How do you manage your maintenance reserves

[Julie Macd]

Across the forum, we talk about ensuring that you maintain your reserves... but how do you actually manage them on you own the properties? This question is for the properties you plan on holding. If you are flipping, reserves are a different topic I think. 

Do you maintain a separate reserve per property, by class or location, or across your portfolio?

Where and how do you hold these funds? do you physically shift $X to a separate fund on a monthly basis? What is the amount based on - rent or property value, so much per door?

Do you keep the funds in cash or money markets or some other type of account? Or do you rely on lines of credit if funds are needed?

How do you determine if you have enough set aside (ie. perhaps you can invest some of them or need to set aside more). Do you use a percent value of your portfolio? or do you look at what might be needed for each property individually? what is the time frame you use

Your advice and thoughts are greatly appreciated

[Bill Gulley]

Julie, two quick rules of thumb lenders consider, at application for purchase money they want to see 6 months PITI and 10% of the home value in reserves or enough consumer borrowing power to borrow for emergencies, to get them at that 10% level......that has room for +/- and isn't a "requirement" but a "like to see". They won't do a loan where it takes all the borrower's cash and is so thin they can't obtain other small loans.

Maintenance reserves are always a guesstimate because there is just plain luck involved. 

Who knows when the blower motor in the HVAC will burn up or if a kid mowing the lawn hit the condenser hard enough to crack a joint in the line, pressure drops and causes damage? Possibilities for damages are endless.

Investors need to do an assessment of the property condition when they buy and annually. The age of mechanical items, roof, appliances, structure and interior is where you need to begin consideration for the reserves for each property. 

You can look to the IRS tables for depreciation, classes of property will have different periods to depreciate an item. Depreciation is an expense, not a cash expenditure but applies to taxable income. Treat it as an expense for your "use of cash" projections and savings or retained earnings. This should apply to all those who buy and hold.

For those getting into the business, their first or first few properties, then;

I suggest you consider MY Target Goal of 4,3,2,1 done approach to reserves. First year withhold 4% of the long term depreciation, a 75,000 property/27.5 years = 2,727.27. 75,000 X 4% is 3,000. 3% the next year is 2,225, the next year 2% will be 1,500 and year 4 is 750.00 in year 5 you're done saving so long as you don'y use those funds, if you do, "2% will do" normally to replace funds. At year 5 you have set aside 4,475 or 6% as a cash reserve.

Now, you say, gosh, I bought the place to get $150 a month out of it! That's only $1,800, I can't make up that 4% in the first year!       

4,3,2,1 doesn't necessarily have to come out of income, it's a target of the balance of cash on hand for each period. That will mean that when you buy the place, you should already have funds to make up that difference, so in year one to hit $3,000, you can minus out the reserve requirement from income, say $50.00 a month and you should then have $2,400 to start with. 

Don't forget your ability to borrow either. What you don't have in cash needs to be available to you from other sources. The ability to raise cash quickly, let's say 3 to 5 days, most anyone doing work for you or supplying materials can bill you and paid within the week. Accounts with suppliers should be set up, many give 30 days same as cash terms. 

Two major concerns initially are the mechanicals (HVAC) and the roof. Larger or well established vendors in these areas usually have financing available, so know where to shop and deal with.

So, your ability to borrow also plays on that 4,3,2,1 approach. By year 5 you should be in a better cash position but for small investors the ability to borrow will always be a consideration for your use of funds.

As your portfolio grows, beyond 3 properties, you begin to start building a business, not just as an occasional landlord. Your use of cash begins to take on an all inclusive approach rather than a per property view. You can begin by weighting factors of each property condition to a whole rather than individually. This is because 2 or more properties can begin to "subsidize" expenses of an additional property. 

What are the chances that 4 HVAC units will all explode in the same year?  Slim and none!

Concentration of units risks, having 5 properties along one street, additional risks are assumed. While many perils are insured, wind storm, fire, hail, etc. something like a railroad gas car overturning or an oil pipeline breaks, might cause a loss of tenants and that will take time to sort out, all the while, you'll have clean up, repairs and leasing duties to get back into the business.  There are advantages of not having all your eggs in one basket. 

Reserves are not just for maintenance, they are for when stuff hits the fan. 

We call the account "maintenance reserves" that's accurate for a few properties, but as you grow into a business I prefer "Operation Expenses/Reserves" taking in a broader definition for what if the stuff hits the fan. An example of expenses that can be tagged to the business and not so much to a single property are legal fees, compliance costs, office expenses, auto expenses, tools and equipment expenses including replacements.

Initially as a small individual investor, your reserves will be higher per door simply because you can't spread the costs over a larger operation. As you grow, the total of your reserves may be higher in a dollar balance but per door they can decrease as other properties subsidize the "what if" factors. Your expenses become better identified and determinable as well. 

Where you keep cash simply comes under cash management. Reserves should be readily available, so you don't want to hold cash initially in "timed deposits" like CDs. Liquidity is most important to any business. 

When investors suggest using separate checking accounts for each property, that is an obvious admission that they can't manage money and lack basic business aspects to finance. When you go to a lender with a sack full of checkbook statements, it tells them the same thing. ONE operational account. ONE escrow account. A money market is what I used. 

There are four types of financial statements:

1.Statement of Financial Position or your Balance Sheet. Assets-Liabilities=Equity 

2.Income Statement showing income and expenses to obtain net income or loss.

3. Cash Flow Statement or Use of Cash, this shows cash income from operation, investments, the sale of assets other than inventory and financing activities, costs associated with raising capital, interest, principal repayments and timing of the movement of cash can be ascertained.

4. Statement of Changes in Equity or Financial Position or Statement of Retained Earnings.  This measures the owner's equity and cash flow over a period of time, during an accounting period. It shows the movement  of net profits, capital repaid  and dividends or drawing to owners as the take out profits. You can also recognize revaluations of assets (appreciation of properties) and changes in accounting policies or corrections of accounting methods.

As to your management of accounts, you have a "Chart of Accounts" this is a simple road map of  your accounting system. Your Operations Account holds all the money of your business operation and from that general account you have sub-accounts on your books, not as separate bank accounts. You will show income, expenses and retained earnings as they are allocated or assigned to appropriate categories, such as 2336 S. Kings Ave income, expenses and retained earnings. Each property is a sub-account.

A chart of accounts are usually noted by a numeric key, 100's as assets, 200's as liabilities/expenses, 300's as equity. Rent from the Kings property could be account 105, the mortgage payment for that property could be 205, what net can be shown as account 305. You can make up the chart of accounts anyway you like, just so long as how you identify funds is consistent throughout the accounting system. 

The above are the basics of accounting, you don't need to be an accountant, but accounting is the language of business, if you can't speak to these basic accounting functions, you can't talk business. 

If you're running different checking accounts, it's time to speak to a bookkeeper or an accountant, you don't need a CPA unless you're a publicly traded or non-profit company, but they certainly have demonstrated a greater knowledge, that might be important to you, but usually not just setting up your books. BTW, if you believe plain English will get you through Quicken or some accounting program, you're wrong, you need to understand those 4 main areas of accounting to properly input data.    

If you sell a pair of boots at a garage sale, you don't need an accounting system, you do if you're trying to run a shoe store. Your system should be appropriate for the size and scope of the business operation, nothing more. 

So, assess each property as to its economic life and use the depreciation tables to set reserve standards. As you grow, identify the risks assumed and plan for the unknown to be covered. Use your cash on hand as well as your ability to fill in any financial gap for emergencies to meet your target reserve requirements. Keep with the requirement for liquidity, quick cash available. Understand the basic accounting statements, what and how funds are to be allocated, this will guide you in your use of cash and the types of accounts you may use to keep cash on hand and other liquid investments. 

My gosh, I hope that covered your questions Julie! LOL :)

Edited: BTW, I think the above post meant to say keep personal and business accounts separate. You certainly deposit rents as income to your operating account. 

A helpful hint as to understanding basic accounting will be to study "T Accounts" and double entry accounting, it isn't hard. Good luck :)