How Much Should I Set Aside from my Rental Income for Cash Reserves?

One of the challenges of rental property investing is that the expenses aren’t consistent or predictable. 

 

You might be sitting pretty for six months in a row with $500 positive cash flow and few repair expenses to eat into it. Congrats — you’re $3,000 richer! But then out of nowhere, the HVAC breaks. In August! It’s $5,000 to get it replaced on short notice.

 

Now, does that mean real estate investing is a bad deal? Absolutely not! Rental revenue has been making people rich since the Feudal era. It just means that to avoid a cash flow crisis, every rental property needs cash reserves. 

What Are Replacement Reserves in Rental Property?

Every smart landlord has cash set aside for these big one-time expenses. These are often called replacement reserves or reserves for replacement.

 

At the level of commercial real estate you will sometimes hear these reserves described as capital expenditure reserves, or “capex” reserves for short. This is because big one-time replacement spending sometimes gets classified as “capital expenditures” rather than routine maintenance. This has consequences for how the property is valued according to the income method of real estate appraisal. It doesn’t really apply to turnkey rentals, but if you want, feel free to call your replacement reserves “capex reserves”.

How Much Replacement Reserves Should I Set Aside As A Landlord?

The rule of thumb is six months’ worth of rent. This should cover most major capital expenditures that arise, so you don’t end up having to dip into your own pocket or credit.

 

Let’s say your property has a market rent of $1,400/month. A good replacement reserves fund would contain $8,400 ($1,400 x 6).

 

If you end up needing to spend $5,000 on that replacement HVAC system, you will have spent your reserves down to $3,400. You should now start setting aside as much cash flow as you can to replenish the fund.

How Should I Build Up My Initial Replacement Reserve?

There are two ways to go about it, each with its own downsides:

Fund Your Reserve With Cash at Closing. In the above example, you would set aside the entire $8,400 in a reserve account when you close on the property. 

 

Bear in mind that doing it this way affects your cash-on-cash return (more about what that is and why it matters in this article about cash-on-cash return). 

 

Let’s say your initial investment is $34,000 with an estimated $2,700 annual cash flow. That’s a cash-on-cash return of roughly 8% ($2,700 ÷ $34,000). Not bad. 

 

But if you set aside $8,400 for reserves right away, your initial investment is now $42,400 ($34,000 + $8,400). With the same cash flow, your cash-on-cash return is 6.3%.

 

Funding your replacement reserves all at once is advisable if you are buying a rental property with several systems you know for a fact are near the end of their useful life (HVAC, roof, plumbing, etc.)

Fund Your Reserve Gradually. If you are confident that you are buying a property in relatively good condition (say, from Martel Turnkey!), you might consider funding your replacement reserve gradually. 

 

This means setting aside some or all of the rent for your reserves — meaning you might not have much or any cash flow for several months or even years as you build up the reserve. 

 

Once your reserve is fully funded, you can start pocketing the cash flow. Just remember that if you spend some of the reserve, it’s time to divert your rental revenue to the fund to rebuild your cushion.

Replacement Reserves and Depreciation

We have spoken before about how the IRS lets you write off a certain portion of your cost basis every year for depreciation (see this article on depreciation for more). 

 

We talk about depreciation like it’s a tax loophole, a love letter to real estate investors from the IRS — and in some senses, it is. But in another sense, that deduction exists for a reason. The IRS actually expects you to spend that money on upkeep … i.e. replacements and capex.

 

As such, some investors feel most comfortable increasing their replacement reserves cushion every year in the amount of their IRS-mandated depreciation allowance.

 

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MartelTurnkey strives to provide landlords with rentals that have a bare minimum of immediate capex needs, so you can build up reserves over time if you like. We also hand over rentals with property managers in place. Your property manager will have useful advice about replacement reserves, based on experience with similar rental properties in the same market.

 

Questions about replacement reserves or capital expenditures? Feel free to message us today!

 

Are Condos a Good Real Estate Investment or Are Single-Family Houses Better?

It’s easy to see the appeal of buying a condo as an investment rental property. First and foremost, they tend to be cheaper. You can usually get a condo for less out-of-pocket than a single-family house in the same neighborhood.

 

Condos can be a good investment. At MartelTurnkey we tend to think it’s hard to go wrong with real estate of any kind as long as you prioritize location and manage your risk.

 

There are, however, some crucial downsides you need to keep in mind. Here’s what to be aware of as you consider investing in condos:

Condos Don’t Appreciate As Quickly

Yes, you can get into a condo for less out-of-pocket than a single-family hom, but you may end up having to settle for less appreciation. If a big part of your investment strategy involves selling or refinancing your property for a profit or capital recapture, condos may not be the ideal vehicle.

 

Conversely, if cash flow is your first priority and not long-term appreciation, a condo can get you there if you run the numbers and manage your risk. As an added bonus, appreciating less precipitously means they don’t have as far to fall in a downturn, so if you want to limit your volatility, condos may actually be a good choice. 

There Are Exceptions

There are circumstances where a condo will appreciate explosively. Remember, the three most important factors in real estate value are location, location, and location. A condo in a location that catches fire with popularity is likely to skyrocket in value right along with the nearby houses — tenant demand is just that strong. Condos in popular urban infill areas will always be in demand, especially in historic, entertainment, and nightlife districts. 

Watch Out for Houses that are Functionally Obsolete

You may be tempted to go with any single-family house if you want appreciation … but be careful. Houses appreciate quickly because they cater to investors and homeowners alike, but you will find minimal homeowner demand for houses that are functionally obsolete. 

 

A house is functionally obsolete when it lacks certain features that the market has come to expect. Examples include a 3bedroom-1bathroom house — most homeowners expect at least two bathrooms. Another example might be an older house that has no dishwasher hookups.

 

A functionally obsolete house in a great location might make a fantastic rental — tenants might be so eager to live in that area that they will compromise on an out-of-date house. Sometimes, functional obsolescence can be cured. However, a condo has little advantage over a functionally-obsolete house.

You May Face Higher Vacancy

This isn’t a guarantee, but condo renters tend to be single people, while a single-family house is more likely to attract a family as a renter. Single people tend to move more often than families which means you will have to deal with more vacancy.

 

This isn’t a guarantee, though. The family you rent a house to may transition to homeownership or simply move on to a shiny new rental. But it’s something to be aware of when calculating your cash flow potential on a condo.

Condos Have Associations and Dues

Condos are usually part of condominium associations, basically a homeowner’s association (HOA) for the entire building. The association has the right to collect regular dues and place restrictions on its owner-members.

 

This might get onerous. The association may demand to screen your tenants themselves. They could fine you for your tenants’ behavior. Some condos will not allow you to rent out your property at all. Condo associations are also notoriously insolvent. If the roof needs repair, or they decide to upgrade the gym (whether you use it or not), they may assess a special and unexpected fee, and threaten you with foreclosure if you don’t pay it.

 

Of course, with a single-family house, you’re on the hook for repairs also, but you are in control. You get to decide when to do the repairs and how much you want to pay. Single-family houses can also be located within HOAs and have all the same downsides. But in general, the condo association is going to be a source of headaches and cash flow uncertainty. Beware.

 

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Condos can be a good investment, but there are several pitfalls to be aware of. The majority of our inventory at MartelTurnkey is single-family homes in desirable neighborhoods. They are usually not the most expensive property on the block which means they have a lot of headroom and excellent investment potential. 

 

Best of all, they come newly renovated, under management, with a tenant already in place! Call us today to find out how easy it is to make one of these cash-flowing properties yours!

4 Tips to Identify the “Path of Progress” … and Then Use It to Buy Properties that Appreciate

If I had to write “Real Estate Investing for Dummies,” I would begin and end with this advice — “Buy property in the path of progress.” If you buy in the path of progress, you can make almost every mistake in the book — buy high, negative cash flow, etc. — and still come out ahead.

 

You see, every city has a “path of progress” — a zone where the city is intentionally targeting its economic development according to a “Master Plan.” Whether or not they succeed depends on the competence of the managers in charge … but if they do succeed, property in the path of progress will almost always appreciate rapidly. This goes for the commercial property as well as the condos and single-family homes nearby.

 

On the flip side, most cities have zones of decline — parts of the city neglected by economic development plans and left to stagnate. Real estate tends to flatline or even decline in value in these areas. You might reap some cash flow, but building wealth in these zones is an uphill battle.

 

If you want to build real estate wealth quickly, buy in the path of progress. So how do you identify this magical zone? Here are four tips to find the path of progress. If you live far away from the target city, all of these tips can be exercised through phone calls, online search, or on-the-ground foot soldiers.

1. Follow the Construction

The path of progress is paved with bulldozers and construction cranes. Economic development often involves the tearing down of old commercial structures and the building of new ones. This represents a significant economic investment, so the city and its developers won’t make that investment unless they expect a big payoff.

 

The city often offers cash incentives to build in the path of progress, so if you see a lot of construction in a particular neighborhood, you can deduce that the city is probably holding out a pretty big carrot to the developers. You can look up online or call for a list of construction permits and look for the same Zip Code to keep coming up. You may even be able to discover where in town the city is offering development grants. New malls, offices, apartment buildings, and condo developments are a great sign. 

2. Follow the Curbs

The city is responsible for restriping and rejuvenating the curbs in commercial and residential neighborhoods. They set the schedule, and neighborhoods outside of the path of progress tend to be neglected in this regard. Want to find the path of progress? Find out which neighborhoods are at the top of the city’s list for curb restriping. 

3. Follow the Chains

Starbucks, McDonalds, Target … national retail chains do extensive research into the path of progress before they open a new store. Following announced future openings for major chains is like cheating off their paper in a high school test — only it’s totally allowed and not at all unethical. 

 

By contrast, if national retailers are leaving a neighborhood, it’s a bad sign. They have the name recognition; the only reason for the franchise to fail is economic decline. 

4. Follow the Artists

The cycle of “gentrification” is pretty well-documented — artists move in for cheap rent, start hosting shows and popups, the neighborhood becomes “cool,” other people start wanting to live there, and the next thing you know — Whole Foods comes knocking. If there’s a “rough” part of town near the city center that has become a favorite haunt for “artsy” types, it might be time to buy before the neighborhood catches fire.

 

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One of the best things about investing with Martel Turnkey is that we do the research for you. We have extensively researched the paths of progress in our target markets and buy assets primed to rise with the tide. These four tips give you the tools you need to check our work!

Investing for Cash Flow vs. Appreciation — Which is Better?

Most people know that there are two core ways you can harvest a return on your investment when you buy real estate — cash flow or appreciation. 

 

Ideally, an investment property will produce both, but nearly every investor comes to a crossroads where they have to pick which one is most important. Whether you prioritize cash flow or appreciation has a big impact on how you look at investment opportunities. Think of it as the “lens” through which you view the real estate market.

 

Is one strategy better than the other? There’s no real right answer. It really depends on the investor and their long-term goals. But let’s examine the question and see if we can declare a winner, even if it’s by a nose. 

Cash Flow

Cash flow in real estate usually means any surplus rent you can pocket after all expenses have been accounted for. Of course this means expenses like property taxes, insurance, and service contracts, but it also means the mortgage payment and contributions to a reserve fund for emergency repairs. 

Deals that Tend to Emphasize Cash Flow

Properties in Slower Growth Markets. How fast a metropolitan is growing really matters. Faster growing economies tend to cause housing shortages which means higher real estate prices. In markets with more sustainable growth — like places in the middle of the country like Ohio or Missouri — real estate values just don’t swing wildly up and down.

 

“B” or “C” Neighborhoods. These are typically workforce housing neighborhoods. You can usually get them at a lower price compared to their rent potential — which means higher cash flow.

 

Property values less than $250,000. This is not a hard rule but, usually, properties at the lower price point have a higher chance of cash flowing. The reason why higher price properties usually don’t cash flow is that people who could afford these higher rents have more options and are able to buy a house instead of renting.

When is it a good idea to invest for cash flow? 

Compared to appreciation, cash flow is more predictable. Yes, sudden vacancies and emergency expenses do happen, but after you settle into a rhythm with your tenant, it becomes easier to know how much cash you can count on each month. 

 

Also, appreciation doesn’t manifest as cash until you harvest it in a sale or refinance. Before that happens, appreciation is entirely speculative. Cash flow, by contrast, manifests itself as cash every month— a big deal for people with their eyes on retirement or financial freedom. 

Appreciation

Appreciation in real estate is when property increases in value over time. Over long periods of time, real estate tends to increase in value … but in the short term, especially in volatile markets, real estate can potentially lose value.

Deals that Tend to Emphasize Appreciation

Properties in Fast Growing Markets. Hot markets like California, New York, Texas, and Florida tend to feature big swings in property value. If you buy at the right time, you can profit big from a dizzying uptrend … but you can also lose big or have to weather a long doldrums if you pick the wrong time.


“A+” Class Neighborhoods. This is real estate talk for “nicer properties in nicer areas.” The purchase price is significantly higher so are the rents but the rents are not high enough for the property to cash flow. That said, because demand for the properties and the area is likely to remain high, they tend to appreciate more than outdated properties in bad areas.


“Value-Added” Strategies. A property that comes with a clear strategy to increase its value — say, a fixer-upper on the market for a song — can enjoy significant appreciation through a “value-add” strategy. Of course, this depends on the strategy succeeding without going vastly over-budget and eating into the appreciation profit.

 

When is it a good idea to invest for appreciation? 

Investors who prioritize appreciation tend to have legacy or generational wealth in mind — building a large net worth to pass on to their successors. 

 

So Should You Invest for Cash Flow or Appreciation?

Again, it’s great if you can have both … but if we have to declare a winner, we call it for cash flow. 

 

Why? Two words — financial Freedom. For most people, financial freedom would have a much bigger impact on their life than some hypothetical windfall that may never manifest. 

 

By financial freedom, we mean the ability to quit or retire from your job and focus on your passions, confident that a predictable stream of passive income will continue to fund your lifestyle.

 

People who are financially free have much more time, many more options — including the ability to occasionally speculate on appreciation, essentially having their cake and eating it too.

 

At MartelTurnkey, we look first and foremost at the cash flow potential of our turnkey rentals. When you buy from MartelTurnkey, you know you are buying a key piece in your personal financial freedom puzzle. 

 

Contact us today for ready-made opportunities to “buy cash flow” … and even bank some appreciation along the way!