Cash reserve?

Question

I now understand the 50% rule but I am unclear about cash reserve. If you have a house you bought following the 50% rule how much cash reserve do you recommend having for the what if's? Is it necessary?

Heather

Jon Holdman · Answer

If six months rent is 6% of the purchase price, then you'll need to be prepared to continue to pump cash into the property. I know this is the traditional rule, but its a money losing rule. If you believe the 50% rule, and so far every time anybody's shown real data it seems to be verified for the long term for multiple properties (especially when using a PM), and if you rent is 1% of the purchase price, then in a year, 6% of the purchase price will go toward expense, vacancies, and capital items. If your interest rate is over 6%, and it seems like 7% is about the going rate for investor loans on SFRs right now, then you're in the hole after interest. That doesn't include any principle paydown, which does come back to you later, but is money out of pocket right. So, if your rent is 1% of purchase price, I'd budget in 1-2% of the purchase price per year in additional contribution to the property. If you've stuck in a 20% down payment, then you're probably right about break even. Fannie Mae currently requires a six month PITIA payment reserve for each property if you're trying to get a loan for the 5-10th property. I'd say somewhere between six months payment and six months rent is reasonable. I don't think you would need this for every property. If you have 10 properties, for example, doesn't seem likely you would have a major expense or vacancy on every one at the same time.

Michael Rossi · Answer

You can use credit as your reserve, but as Jeff said adding more debt to the situation can be a business killer. If you were going to use debt, it would be essential that you aggressively put that $500 per month into a reserve account so that you wouldn't actually need the credit. Additionally, you would need to really do a thorough due diligence (including tenant screening) to minimize the chance that you have any large expenses in the first few months. Finally, in the current banking environment, counting on credit for anything is risky. The credit card companies are in a LOT of trouble and they simply don't have the money to lend. As their balance sheets deteriorate with future credit card defaults, they will cut back on credit even more than they have. If you can truly put away $500 per month, then maybe the best solution would be to put away $1,000 or so cash before you buy and then $500 per month after that PLUS the left over maintenance and capital expense money that is generated by the property each month. Good Luck, Mike

Lance H. · Answer

Thanks, Ya, I wasn't thinking of that, but that could get bad if I'm counting on credit for reserves and then the credit isn't there because the company pulled it. It will probably be a couple months before I purchase anything anyways, as I have to line up funding, start an LLC and most importantly, find a good deal! Lance

Jeff Tumbarello · Answer

I would advise against using leverage as a reserve. Nothing like adding more debt when you are in the red

Lance H. · Answer

Hey Mike, Do you think the initial 5000 reserve needs to be actual cash, or can it be available credit. I just got a new job after college and plan to put away 500/month away, but I don't necessarely want to wait 10 months to buy my first prop. Thanks, Lance

Heather Pelletier · Answer

Thanks Mike, I appreciate your reply. You alway offer great advice. Heather:)

Michael Rossi · Answer

Heather, When you're first starting out, yes you need to have a cash reserve. I think that $5,000 would be plenty. Assuming that you bought the property right (based on expenses being 50% of the gross rents), then you should have money left over most months to contribute to a reserve account. As your portfolio grows, your need for the reserve decreases because the current cash flow will take care of almost every contingency. The things that happen only sporadically (like a new roof, new furnace, etc) when you have a few rentals, happen all the time when you have a large portfolio. So, to answer your question directly, I'd start by putting $5,000 into a reserve account and then put any unused money each month (not including your $100 cash flow) into that reserve account. Allow it to grow to a reasonable level (maybe $10K to $20K) as your portfolio grows and that's it. Good Luck, Mike

Heather Pelletier · Answer

Thanks Guys, That's exactly what I was looking for, a rule of thumb. I appreciate it! Heather

Brendan O'Brien · Answer

Yes, of course you must hold some cash back. How much? Well, I would keep six months rent in my pocket. That is money that can be used for major repairs or to keep paying the mortgage if you can't find a tenant. Generally, six months rent for a property is going to be about 6% of the purchase price, say $12,000 for a $200,000 property. That is plenty to deal with almost any situation.