It’s bound to happen.
Particularly if you invest long enough.
Your Resident calls you on a frigid Saturday evening…
“Hello, Mr. Landlord,” the Resident says, teeth chattering. “My furnace isn’t working. It’s 47 degrees in my house, and it’s expected to get below zero tonight.”
You scramble to find an HVAC company which, due to overwhelming demand, doesn’t arrive until the next day.
Shortly after arriving at your property, the technician phones with bad news.
“Your furnace is dead,” the technician says. “Cracked heat exchanger.”
Then, to make matters worse…
“We can get it replaced on Monday for $5,500.”
Your heart sinks.
On the one hand, you are very concerned for the Resident, who can’t legally or reasonably live in a property without a heat source, particularly in dangerously cold temperatures.
On the other hand, you are also highly concerned about your personal finances.
This rental home, which you were just certain would produce positive cash flow, has done anything but.
To this point, you’ve been able to overcome a refrigerator repair in September and a broken garage opener in November. Even though those repairs wiped out any cash flow you earned those months, at least you didn’t have to dip into your own pocket to pay for them.
This maintenance issue, however, is different.
Any cash flow, at least for one year, is gone.
And to make matters worse, you’ve failed to set up any reserves to pay for large expenses.
What do you do?
Clearly, the options aren’t great.
Option #1 – If you move forward with the replacement, you’ll likely need to borrow funds, which can be costly and time-consuming, further damaging your relationship with the Resident and further degrading your return.
Option #2 – If you fail to replace the furnace, you risk the Resident filing for constructive eviction, which can be REALLY costly and painful.
You decide to move forward with Option #1, which is – let’s face it – the only good option here.
You then secure a high-interest loan with a local bank, which takes 7 days to fund and comes with some additional processing fees. The HVAC company installs the new furnace three days later.
Your Resident, meanwhile, had to temporarily move out and secured a hotel room for 10 days. The Resident is now demanding you pay for the hotel since you failed to provide a safe and habitable living environment for an extended period of time.
That costs another $750 and, as an added bonus, your Resident provides you an advance notice to vacate, citing your inability to handle maintenance efficiently as the driving motivator.
What a disaster.
All of this additional cost could be avoided by simply creating the reserve account in the first place.
Treat Your Rental Property Like a Business
Whenever you make the decision to become a real estate investor, it’s critical to treat this venture like a business.
All businesses have, or at least should have, financial reserves.
Setting up this reserve BEFORE you purchase that first property is imperative.
What is a financial reserve?
Fundamentally, a financial reserve is a specified amount of money that an investor sets aside to pay for large maintenance items and/or vacancy.
As noted above, large maintenance items WILL occur.
And be certain that vacancy WILL occur as well. During vacancy, not only are you not collecting rent, but you are also spending money on turnover, utilities, lawncare, etc.
Some people refer to this money as a SWAN account, or a Sleep Well at Night Account.
If this account is well-funded, you should certainly sleep better knowing you have the funds to handle most major issues.
Factors that should influence the amount of reserve
There are a few key components to consider. Let’s explore each of them:
- Age of the home – This should be obvious but, generally speaking, older homes require more maintenance. The chance of furnace replacement is almost nill in a new home but could be much more likely in an older home.
- The Overall Condition of the home – When you purchase a rental home, a home inspection is a must.
Take note of the age of all your major components: HVAC, roof, plumbing, electrical, etc. The older the component, the sooner it will need to be replaced, so prepare accordingly.
The reality is that a very old home (let’s say, a 1920 build) could be in MUCH better shape than a home built in 2005.
- Vacancy history – Again, vacancy is expensive and a true cash flow killer. Some questions to consider here:
Is the home easy to rent? Do Residents in your area have a track record of staying for multiple years?
For example, if you buy a home in an area filled with college students, you should expect high turnover.
If you buy a home in an area known for retirees or known for great school systems, you may have less turnover.
Establishing the reserve amount
There are a couple of different thoughts on how much you’ll need in reserve.
- Percentage of rent – This is a popular method for determining reserve amount and it’s super simple to calculate. Depending on the three factors noted above, you may choose to set your reserve somewhere between 20% – 40% of annual rent collected.
Let’s assume that you have a newer home and it’s located in an award-winning school system. The home rents for $2,000 per month. In this case, you may choose to reserve as little as $4,800.
If you have an older home with mechanicals and major systems that are older as well. It’s located in an area full of young people who are close to home ownership and rents for $1,500 per month. In this case, you may choose to reserve $7,200.
- X number of monthly rent in reserve – This is a very popular method for setting a reserve. In this case, the investor simply chooses the appropriate number of monthly rent payments and places that amount in reserve.
For example, if the home rents for $1,000 per month, the investor wants to reserve 6 months of rent, they would place $6,000 in reserve. Again, the investor should use the three factors noted above to set the right reserve limit.
The general rule of thumb is that somewhere between 3-6 months of rent is appropriate.
It’s better to be conservative
As you likely know, the cost of material and labor have sky-rocketed over the past 2-3 years. Even though rents have increased nicely as well they haven’t generally outpaced the cost for home repairs.
So, be conservative with your reserves. If at all possible, reserve more than you THINK you’ll need. There’s nothing wrong with having a little extra cash on hand.
“But, I can’t afford to have money in reserve!”
If you don’t have the extra cash to establish a proper reserve, maybe you aren’t ready to invest.
Again, you are entering into a small business. You need to be prepared accordingly. If you need to wait a few months to establish the reserve than do so.
Be prepared and you’ll be in much better shape to succeed.