The Importance of Reserve Accounts (Or What a Surprise Roof Replacement Taught Me)

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I feel like I read Forum posts constantly talking about how important or unimportant reserves are. Are they really necessary? Why not apply that cash to whatever I purchase, giving me the ability to purchase more? I see it on BiggerPockets and other business forums I frequent. The fact is that people new to business underestimate the importance of reserve accounts – just like I did.

For those of you who don’t know, I purchased my first investment property earlier this year. It’s a multi-family located about 400 miles away from where I currently live (you can read about my due diligence process for investing at a distance here) and will be a cash cow… after I replace the roof.

Yep, you read that right, not even four months into my investment, I find out I need to replace the roof. I can hear you calling me “rookie,” which I may deserve, but not so fast!

Being a finance/accounting guy, I spend hours building and enhancing financial models (sometimes just for fun) and understanding how different variables affect overall outcomes of cash flow, return on investment (ROI), internal rate of return (IRR), net operating income (NOI), etc. Inclusive in every financial model I build is a “Capital Expenditure” section, which breaks out all the property’s components into estimated remaining life and cost to replace such components. My estimates were developed based on various contractors that I had inspect the property during my due diligence period. I determined the monthly amount needed to be set aside for capital expenditures, and I have appropriately accrued based on my estimates.

Related: How to Determine Your Multifamily Capital Expense Budgets and Recurring Replacement Reserves

I knew the roof was an upcoming project, as in needing to be replaced within the next four to five years. It’s a mansard roof and had a few shingles missing on the vertical portions, which my contractors told me not to fret over. I figured I could get by with repairs or a patch job, which would hold me over until I decided to replace it.

I took these expenses into account, and the property was still a sweet deal for my desired hold period. I went through with the purchase and have been sitting pretty ever since. Until last week.

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Where I Went Wrong

I thought I did everything right, my due diligence was extensive in nature and I was confident about the purchase. Sometimes, though, there are things that you just can’t predict regardless of whether you have done no deals or hundreds.

What I didn’t account for was my insurance dropping me from their policy because shingles were missing from the roof. I can understand their concern – who wants to insure a place when the roof is missing shingles and, as a result, subject to a higher risk of requiring a large insurance payout?

They sent notice that if repairs weren’t done within 20 days, they would be terminating my policy. To mitigate their concerns, I needed to provide visual evidence that the repairs had been made. If 20 days was not enough time, I would have the option to reinstate the policy after repairs were completed.

My truly awesome property manager contacted various roofers around the area and had them provide me with estimates. As I was receiving the estimates, I noticed they were quoting me on a full re-roof job. That’s not what I wanted, so I called each of them to discuss.

Each of them said something similar to, “the roof is in such bad shape that a repair really isn’t worth it, and you should just go ahead and do the re-roof.” I have no idea whether it’s true that a repair wouldn’t suffice, or if the contractors just wanted a bigger job with more profit involved. In either case, the message was clear: nobody was simply going to repair my roof. This meant I had to replace it, and 20 days isn’t nearly enough time to get such a job completed. So now I was racing against the clock.

Luckily, the property’s roof is a mansard, which is inherently more expensive to replace (that’s sarcasm, people). How expensive? About 7-8 months of the free cash flow the property is on track to generate. Lovely.

Again, I did account for the capital outlays; however, I had expected the re-roof to occur in or around 56 months.

The Importance of Reserves

When I purchased the property, it had nearly tapped me out in the cash department. I figured I could take on the extra risk of having limited reserves because I’m young and have a solid monthly income. The plan was to stash away my income from both my W2 job and the rental property for a month or two and call that my “reserves.”

But a new roof requires a bit more than what I had planned as reserves. As I said, the expenditure will amount to 7-8 months of the property’s free cash flow, and since I have not yet owned the property for that amount of time, I need to tap into the small reserve account I was building up.

I’ll admit I consider myself lucky here; my side CPA business has taken off and allowed me to bank extra cash quickly. It allowed me to roll those earnings into the roofing job and still keep my financial goals intact. If I didn’t have my CPA business, I wouldn’t be under financial strain, but I’d certainly be sweating.

Related: Is Optimism Killing Your Budget? How to Mitigate Risk by Playing Devil’s Advocate

If I didn’t have the money for the re-roof, I’d have to wait a couple more months for the property to generate enough cash for the project. By that time my insurance company would have dropped me, and I would be at the mercy of a new insurance company my mortgage provider decided to stick me with, likely costing more and further digging into the cash flow the property generates.

Reserve accounts give investors the ability to adapt to changing situations quickly. I have certainly learned from this experience and will always keep a good sized reserve account on hand just in case something unforeseen happens.

Conclusion

Don’t neglect your reserve accounts, and don’t buy properties that completely tap you out in the cash department. I was lucky enough to lean on the earnings generated from my side CPA business. I’m still excited about the property, as even with the surprise capital expenditure, the IRR over my hold period is still fantastic.

I can’t tell you how much to keep in reserves, but in the future, I’ll be sure to keep at least as much of the cost of a new roof.

Investors: Have you ever found yourself in a situation where you were glad you had some reserves on hand?

Let us know your experiences in the comments section below!

About Author

Brandon Hall

Brandon Hall, owner of The Real Estate CPA, is an entrepreneur at heart who happens to be good at taxes. Brandon is a real estate investor and CPA specializing in providing business advice and creative tax strategies for real estate investors. Brandon's Big 4 and personal investing experiences allow him to provide unique advice to each of his clients. Sign up for my FREE NEWSLETTER to receive tips and updates related to business and taxes.

15 Comments

  1. John Thedford

    Welcome to RE investing. My current situation: roto rooter last night; need new compressor for a/c in different house; need new privacy fence on another house. I will write checks for these. Putting money aside is your best option. My insurance company did the same thing on one of my roofs. Replace it or be dropped.

    • Brandon Hall

      Hey John – welcome to RE investing indeed! I don’t feel too burned as I had anticipated replacing the roof within 3-4 years and I estimated the cost to do so appropriately. But I wasn’t expecting to do it so soon. I can’t imagine how investors that don’t estimate capex get by.

  2. This is too late to help you, but could help other investors. I had no idea this was even possible until I was looking into buying a franchise, and they put this into the loan request to the bank. They asked for the monthly payments on the loan to begin 6 months after closing. Of course, the extra 6 months are tacked onto the end of the loan term. I ended up not buying the franchise, but used the idea when I purchased an apartment complex. The bank had no problem with doing this. It allowed me to use the first 6 months of rent to establish a reserve account, so that I had plenty of money available when the property needed a new roof, etc.

  3. Sandra Rea

    I enjoyed this article. It’s funny that I saw it in my email box when I did, because my investment partner and I JUST had this conversation about the importance of reserves. He is UBER conservative on that side; me… not so much. But you just changed my mind. I sent my partner a link to your article!

    We are looking at a property here in southern CA that has a good roof, and when my partner said we need to make sure we have reserves enough for a new roof, I thought he was being overly careful. Maybe not, huh? One never knows what the future holds and it’s better to be prepared.

    We use private capital for our deals, so there is no bank in our case, but the six-month delay in payments or even longer is always part of the conversation. Especially when a rehab is involved.

    Anyway, great piece!!!

    Enjoy your life as an investor. It really does beat anything else I have done or do. I don’t know what it is about REI that tickles my fancy, but it works for me. And I’m new at it, too, BTW.

    Educated a long, long time ago and passion re-ignited only over the past few months. ; )

    • Brandon Hall

      Hey Sandra – thanks for reading and commenting. Yeah as I said the roof was expected, but certainly not so soon. It’s really the fact that none of the contractors will do a simple repair that nailed me. So yeah, reserves are important 🙂

  4. Ben Rasche

    Great article Brandon. Very timely as I’ve been trying to decide how much to keep in the reserve account. As you aquire more units, how do you plan on figuring your reserves? Would you suggest a certain percentage of gross rent per door? Also, I know several banks require 6 months worth of mortgage payments in the bank prior to lending. Do you feel this is enough?

    • Brandon Hall

      Hey Ben – 6 months worth of payments is not enough. There are many ways to calculate capex reserves. The method I most commonly use is to determine “today’s total cost per component” then find the future value of that component based on the number of units I own and inflation. I then determine how much I need to accrue per month for capital expenditures and how much I need annually.

      Unfortunately, that method doesn’t always work as a capital component could require fixing much earlier than anticipated (as I found out). In the future, I will probably look at the property and ask “if x component had to be replaced tomorrow, would I have enough to fund the repairs?”

  5. Paul Halphen

    I also had trouble with insurance not wanting to cover roofs that had plenty of life left in them.

    Unfortunately, you have already replaced your roof. But, next time talk to a quality insurance broker and they will find you a good carrier that will cover your roof or let you have a roof exclusion. No one likes insurance folks or bankers forcing your hand and advancing your capx. Happy to give you a referral or specific insurance rec’s.

  6. Paul Halphen

    I find handymen are a lot more willing to do such a repair. Roofing companies don’t want to put their name on it which makes sense.

    I also had trouble with insurance not wanting to cover roofs that had plenty of life left in them.

    Unfortunately, you have already replaced your roof. But, next time talk to a quality insurance broker and they will find you a good carrier that will cover your roof or let you have a roof exclusion. No one likes insurance folks or bankers forcing your hand and advancing your capx. Happy to give you a referral or specific insurance rec’s.

  7. A surprise roof replacement would definitely cause disruption in your budget. Getting some major roof repairs is quite costly itself, let alone a complete replacement. This is why people should develop a habit of always having some reserve cash at their disposal, in case of such emergencies.

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