Over the past three years that I’ve been in the rental business, November 2012 went down as one of the most expensive months to date. Whether it’s deferred maintenance, general wear-and-tear or vacancy related costs, the reality is holding that rental property is not cheap. Curious what my last month looked like? Here are a few highlights with notes:
Here are a few highlights with notes:
10.6. 12: Tenant in Glenwood property late on the rent ($550).
10.9.12: Work order on Auburn Duplex – re-pipe one unit ($3,400).
10.11.12: Work order on Baylor property – replace water heater and garage door hinges ($705).
10.22.12: Work order on Berkley property – fix leaking toilet and repair damage from leaking roof ($465).
10.25.12: Work order on Cedar property – furnace servicing ($235).
10.29.12: Vacancy in Cherrywood property – 2 months revenue loss ($1,860).
If you’ve been keeping count, that’s a grand total of $7,215 in additional expenses. I should mention that most months I don’t hear from my tenants and things run on auto-pilot, but on occasion I have a month where all hell breaks loose. It’s easy to see how failing to hold a sufficient amount of cash reserves can easily wipe out an investor’s portfolio.
Whether in liquid cash or in available lines of credit, reserves are essential to keeping a healthy rental portfolio. Out of curiosity, I spent a few hours browsing the threads here on BP and I came across differing philosophies on the matter.
I’ve generalized the various approaches into three separate categories below:
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Three Views: How Much Liquid Reserves Should I Have For My Rental?
The Gambler: This is the investor who has little in cash reserves. They’re likely to use mainly lines of credit and little, if any, cash. Their philosophy is to reinvest all positive cash flow back into their business in order to acquire new properties. This might sound risky to some readers, but if executed prudently, it can be a great way to rapidly grow a portfolio.
For example, if you have $25,000 held in the bank for cash reserves, you would be earning ZERO dollars in interest. “The Gambler” on the other hand would rather hold the reserves in a home equity line of credit where the capital is still earning interest (in the form of cash flow) and allows them to use their liquid cash to fund additional deals.
The big downside here is that banks can change their policies at will and if the line of credit has not been pulled, this investor might not be able to access the credit if cash were needed.
Average Joe: This investor likes formulas and rules of thumb to determine the amount of cash they should have on hand for their rental business. I’ve rolled a few of the more prominent ideas below:
- Keep 3 months of mortgage payments, per property
- Keep 6 months of mortgage payments, per property
- Maintain $2,000 in cash, per unit
- Maintain $5000 in cash, if you own less than four single-family homes
- Maintain $10,000-$15,000 in cash, if you have more than 5 but less than 10 single-family homes
“Joe” keeps his reserves in a separate bank account specifically for his rental business and does not co-mingle his personal accounts with the business. This might seem like an obvious point, but many new investors never open a separate account and have no idea how much money they are making or losing each month.
The Goodie Bag Investor: “The Goodie Bag” investor doesn’t hold all their reserves in cash or in credit lines, but uses a combination of the two philosophies listed above.
Typically they have a dollar amount they feel comfortable with (let’s say $25,000), so they would keep $15,000 in liquid cash deposited in the bank and hold the additional $10,000 in a line of credit. The goal for this investor is to always maintain $25,000 on hand. Once the reserve is met, they will divert the excess cash to different ventures within the business – direct marketing, new acquisitions, etc.
On a personal note, I most identify with the last strategy. I feel it maximizes security without tying up too much capital.
I still think owning rental property is the best way to build long-term financial security, but I’ve also been doing it long enough to know that expenses are a very real part of the business. In closing, I’d like to quote a fellow BP member, Jon Halderman, because I feel his quote sums up my philosophy best:
“…I think having sufficient reserves to weather a downturn is more important than adding to your business. If a furnace fails in the middle of winter, you MUST have cash or credit to get that working ASAP… failures or sudden tenant move-outs can happen at any time. If you can’t cope with that, your rental business will crater when (not if) this happens.”
Readers: how do you determine the amount of cash you have on hand for reserves? Leave a comment below!
Photo: Ian Roberts