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!