Unexpected Capital Improvement

[Account Closed]

I have not run across anyone talking about building or having a reserve fund for a property. What is The recommendation to accrue and pay for a unexpected capital upgrades, i.e. furnace, roof, sewer, parking lot, windows, etc. when you are just covering expenses at 10/12% cash-on-chash returns?

[Erik W.]

@Account Closed, hi and welcome to BP!

First, without any disrespect to our colleague Bjorn, I take serious exception with this statement: "You can build a reserve fund with help from security deposits..."

That is ILLEGAL in my state.  Per the Revised Statutes of Missouri: 535.300. Security deposits, limitation — holding of security deposits, "All security deposits shall be held by the landlord for the tenant, who is a party to the rental agreement, in a bank, credit union, or depository institution which is insured by an agency of the federal government. Security deposits shall not be commingled with other funds of the landlord. All security deposits shall be held in a trust established by the landlord and deposited in a bank, credit union, or depository institution account in the name of the trustee."

If you'd like that in plain English: the money belongs to the TENANT and you are holding it in trust for them in an account that is dedicated for that purpose.  It is not your slush fund to play with or repair the HVAC, period.  I know a lot of Mom and Pop land lords who fly under the radar don't do this properly, and there are precious few times the tenant would actually sue someone over this, and there isn't any formal auditing.  BUT!  A shortage of litigation and someone peaking over one's shoulder doesn't give anyone the excuse to break the law.

I now decend from my soap box. (*grins)

You should be setting aside approxilately 3-7% of your monthly gross potential market rents--regardless if units are rented or vacant--each month in anticipation of Capital Expense repairs.  I'm worried that you're "not run[ing] across anyone talking about building or having a reserve fund for a property."  That tells me you are not reading good source material, or not reading a sufficient amount of source material.

Some gurus and pod-casters are notorious for glossing over the realities of running a rental business.  All they talk about is how to go from 0 to 3,000 doors in 2 years using OPM.  All that's missing is the 1980's late night infomercial dude with his Lambo on the beach with three hot bikini girls.... am-i-right?  

Capital repairs WILL happen, and they should not be unexpected. You know that the sun, rain, and hail are constantly beating up the roof and siding.  You know the heat and air systems are constantly running even when the place is vacant to control humidity and/or reduce thermal expansion and contraction of inside elements (and avoiding frozen pipes in Wisconsin!).  You must be prepared.  

A credit card/LOC are bad options: going into debt for known expenses tells me cash flow is too poor and the property is not performing. It's a terrible thing to pay off a property in 20 years, only to have to go back into debt for 10 more years to redo the whole place.

Why use gross potential rents instead of actual rents? Again, because CapEx items are wearing out regardless if you are rented or not. The weather doesn't take off 3 months to account for your vacancies, so neither should your contributions to a CapEx fund.

Anyway, my suggestions are above.  And dig into more authors/SMEs (subject matter experts) and you will absolutely find people talking about this topic extensively.....at least, the ones who are still in business after 10+ years.  *wink

I hope this helps!