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What you'll get from this article:
🏠 Why cash reserves are the foundation of a real estate investor's financial plan.
🏠 How much money do you need in cash reserves for your rental property?
🏠 How to build cash reserves when you are just getting started as a landlord.
🏠 Where to keep cash reserves for your rentals.
🏠 How to rebuild cash reserves after you have spent them.
What happens if your tenant does not pay their rent, but you must pay your rental mortgage, property taxes and utilities anyway? Or if a hurricane hits damages your rental and you need to cover the insurance deductible? Imagine you need to install new appliances, replace an air conditioner, or even put on a new roof? Where will you find the money to pay for these expenses?
Prioritize building cash reserves in your budget
Maintaining cash reserves to pay large or unexpected expenses is a critical component of a real estate investor’s financial plan. Your first financial goal once your property is rented is building your cash reserves. Cash management is the foundation of financial wellness – and it is crucial to surviving the rollercoaster of the impact of COVID-19 on rental property owners.
Prioritize savings in your rental property budget. Real estate investors who do not build and maintain adequate cash reserves and sources of liquidity risk personal financial damage or selling their property at a loss if they cannot cover rent loss or unexpected expenses.
How much money do you need in cash reserves for your rental property?
Income property owners need cash reserves for deferred expenses, unpredictable but expected expenses, and the costs of unexpected events:
Vacancies – In our rental business, we assume one month vacancy per year per unit in the budget. Over time, we have found that some units rent quickly to great tenants who have always paid on time. Others have remained unoccupied for a few months. You can find rental vacancy rates by region and metro area in the U.S. Census Housing Vacancy Survey.
Late or Unpaid rents – While tenant screening can reduce the risk of late or unpaid rent, it happens during good economic times and increases during recessions. Expect late or unpaid rents to continue to increase during the pandemic. The National Multifamily Housing Council’s Rent Payment Tracker found that only 76.4 percent of renters had made full or partial rent payments by September 6, 2020.
Planned spending – Set aside funds regularly for expenses which are not paid monthly, but can be estimated:
Maintenance and repairs -- While it is difficult to predict what exactly is going to need repair or replacing during the year, count on the fact that something is going to require work. Have a brand new property with new appliances? You can probably get by for the first decade by reserving 1 percent of the property value in liquid savings to meet repair/maintenance expenses. Is your property a 150 year old building? You may find that maintenance and repair costs closer to 4 percent of the property value per year.
Property taxes – If you are not escrowing your property taxes with your mortgage lender, save from each month’s rent for your payments. If you are a new property owner, use the prior year’s taxes to estimate until you receive a bill.
Insurance – Expect your landlord insurance policy to be about 15-25 percent more expensive that homeowner’s coverage for a similar property, due to the increased risk of damage when your rent a property to tenants.
Seasonal and irregular expenses – Include planned seasonal expenses, such as snow removal, landscaping, and tree care.
Insurance deductibles – Keep your full insurance deductible in your cash reserves. A deductible is the amount of a covered loss that you must pay before your insurance coverage pays. For example, if your landlord policy has a $2000 deductible and you have a covered claim for a $10,000 loss, you would pay $2000 and the insurance company would pay $8000.
Emergency fund for unplanned or unexpected expenses – Stuff happens that will cost you money. You do not know what it will be or when it will occur. Your tenant puts baby wipes down the toilet causing expensive plumbing repairs. There is a mudslide above your property and the owners and city are in endless litigation. The boxwoods in front of the building turn yellow from blight and must be replaced. You get the drift.
Savings for the down payment on your next property – Once you have enough saved for all these deferred and unexpected expenses, you can turn your attention to saving for the down payment on your next income property.
How to build cash reserves when you are just getting started as a landlord
Build ample cash reserves for a new property before paying anything to yourself or buying another rental property. I encourage income property owners to save all net rents (rent – mortgage, taxes, insurance, and expenses) in until you have a full year of building expenses. This can take 18-24 months with your first property if you are starting with zero and do not have alternative sources of emergency funds.
Here is a simple example:
Mortgage + monthly expenses $1000
Monthly share of annual planned expenses: $300
Net to cash reserves: $1000
Annual estimated property expenses: ($1000 + $300) x 12 = $15,600
Months to build target cash reserves: $15,600 / ($1000 - $300) = 22.3
Where to keep your cash reserves for your rentals
Manage your rental property finances using business principles. Do not commingle personal and rental property finances and do not commingle security deposits with operating funds.
I encourage clients to keep 2 (operating/cash reserves + security deposit) or 3 accounts by separating out cash reserves in savings:
- Operating account – Some income property owners prefer owning all their properties in one LLC with one operating account, while others create a separate LLC for each property with an operating account for each property.
- Security deposit account – Landlords are legally required to keep security deposits in reserve -- either pay for damages or unpaid rent when the tenant moves out, or to return to the tenant. Keep them in a separate account to avoid accessing those funds for regular expenses.
- Business cash reserves –Consider keeping cash reserves in a separate account, linked to your primary operating account so it is easy to transfer money between them. Keep cash reserves in low risk, liquid savings such as high yield bank accounts, and money market funds. This is definitely not a place to take risk with your money or experiment with stock mutual funds - the money needs to be easy to access and stable in value when you need it.
How to rebuild cash reserves after you have spent them on an emergency
Real estate is a “buy, hold and maintain” investment. There are carrying costs. Expect to dip into your cash reserves, possibly at the most inconvenient times. That is just part of being a real estate investor.
The rule of replenishing cash reserves is simple: after you spend cash reserves on planned expenses or unexpected expenses, go back to saving 100 percent of your net cash flow until you have fully replenished reserves.
If you are unable to do save 100 percent due to personal financial difficulties, earmark as much as you can for reserves until you have fully replenished them.
The power of diversification as you add new properties
As you grow your real estate portfolio and increase the number of units which are generating rental income, managing your cash reserves can get easier if you are following cash management principles. While stuff still happens, it is less likely to happen in every property all at the same time. That means you will still have rental income coming in from other properties while some units are vacant.
It takes time to build sufficient rental reserves. If you are thinking about becoming a rental property owner, make sure you will have enough wiggle room in your personal finances to handle unexpected expenses during the first few years of property ownership. See Are You Financially Ready To Buy Your First Rental Property?
How are you managing your cash reserves for your income properties? Send me an email at email@example.com
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