Why are rental repair/maintenance reserves a percentage of rents?

Question

I'm confused how using setting aside a percentage of rents for repairs makes sense. And where does that number come from? A $600/mo rental and a $2500/mo rental may have the same reroofing or repipe or mainline or HVAC cost. Saving 10% of $600/mo for 5 years won't get you a new roof where I am. Saving 10% of $2500/mo for 5 years will be more than enough. I had a mainline repair on a rental with a $700 rent after owning it for 1 year. No percentage was going to cover that.

Why the percentage? Wouldn't it make more sense to plan for the actual repair?

Account Closed · Answer

My husband and I owned 40 rental properties. We budgeted $100.00 in repairs for each building and if it was an apartment building or duplex, it was $100 per unit. Of course not all 40 rentals had repairs, so that gave us $100.00 that wasn't used per rental to be put into a reserve (Escrow Account, which of course would be used for high expense emergencies, like new roof and furnaces) We also told each other that if we made at least $100 a month profit on each rental as well per unit, we'd be happy. (Even though we knew beyond a shadow of a doubt we would make $100 profit on each rental unit, but one never knows). Plus, half of our homes were paid off. So we made pure profit on those homes) Whoooeee... We purchased our properties Cheap like today. Then worked hard to pay them off. But we bought in quantity. The more house you have, the more money you have to set aside for the other houses that need repairs, or has a tenant who isn't paying rent, or for those damages, or to BUY ANOTHER HOUSE....hot dog!Once you have a lot of houses in your pocket, each house will pay for each other. By still allowing a budget of $100.00 for each rental unit in repairs and net profit, helps take away the stress. Anything you make over that $100.00 profit you plan a month per rental unit is like Christmas!We managed that way for 30 years. It wasn't until the market turned that we were forced to retire. A ton of vacancies due to tenants leaving to buy houses and a City that kept getting worse. But up until then, we made a pretty good penny! Nancy Neville

Elizabeth Colegrove · Answer

That is why I personally like to have $6,000 or the largest "big" repair possible in my account. Plus as you start to have more rentals you can mitigate the risk and therefore having less money as a group per house.

Peter MacKercher · Answer

I agree that is way it best to save in a reserve account until you feel you have enough saved up to cover all the major repairs that could go wrong. That is one of the reason that is its best to have a lot of units that can help cover anything that could go wrong and will go wrong. There is not an exact amount on what you need to have in an account. but to save up a lot of us use 10% to feel safe. It makes it easier to sleep at night if you have a lot of money in the bank for the whatifs. If you have a lot of extras and you keep saving 10% you can always use that for a downpayment on a new rental or rehab. Systemic saving is hard for most of us so if you keep on doing 10% it will be most beneficial.

Chris Martin · Answer

The reserve rule of thumb is like the 2% (or 1%) rule of thumb or the 50% expense rule of thumb. The interesting thing is that Fannie Mae used to have a form for calculating reserve requirements, both initial and recurring (monthly). Now what do they have? "6 months". I can only guess that people didn't like having to spend the time to calculate reserves based on actual systems, and end-of-life calculations became a burden. Is that stove 3 years old or 5? So FNMA said... 'it's about 6 months...' hence they now have that 'rule of thumb' as their underwriting standard. I can't find the old FNMA spreadsheet form that was based on the actuals. In my area, a $600/mth rental and a $2500/mth rental do not have the same re-roofing or HVAC cost. In fact, although not quite proportional to the rent, these capitalized costs do approximate a percentage of rent... in my area. For many of us, we do implement capitalized reserve accounts based on actual system costs and EOL expectancy.

Eric Bowlin · Answer

I just have an active account, strong incomes, and several very good lines of credit/credit cards. I have never had to use the credit cards but 50k with low interest can get you pretty far.Just for fun though, you could get crazy with the math and do a risk adjusted savings per unit! Say you believe there is a 10% chances of a major repair happening on any one building...ie one major repair every 10 years. Say the average cost of this repair is 5000. You might start with 5k then save 500/yr/unit. You might want to calculate the odds of having two major repairs in one year happening (10%*10% = 1%) and have a reserve to meet both. The odds of 3 events happening is very small in this scenario. You can really get as crazy with it as you want.Another thing you might want to consider is to have the reserve to cover your insurance deductible for every bldg. Assume catastrophic event that damages EVERY property at the same time (hurricane, ice storm etc)..if you have 2k deductable an 10 bldgs..maybe 20k is a good number to have.Hard to say what is the 'right' way to do it. I'm sure an actuary could calculate it for you though.

Chris Martin · Answer

I agree with you. I think FNMA and Freddie Mac should go back to the "true" numbers for reserves. This is the form that used to be required: http://www.freddiemac.com/singlefamily/forms/sell/pdf/998.pdf not the "6 month" reserve underwriting requirement in place now.

Account Closed · Answer

I work in two markets 150 miles apart. The actual rents are more like $1000/mo versus $3500/mo....for pretty much the same 3/2. While I work with cheaper crews in the the cheaper rental markets, there is still a base price for a roof or HVAC.

Mike H. · Answer

I love Nancy's post there. Work of art there. That to me is the essence of investing.As you grow your portfolio, you start seeing economies of scale. Not necessarily that you're going to get deals on rehab or carpet or anything. But that the law of averages starts to come into play and you see can see how the other houses help make up for the bad ones and the "house" (i.e. the investor) always wins. :-)One thing I would agree with as well though is that a percentage of rent makes zero sense. Someone may have had some numbers that worked out that way but it would have been strictly based on their portfolio. Who's to say that your portfolio would look like theirs. The real problem I have with it is that many times the houses in the lower rent range end up needing the most repair dollars. I actually believe there is an inversion deal working there but don't really care.I follow pretty closely to that $100 a month per house rule of my favorite friend Nancy above. So far in the first 7 years, I'm seeing more like $75 a month per house. But I'm sure as my rehabs age a little, that may start to get closer to $100. In the meantime, that means I'm making an additional $25 per month per house - which is then being used to buy more homes and increase my income. It also has the added effect of pushing my average rehab age out further which helps me keep closer to that $75 a month number. i.e instead of 10 houses at 7 years since acquisition and complete rehab, I have 3 at 7, 3 at 6, 3 at 5 3 at 4..... and 10 at 1 (32 total).It also means that even as my older ones continue to age, my average of $100 a month should help support them even as they get closer to 100 to 125/month.At some point, my number may have to go up there. But I'm hoping that by the time it does have to go up, my rents will be so much greater that the $25 or even 50 more a month I might have to account for will be more than made up by the 200 to 300 a month increase in rents. :-)To me, the formula for calculating actual repairs should be more based on the type of home you buy and in this order:1) Age of home.2) Condition of rehab.3) Age of mechanicals (hvac, water heater, roof)4) Size of home.5) Area of home - nicer the area, the better the tenant pool. The better the tenant pool, the better they'll typically take care of the home.I have houses in 15 different towns. And I can say without a doubt that I know the likelihood of giving 100% of the security deposit back in some towns is far greater than in others. So I know my make ready costs are far less in that town than they are in others.

Account Closed · Answer

Thanks for the responses. It sounds like those responding are those that are saving and/or have other ways access to repair funds, so they are not worried about a percentage. But we hear about newbies here on BP using their last penny for a down every day. Lord help those tenants when necessary repairs come along.

Reggie Maggard · Answer

I say, buy that property, account for cost of fixing it up, make it new (fix what needs fixed the right way), and then that makes pm that much easier. If u have a new hvac, roof 5 yr old or less, relative new appliances, do thorough tenant eval, etc..., you should be able to limit expenses for cap ex and maintenance. That being said, I advocate a backup plan for your backup plan????.