When you first acquire a real estate asset, you venture into the world of property management – that means you will need to learn and understand how a property is maintained, and more importantly, how much capital you need to ensure that your property continues to have the ability to operate. This cash is known as the reserve fund and is the available money that you set aside in order to protect yourself in case there cash flow needs that for one reason or another you will need. You must always be able to cover the property’s expenses, including potential instances of vacancy, damage, etc. Sometimes and some landlords also like to build up the reserves for capital improvements. The amount in your reserves account can vary depending on asset types, property condition, location, and the list or factors goes on. Therefore, my goal in this article is to outline what reserves are and why they are important, as well as to provide insight on how to calculate the amount I would want in my reserves account. Everyone is different and this is strictly subjective but I have found this formula mitigates possible risks and protects the property.
On a side note, the COVID 19 pandemic taught us how sometimes suddenly an income producing asset can STOP producing that income and you still need to pay for expenses. The properties that had reserves were able to weather the storm. The properties that didn’t may have been sold as a distressed sale, may have missed mortgage payments or had to do a workout with lenders. You never know when you will need the cash, so if you are a long term holder, you need to prepare for the long term bumps.
What Are Reserves?
Reserves refer to the savings set aside by a property owner or business that are allocated to meet any future costs or financial obligations, especially those that arise unexpectedly. A reserve fund is typically kept in a highly liquid account, such as a savings account, because expenses may arise unexpectedly. You do not want this money tied up in the case of an emergency.
You will also want to keep in your reserve fund finances for capital expenditures, or CapEx. This is the money used to add to or improve a property beyond typical repairs and maintenance. It includes capital needed for a new roof, HVAC, or construction needed to add value to your property.
How Much Should You Have in Your Reserve Account?
This is one of the most common questions new investors ask when they acquire their new property – It is an extremely important concept to understand to ensure that you are covered if something were to happen. Unfortunately, there is no simple answer for this, and instead of adhering to a hard and fast rule, the amount in the reserve fund will depend on a few variables. The specific amount should be identified when developing one’s investment strategy. Here are a few examples of common ways to calculate your reserve fund:
- Six months of operating costs; this includes how much it would cost to maintain the building at zero percent occupancy. This is often the preferred method and the one required by lenders?.
- Saving a specific amount per square foot of your building; for example, $0.15 to $0.25 per square foot for a retail building, with $0.15 being moderate and $0.25 being conservative.
- Two to three months of gross rent per unit for an apartment.
No matter what strategy you use to determine the reserve amount, make sure that you have a specific number identified – Your goal will be to save this fund as quickly as possible before money goes to ownership(s).
How Do You Save for your Reserve Fund?
No, you do not need to have the capital readily available when you purchase the asset, although it is generally a safe rule to have it at acquisition. Instead, you could allocate a specific amount to your reserve fund each month until you reach your goal. The amount that you can save on a monthly basis should be initially calculated when you underwrite the deal. Let’s review this a bit further.
Underwrite and Understand Your Cash Flow
When you underwrite the property, you will assess what your cash flow will equal from the investment. This means taking your income and deducting expenses, including your recurring CapEx, your mortgage payment, and taking into consideration a vacancy factor. Once you have calculated this, you will have your net operating income, or NOI.
At this point, you want to identify how much you need from the revenue to distribute to ownership(s), and commit the rest to your reserve fund. Remember that the reserve fund can save you from losing your asset, so you want to make sure you have this fulfilled. If there is a month during which you have extra cash from your personal allocation that the ownership can go without, put it towards the reserve fund.
*It is important to note, though, that the expenses for capital expenditures should continue to be placed in the account because these are ongoing anticipated expenses. So, if you are allocating $0.20 per month per square foot for the recurring CapEx, this will be considered an ongoing expense that will not stop once you reach your reserve fund goal.
What About Debt?
Many investors want to focus on paying their debt instead of building their reserve fund. This, however, can be dangerous because if an unexpected event occurs and damages the building, you want to be prepared. If you are not, then your reduced cash flow from a problem could turn into a bigger problem if you cannot pay your mortgage. Therefore, always allocate your extra capital to your reserve fund until it is complete, even if any loan you have doesn’t require it.
Once your goal is achieved, re-allocate those expenses directly to your debt if you want to get rid of your loan – Do not take extra income just because your reserve fund is full. As you have debt on the property, you are paying interest, which means you are paying to borrow the capital. So, the quicker you pay down your debt, the less money you will paying in interest and the quicker you get to a free and clear title. Note that many loans may not allow you to prepay without incurring some penalties and remember that each situation is different. Paying down your loan may not be the best use of your money if you have other investments that yield a great return – just be cautious with that strategy.
Always Take Care of Your Business Before You Take Care of Yourself
It may seem like all income from your property is now being allocated elsewhere, and you may be inclined to take a little more each month to really reap the benefits of owning real estate. However, this could be detrimental to the financial position of the asset. The goal is to have a full reserve fund and own the property with low or no debt, and then you can really benefit from the passive income of real estate investing! Just always remember to take care of your business before you take care of yourself so that you do not risk losing it all!