Do you have a rental property reserve fund? One of the most common mistakes new landlords make is buying a rental property without creating a reserve fund. Learn why reserve funds are vital to smart real estate investing and joint ventures.
So what is a rental property reserve fund and why do I need one?
A reserve fund is your emergency cash fund. It’s a certain amount set aside in your property’s bank account. You can access the fund during an emergency, vacancy or for repairs without having to withdraw money from your personal bank account. Having a reserve fund also means you avoid cash calls to your joint venture investors.
New landlords and joint venture investors often overlook the importance of creating a reserve fund. After all, why do I need a reserve fund if my property positively cash flows? In an ideal world, your new investment will have immediate cash flow and no large expenses. Unfortunately, we don’t live in a perfect world. Furnaces quit, water leaks happen, tenants move out, and sometimes you can’t avoid an eviction.
Creating a reserve fund means you won’t break a sweat for unexpected expenses or a month without cash flow. The money is in the property’s bank account, available now. You can deal with the problem stress-free and focus on better things like finding your next investment.
How much do I need to set aside?
The amount you set aside depends on the property type, size, age, and your tenants. Rehab and older properties require more maintenance than new construction. Multi-unit properties have more windows, fridges, stoves, and toilets. Executive rentals have higher turnover with more opportunity for a vacancy, while lower-income units can have more late rent payments or evictions.
There isn’t universal agreement on how much you should save. Zillow’s Investing 101: Estimating Rental Property Expenses suggests saving 1% of the property value per year. Financial Nirvana Mama suggests, “to cover two months of expenses for every property.” One thing savvy landlords and property managers agree on is that a reserve account is non-negotiable.
How reserve funds save the day
Brandon Hall from Bigger Pockets explains reserve funds are critical because “there are things that you just can’t predict regardless of whether you have done no deals or hundreds.” Brandon’s article The Importance of Reserve Accounts (Or What a Surprise Roof Replacement Taught Me) explains how he found out about reserve funds the hard way.
We also learned why reserve funds are vital during our first joint venture. We purchased a rehab fourplex that had a “filler tenant.” A filler tenant is someone placed in a unit by a slumlord or unethical property manager to fill a property for sale. The tenant is not vetted and unqualified to pay rent. Banking on a quick sale, the landlord doesn’t care about finding a good tenant, they just want to show income on paper.
After closing on the fourplex our filler tenant didn’t pay the first month’s rent to us and we later learned they had never paid rent. Having identified this tenant as a potential challenge during the purchasing process, once they didn’t pay rent on time, we immediately started the eviction process immediately. Unfortunately, in Ontario evictions are slow. It took almost 3 months before we could evict, which meant 3 months without $950/month in rent. Then we had to remove all the trash they left behind, clean, and make repairs which meant another month without rent.
Luckily we already knew about reserve funds, had one created, and our joint venture investors understood we couldn’t control the actions of a previous landlord. Because of our reserve fund, there was never a cash call. Evictions are never fun, but we could focus on the paperwork and process without worrying about paying the bills too.
Reserve fund best practices
Our rule of thumb is to start each property on Day One with a reserve account, yes Day One. We always budget “float money” into our acquisition costs. It’s also a standard requirement included in each our our joint venture agreements.
The amount we put aside depends on the property, but each property always closes with at least one month’s gross rent for the property (all units combined) already in the bank account. We reserve extra funds if the property is a rehab property or if we are inheriting questionable tenants.
Then we set aside an agreed-upon amount monthly until the reserve fund reaches a pre-set amount. On average, 5% of rents are set aside for vacancy plus 3-10% for repairs and maintenance depending on the property’s condition and age.
When the reserve fund reaches the pre-set amount (i.e. $4,000), these amounts convert to extra cash flow. If we withdraw from the reserve fund for a vacancy or unexpected expense, we begin saving again. Hence, we call it “float money.”
Once you own multiple properties individually or with a joint venture investor, you can then begin to combine reserve funds.
For example, instead of having four reserve accounts with $4,000 each, you can create one $12,000 account. This frees up $4,000 to invest elsewhere. Be sure your combined fund will cover the expenses of your most expensive property plus extra just in case. It’s also important to always to keep reserve accounts separate for each joint venture and your personal investments, never mix funds.
What’s your experience with rental property reserve funds? How much do you set aside for the unexpected? We’d love to hear how you invest.
Looking for more information about reserve funds? Here’s a great article from Ezytrac Property Group
Co-owner of Rethrive Properties, Kimberly is an e-learning developer, corporate trainer, experienced real estate coach, and content writer. As one of those quirky people who remembers endless details, Kimberly loves researching, reading, and exploring new ideas. Her mission is to educate others with creativity and integrity so they can, in turn, add value to those around them.