How Much Do I Need for My Rental Property’s Cash Reserve?
You know you need a cash reserve for your rental properties, but how much should you save? And which savings strategy should you use? Every property is unique, so it’s important to evaluate your investment properties before setting a savings goal or picking a savings strategy. Today, we’ll discuss the six most important factors and strategies to consider when setting a savings goal for your property’s cash reserve.
Factors to Consider When Setting a Savings Goal
No two properties are the same, so your savings goals for each property will vary. But you’ll need to consider the same factors to help you determine how much to save.
1) Location
Real estate is all about location, even with savings. Property tax rates vary. Urban areas have higher prices for contractors and materials than in rural areas. One of your properties may have homeowners’ association (HOA) fees, but your other doesn’t.
Think about how your property’s location affects its monthly expenses, planned outlays, and capital improvements. Research how much it would cost to replace appliances, update wiring, or repave a driveway.
2) Property Type
If you own a condo, the HOA usually maintains the exterior of the unit. You’ll have lower maintenance costs, so you can carry a smaller reserve as long as you can pay the HOA fees.
A single-family home or apartment complex, however, has much more exterior maintenance to handle. The roof, siding, driveway, and landscaping will all need attention at some point. Your reserve needs to account for those fees.
3) Property Age and Last Update
The age of the property alone isn’t always the best indicator of how large your reserve should be. You need to account for when the property was last updated.
If a property is 50 years old, and it just had major updates, it could carry a smaller reserve than a 10-year-old unit with no updates. The newer unit may need repairs and improvements sooner.
As you calculate your savings goal, look at the age of your plumbing and electrical systems, roof, and appliances. Use their life spans to help you plan both when you may need updates and how much to set aside.
4) Number of Units
The fewer units you have, the more you’ll feel major expenses. When you have more units, you have more income to handle issues when they arise. However, you also have more opportunities for something to go wrong more often.
5) Turnover Frequency and Vacancy Rate
Turns can cost from one to four months’ rent for repairs and improvements. If you have frequent turnovers for your unit, those costs add up rapidly.
And once a unit is ready for a tenant, it may take awhile to find one. Look at your vacancy rate to see how long your units are sitting empty. Make sure to factor that into your savings goal.
6) Risk Aversion
Your savings goal is affected by more than just numbers. Your personality plays a part as well. If you’re comfortable with risk, you may be happy carrying a smaller reserve. If you’re more averse to risk, you may want to play it safe and have a larger reserve fund. For those who are extremely cautious, take a reasonable estimate, double it, and use that figure for your reserve goal.
Strategies for Calculating a Reserve Amount
Okay, you’ve considered the factors that will affect your savings goal. You know how to save and when to dip into the funds. You’ve set up a reserve account. How much should you actually save for your property’s reserve?
Where you are in your investment career may determine the size of your reserve. If you’re just starting out or buying new properties, you may have a smaller reserve since more of your funds are going toward acquisitions. If you’re maintaining your current portfolio, you may keep a larger reserve to decrease your risk. We’ve seen real estate investors use six different strategies when it comes to savings.
1) $5,000 per Property
Set aside 10% of your profits each month to fund your reserve. Keep saving until you have 10 to 15 thousand dollars set aside.
2) Three Months’ Rent per Unit
Three months’ rent should be enough to cover your mortgage, taxes, and insurance in case of vacancies. This strategy is for someone comfortable with risk.
3) Six Months’ Rent per Unit
For those less comfortable with risk, or those looking to grow their portfolios, consider saving six months’ rent per unit. This more sizable cushion helps cover vacancies, major repairs, and planned outlays. But this approach also helps if you are planning to acquire another property. Banks like to see six months of expenses in a reserve.
If you have multiple units, you can reduce the six-month rule.
4) 10% of Monthly Income
This approach saves 5% for vacancies and 5% for capital improvements. If 10% is a bit too much for you right now, start lower and increase over time.
5) Annual Depreciation
As your business grows, you can use your annual depreciation amount as a savings goal. Take your annual depreciation amount minus the cost of any capital improvements from that year and add that figure to your reserve fund.
6) Capital Spending Study
If you’d rather have a customized estimate of how much you’ll need in a reserve fund, perform a capital spending study. This approach is very thorough:
• Determine the age of all parts of your property.
• Estimate the remaining life span of each part.
• Estimate replacement costs for each part.
• Summarize the costs in an annual spend/save rate.
• Set aside the estimated need each year minus any capital improvement outlays from that year.
A capital spend study can also help you estimate when you’ll need to make certain repairs.
Takeaways
Many factors affect both your savings goal and strategy, so each property may need a different approach. Spend time evaluating your rental properties and your savings strategy so you can set an appropriate reserve amount for your business. Remember, it’s not just the data about your rental properties that matters. Your cash reserve needs to account for your comfort with risk, as well as your business goals.
