The Reserve Expense Prinicple of Property Analysis

[Kirk B]

I was looking at a property that had extremely high taxes in relation to Gross Rents:

2 apts $500 ea, $1,000 Gross
Taxes: $4,250/yr $355/month
Insurance: $600/yr $50/month

50% of expenses = $500

Actual expenses (pro forma):
Taxes $355
Insurance $50
Property management $100
Expenses: $505
Reserve = -$5

Therefore I know that expenses will exceed 50%.


This is an extreme example. But I have evaluated several local properties and noted significant differences in "Reserve Expenses" When evaluating Gross rents in relation to operating expenses.

We all know that long list of operating expenses that are incurred infrequently "Reserve Expenses": evictions, roofs, repairs, vacancy, advertising, lawn, rental registry, etc... When evaluating a property using the 50% rule I like to create a mock income statement based on things I know like taxes, insurance, property management, and total operating expenses. Look at the income statement below:



There is a Reserve of only $57 per month per unit or $1,368/yr. That seems like a small amount to cover all of the "reserve" operating expenses.

Do you think that I should have a minimum "Reserve Expense" that is born out of the things you do know with relative certainty such as the taxes, HOA fees, insurance, and property management? Wouldn't this make the analysis much stronger?

If you take two properties that are exactly identical except one has higher taxes, should you enhance your analysis so you see the difference.

[Michael Rossi]

If you know that a property is an "extreme example" of high expenses, then I wouldn't buy it unless I could get the expenses back down to normal (50%). I certainly wouldn't intentionally buy a bad deal and then put money aside in a reserve account to make up for the loss. Furthermore, I wouldn't buy a property that has HOA fees or owner-paid utilities as that is an invitation to disaster. So, in answer to your question - no, I wouldn't set up a minimum reserve expense, I'd just move on to the next property.

If the problem with the expenses is high property taxes, then I would check with the taxing authority to see if they could be lowered. It could be the taxes were based on a previous sale at an inflated price during the bubble or it could be the high taxes are just a mistake. Also, some areas have higher taxes, but those are offset by other expenses that are lower. If you're going to try to itemize the expenses, you need to itemize all of them.

Mike