Unexpected Capital Improvement
Rental Property Investor · Waukesha Pewaukee, WI · Member since 2020 · 13 posts · 1 vote
I have not run across anyone talking about building or having a reserve fund for a property. What is The recommendation to accrue and pay for a unexpected capital upgrades, i.e. furnace, roof, sewer, parking lot, windows, etc. when you are just covering expenses at 10/12% cash-on-chash returns?
@Account Closed, hi and welcome to BP!
First, without any disrespect to our colleague Bjorn, I take serious exception with this statement: "You can build a reserve fund with help from security deposits..."
That is ILLEGAL in my state. Per the Revised Statutes of Missouri: 535.300. Security deposits, limitation — holding of security deposits, "All security deposits shall be held by the landlord for the tenant, who is a party to the rental agreement, in a bank, credit union, or depository institution which is insured by an agency of the federal government. Security deposits shall not be commingled with other funds of the landlord. All security deposits shall be held in a trust established by the landlord and deposited in a bank, credit union, or depository institution account in the name of the trustee."
If you'd like that in plain English: the money belongs to the TENANT and you are holding it in trust for them in an account that is dedicated for that purpose. It is not your slush fund to play with or repair the HVAC, period. I know a lot of Mom and Pop land lords who fly under the radar don't do this properly, and there are precious few times the tenant would actually sue someone over this, and there isn't any formal auditing. BUT! A shortage of litigation and someone peaking over one's shoulder doesn't give anyone the excuse to break the law.
I now decend from my soap box. (*grins)
You should be setting aside approxilately 3-7% of your monthly gross potential market rents--regardless if units are rented or vacant--each month in anticipation of Capital Expense repairs. I'm worried that you're "not run[ing] across anyone talking about building or having a reserve fund for a property." That tells me you are not reading good source material, or not reading a sufficient amount of source material.
Some gurus and pod-casters are notorious for glossing over the realities of running a rental business. All they talk about is how to go from 0 to 3,000 doors in 2 years using OPM. All that's missing is the 1980's late night infomercial dude with his Lambo on the beach with three hot bikini girls.... am-i-right?
Capital repairs WILL happen, and they should not be unexpected. You know that the sun, rain, and hail are constantly beating up the roof and siding. You know the heat and air systems are constantly running even when the place is vacant to control humidity and/or reduce thermal expansion and contraction of inside elements (and avoiding frozen pipes in Wisconsin!). You must be prepared.
A credit card/LOC are bad options: going into debt for known expenses tells me cash flow is too poor and the property is not performing. It's a terrible thing to pay off a property in 20 years, only to have to go back into debt for 10 more years to redo the whole place.
Why use gross potential rents instead of actual rents? Again, because CapEx items are wearing out regardless if you are rented or not. The weather doesn't take off 3 months to account for your vacancies, so neither should your contributions to a CapEx fund.
Anyway, my suggestions are above. And dig into more authors/SMEs (subject matter experts) and you will absolutely find people talking about this topic extensively.....at least, the ones who are still in business after 10+ years. *wink
I hope this helps!
@Account Closed This is pretty common. In fact, on any purchase a reserve should be already present and then a percentage of rental income needs to be put aside for large expenses or capital expeditures, capex. The bigger the purchase the bigger the reserve up front.
For up front reserves on apartments, $250 a door is good up front. So on a 12 unit, 12 x 250 = 3000 reserves.
For continued capex, anywhere from 3-8% of rental income is typical depending on size and age of the property.
@Account Closed I have set aside about 5 mos gross rent. You can build a reserve fund with help from security deposits and excess rents. Make sure you have enough to cover surprises they will happen.
Chris thank you for the guidance.
@Bjorn Ahlblad Security deposit funds are an interesting option.
@Account Closed, hi and welcome to BP!
First, without any disrespect to our colleague Bjorn, I take serious exception with this statement: "You can build a reserve fund with help from security deposits..."
That is ILLEGAL in my state. Per the Revised Statutes of Missouri: 535.300. Security deposits, limitation — holding of security deposits, "All security deposits shall be held by the landlord for the tenant, who is a party to the rental agreement, in a bank, credit union, or depository institution which is insured by an agency of the federal government. Security deposits shall not be commingled with other funds of the landlord. All security deposits shall be held in a trust established by the landlord and deposited in a bank, credit union, or depository institution account in the name of the trustee."
If you'd like that in plain English: the money belongs to the TENANT and you are holding it in trust for them in an account that is dedicated for that purpose. It is not your slush fund to play with or repair the HVAC, period. I know a lot of Mom and Pop land lords who fly under the radar don't do this properly, and there are precious few times the tenant would actually sue someone over this, and there isn't any formal auditing. BUT! A shortage of litigation and someone peaking over one's shoulder doesn't give anyone the excuse to break the law.
I now decend from my soap box. (*grins)
You should be setting aside approxilately 3-7% of your monthly gross potential market rents--regardless if units are rented or vacant--each month in anticipation of Capital Expense repairs. I'm worried that you're "not run[ing] across anyone talking about building or having a reserve fund for a property." That tells me you are not reading good source material, or not reading a sufficient amount of source material.
Some gurus and pod-casters are notorious for glossing over the realities of running a rental business. All they talk about is how to go from 0 to 3,000 doors in 2 years using OPM. All that's missing is the 1980's late night infomercial dude with his Lambo on the beach with three hot bikini girls.... am-i-right?
Capital repairs WILL happen, and they should not be unexpected. You know that the sun, rain, and hail are constantly beating up the roof and siding. You know the heat and air systems are constantly running even when the place is vacant to control humidity and/or reduce thermal expansion and contraction of inside elements (and avoiding frozen pipes in Wisconsin!). You must be prepared.
A credit card/LOC are bad options: going into debt for known expenses tells me cash flow is too poor and the property is not performing. It's a terrible thing to pay off a property in 20 years, only to have to go back into debt for 10 more years to redo the whole place.
Why use gross potential rents instead of actual rents? Again, because CapEx items are wearing out regardless if you are rented or not. The weather doesn't take off 3 months to account for your vacancies, so neither should your contributions to a CapEx fund.
Anyway, my suggestions are above. And dig into more authors/SMEs (subject matter experts) and you will absolutely find people talking about this topic extensively.....at least, the ones who are still in business after 10+ years. *wink
I hope this helps!
Erik thank you for your great response. This is exactly what need to be discussed more, how to plan and protect an investment. Good advice.
@Account Closed The 10-12% ROI is after taking in account vacancy, repairs and capex. You are a pro member so you can start analysing properties. You need to understand the numbers you input. The calculator uses percentages. I see a lot of investors use 5% which is 1 vacancy in 20 months. I use 8% or 1 vacancy in 12 month ( rounding). Repairs are a function of how many service calls. I usually use 5%. Capex can be determined by downloading a spreadsheet by @ sam tato in the files section. My capex budget includes but not limited too: Roof 25 year life span, floors 10 year life span, appliances and hot water heater 12 years, hvac 20 year life span, bath and kitchen remodel 20 year life span, etc. I normally use 10%. You need to also include property management 10%. The object is to get big enough that you need property management.
Tim thank you - these look like good guidelines to manage expenses. Also good advice in the planning and consideration when placing an office.
@Account Closed I have set aside about 5 mos gross rent. You can build a reserve fund with help from security deposits and excess rents. Make sure you have enough to cover surprises they will happen.
You can’t touch security deposits. They are to be held in a trust account as this money belongs to the tenant not the owner. You are holding this in trust.
I have not run across anyone talking about building or having a reserve fund for a property. What is The recommendation to accrue and pay for a unexpected capital upgrades, i.e. furnace, roof, sewer, parking lot, windows, etc. when you are just covering expenses at 10/12% cash-on-chash returns?
Most lenders are going to require a reserve account to be funded before you close the property. You can do this through your own funds or through the capital raised from investors. The amount will depend on the age, condition, type of property etc. the amount of CapEX reserves moving forward will also depend on the property as described above. Also your monthly reserve amount should be included in the operating cost of the property for P&L purposes. Many brokers will not do this as the want to boost the NOI but the banks will take this off your NOI when they underwrite the deal as it is part of the expense of operating a property. The actual capital expense is not an operating cost but the monthly reserve amount is.
I have not run across anyone talking about building or having a reserve fund for a property. What is The recommendation to accrue and pay for a unexpected capital upgrades, i.e. furnace, roof, sewer, parking lot, windows, etc. when you are just covering expenses at 10/12% cash-on-chash returns?
If you haven't run across the discussion, this means you have not done much digging on the forum. This is a vital issue that is discussed here often. You can find countless discussions on the topic here. No, there haven't been many (any?) lately - not sure why.
Property physically depreciates whether it is occupied or not! You, as the owner, will have to pay for these as they come up. Because certain repair items occur at much longer intervals than "normal" repairs, people tend to place them in a separate category of repairs, often called Capital Expenditures or Capex for short (there are tax reasons too). However, the truth is a repair is a repair is a repair and all of them ought to be foreseen, especially the ones we call capex (a roof or furnace for instance).
The best way to predict and prepare is to have a reserve study done. This is commonplace for a condo association (law in WI maybe?) and there are companies that provide the service. However as an investor, this is really something you ought to learn how to do yourself for your own properties.
A reserve study breaks a property down to the component level, assesses the current conditions of components, and estimates the likely timing of repairs, with an estimate of cost that includes an allowance for inflation. Armed with this information, an owner can more accurately predict and prepare for the expense.
This is however tedious, complicated, and inevitably inaccurate (because things wear out faster or last longer than predicted) and what most investors do is ballpark the whole thing. Once an investor has enough money in the bank to handle any major repair, and enough cash flow to replenish that reserve, they pretty much let things be and move on. This is much easier to do when an investor has multiple properties bringing in income, and what ends up happening is the properties that don't need repairs at the moment end up paying for the ones that do. This is why disciplining yourself to take a certain amount of rents from all properties and lumping them into a single fund makes a lot of sense. Many investors reserve between 5-10% of total rents for capex alone, and another 5-10% for other repairs. As it turns out, one months rent is 8.33% of annual gross rents, so often the reserve is based on a months rent annually. However, the actual cost of repairs may not be in alignment with what you are charging in rents!!!
Another strategy is to make sure you have credit and equity. That way you can simply pull a home equity loan or whatever works to pay for a large expense as it happens.
Welcome to BP neighbor. I live in the village.
This is all great input, thank you all for the discussion input and I am sure it is well apprieiated by many existing and newer investors out there.
@Anthony Waite - I'm a SFH investor and I keep a minimum of 6mo PITI per property in reserves at a minimum with 15% gross rents added to it per property per month. When the it reaches a point that I have my minimum reserves covered and another down payment and minimum reserves for another property acquisition, I buy another property. This puts me in a position to acquire new properties on an every 18mo timeframe.
@Account Closed I have set aside about 5 mos gross rent. You can build a reserve fund with help from security deposits and excess rents. Make sure you have enough to cover surprises they will happen.
You can’t touch security deposits. They are to be held in a trust account as this money belongs to the tenant not the owner. You are holding this in trust.
In the state of Wa you can keep security deposits in a shoe box under your bed as long as they are accounted for.
I think just holding back $100-150 per door per month would be a fairly safe bet depending on how much you've done to the home when you first purchased it.
@Anthony Waite to echo other’s, using security deposits is a huge no no. That is the tenants money until move out and any claims made against it.
@Account Closed
I agree with the security deposits. Leave them alone. Check your state and/or city requirements. On SFR I use 6 months of expenses. I also account for capex. I break out each component; it typically comes to around 10% of rent. This also applies to my multi tenant buildings. I'm fairly conservative or at lease as conservative as you can be as an investor. It's an oxymoron. To be a successful investor you definitely need to step out of your comfort zone. As a rental investor you always need to plan for the unexpected. Be prepared.
@Anthony Waite. You should have 3 accounts
Capital reserves - this is replacing things (e.g., appliances, roof) or improvements. You should put away $250-$350/yr based on property vintage. In some cases could be higher especially if you know you are planning for something.
If your property is large enough a cost segregation study will give you an exact accounting of everything on your property and the typical replacement timeframe, along with the depreciation benefits.
Operating Reserves - 3 months of operating expenses is typical. This is to cover general daily business expenses and occupancy volatility.
Rain day fund - this is for the unknown. Another 3 months of operating expenses. For example, If you have a property built before 1980 with corrugated steel drain pipes, I’d be putting some away for when that backs up.
It's surprising that you have not run across anything talking about reserves. Reserves is a must and always included in the underwriting process. Every year, you need to budget a certain amount of reserves on top of the original reserves you have.
@Account Closed
DO NOT use security deposits as a reserve fund, that is not your money. It is protected and should be in a separate account as you owe the tenant that money back when they vacate if they live out their lease and return the unit to you in acceptable condition.
If however, they do cause undue damage or break the lease then any forfeited deposits you can move over to your reserve account.
@Chris Levarek Thank you for such great advice on having a reserve fund and how to build one.
I just watched a good overview video from BiggerPockets that maybe helpful to newer investors regarding expenses including CapEx. check-it-out https://www.biggerpockets.com/intro-to-rei/expenses?save=1