserves (if I have a repair reserve of $20, and I paid out $10, then I will record the repair expense of $10 and add $10 to my reserve).
I should also add that I use project based accounting....so I can track each property individually through my accounting reports.
Hi Ed,
The step by step approach is really helpful. Appreciate you providing insight as to how you manage your reserves. How did you determine your allocation percentages?
Dan
Honestly, I asked myself the same question you are asking. The standard answer I hear for repairs is 10%. When I calculated 10% of gross rents, I quickly figured out, it may or may not be enough. I have three rentals - $725 per month, $600 per month, and $795 per month. When taking into account each house individually, $72.50 per month at 10% for repairs isn't too much in the grand scheme of things. My properties are outside my immediate area - last month, I had to pay a handyman to replace the flush valve on a leaky toilet - on one property - that was $50. I had to pay an exterminator at the $600 per month property $75 because they complained about crickets, and I had to pay $115 to a plumber at the $725 per month property to go out on a Sunday and re-attach drain pipes under the kitchen sink. Repairs go quick and at 10%, I feel it's a reasonable month to month estimate. Again, it's a revolving fund. Think about how much it's going to cost you to flip the unit based on normal wear and tear when your tenant leaves. I capitalize anything over $2,500 - which leads me to the Capital Expenditure reserve.
Capital Expenditures - based on monthly depreciation. I use Xero for accounting software. I calculate depreciation monthly. My depreciation expense per property is my capex reserve. As mentioned, if I have a stove with a useful life of 7 years, then I need to reserve the value of the stove over 7 years. I use MACRS depreciation method as opposed to straight line so if I need to replace it in 5 years instead, most of that cost is covered. Same goes for the general structure, replaced roof, etc., etc.
My "Vacay/No Pay" reserve as mentioned has two components. First is the vacancy rate for that area. Usually you can find a website that has historical data. A quick Google search will get you to multiple websites that will give you this info. Here's a quick example => https://www.apartmentlist.com/rentonomics/rental-v... If the vacancy rate is 8% then I take 8% of gross rents. On a one year lease at $725 per month, that works out to $696 which gives me about 4 months worth of reserve for utilities on that property. The second component is a 5% reserve for evictions and legal costs associated with non-paying tenants. On that one year lease at $725 per month, that works out to about $435 which will cover fees associated with having my property manager do the work for me and is a good start with relation to court costs.
My rentals are owned outright so it's easier for me. If you have a mortgage on a property (taking the $725 per month example), your vacancy reserve may need to be a little higher so you can cover that mortgage.
It gets much easier when you have more than one property funding your reserves at one time. As mentioned, your Capex reserve is going to make you under-reserved for about the first 2 or 3 years simply because of how MACRS depreciation works (you're depreciating up to 20% of the capitalized item in the first year alone depending on the useful life of the item).
Hey Cara,
Really enjoyed your feedback, thank you. My lender just got back to me so you are 100% correct, she informed me that I need 6 months reserves. She specified for 3 and 4 family properties, so I asked what about 2 family. I assume its the same, but we shall see.
I never knew that bit about being required to have 6% of your total loan balances in addition to 6 months reserve for the subject property. Now I'm beginning to see how difficult it might be scaling your real estate portfolio and how valuable your 401k becomes.
Will definitely include CapEx into my expense calculations.
Interested in finding out more about home warranty's. If you find any articles that do a good job explaining them in detail, please feel free to send this way! I'm gonna see what I can dig up.
Thanks,
Dan
Funny that you mention it.... I started a discussion debating the pros and cos (and the differences between) of Home Warranties. You may want to follow it. People tend to be pretty split when it comes to home warranties and their value. I think what has become clear though is that there are some obvious stand outs on companies... and you have to know what kind of exclusions the warranty will have (galvenized pipes, esbestos, etc), and you have to be a patient person as many times the repair takes a week or longer to facilitate through the warranty.
I still maintain that a home warranty is the way to go when you are starting out on a budget and building reserves. All it would take is 1 HVAC to go out to through you into a panic if you didn't have the funds. I guess it's like having homeowner's insurance. You hope you never have to use it, but when you do, you are thankful it is there.
Everybody has their own strategy - here's what I do:
Property Tax Reserve - this is simple...take your estimated property tax and divide it by 12. Plan to pay from this reserve twice per year.
Repair Reserve - 10% of gross rents. This can be a revolving account depending on when repairs are made
Capital Expenditure Reserve - this equals my depreciation expense every month on my rentals (i.e. - if you have a stove with a 7 year life, you will be completely reserved for a new stove in 7 years)
"Vacay/NoPay Reserve" - I take the vacancy rate in the rental property area (most national real estate sites have estimates) and multiply it by gross rents. I add 5% of gross rents to that as a legal reserve for evictions, etc.
You will be under reserved for about the first two or three years mostly because of the capital expenditure reserve amounts. Eventually it will catch up to itself if you don't pay yourself during that time. You could also add to that balance every month to start, or get a line of credit to borrow against just in case.
My reserve funds sit in a business savings account - this is a revolving account and I will usually net current month activity against reserves (if I have a repair reserve of $20, and I paid out $10, then I will record the repair expense of $10 and add $10 to my reserve).
I should also add that I use project based accounting....so I can track each property individually through my accounting reports.
Hi Ed,
The step by step approach is really helpful. Appreciate you providing insight as to how you manage your reserves. How did you determine your allocation percentages?
Dan
Honestly, I asked myself the same question you are asking. The standard answer I hear for repairs is 10%. When I calculated 10% of gross rents, I quickly figured out, it may or may not be enough. I have three rentals - $725 per month, $600 per month, and $795 per month. When taking into account each house individually, $72.50 per month at 10% for repairs isn't too much in the grand scheme of things. My properties are outside my immediate area - last month, I had to pay a handyman to replace the flush valve on a leaky toilet - on one property - that was $50. I had to pay an exterminator at the $600 per month property $75 because they complained about crickets, and I had to pay $115 to a plumber at the $725 per month property to go out on a Sunday and re-attach drain pipes under the kitchen sink. Repairs go quick and at 10%, I feel it's a reasonable month to month estimate. Again, it's a revolving fund. Think about how much it's going to cost you to flip the unit based on normal wear and tear when your tenant leaves. I capitalize anything over $2,500 - which leads me to the Capital Expenditure reserve.
Capital Expenditures - based on monthly depreciation. I use Xero for accounting software. I calculate depreciation monthly. My depreciation expense per property is my capex reserve. As mentioned, if I have a stove with a useful life of 7 years, then I need to reserve the value of the stove over 7 years. I use MACRS depreciation method as opposed to straight line so if I need to replace it in 5 years instead, most of that cost is covered. Same goes for the general structure, replaced roof, etc., etc.
My "Vacay/No Pay" reserve as mentioned has two components. First is the vacancy rate for that area. Usually you can find a website that has historical data. A quick Google search will get you to multiple websites that will give you this info. Here's a quick example => https://www.apartmentlist.com/rentonomics/rental-v... If the vacancy rate is 8% then I take 8% of gross rents. On a one year lease at $725 per month, that works out to $696 which gives me about 4 months worth of reserve for utilities on that property. The second component is a 5% reserve for evictions and legal costs associated with non-paying tenants. On that one year lease at $725 per month, that works out to about $435 which will cover fees associated with having my property manager do the work for me and is a good start with relation to court costs.
My rentals are owned outright so it's easier for me. If you have a mortgage on a property (taking the $725 per month example), your vacancy reserve may need to be a little higher so you can cover that mortgage.
It gets much easier when you have more than one property funding your reserves at one time. As mentioned, your Capex reserve is going to make you under-reserved for about the first 2 or 3 years simply because of how MACRS depreciation works (you're depreciating up to 20% of the capitalized item in the first year alone depending on the useful life of the item).
Hey Ed,
Excellent feedback, thanks for providing such detailed insight into your strategy!
Dan