How do you handle reserves on your rentals?

[David Nacco]

So this is a total newbie question but how do you guys handle your reserves? On a rental that’s renting 1500 a month and saving 15% ($225, 5% capex, 5% maintenance, 5% vacancy) it just seems low to me. Am I just being nervous here or is that lower than should be saving? I understand it depends on the property, example if you have a fresh rehab or a new roof and plumbing you won’t need to worry as much about maintenance/capex as someone who say needs a few things updated or knows a roof is gonna be needed in the next few years. But as a general rule of thumb is 15% usually enough?

Do you guys have a set minimum you will not go below even if it means going over 15%?

Next question, do you keep your capex/maintenance and vacancy reserves all in the same place?

And lastly at what point, if any, do you stop contenting to reserves? Say you have a generous amount saved would you stop adding to it until you’ve had to take some out then contribute again? And with a large portfolio do you do anything such as a large reserve account for all properties rather than individual reserve accounts for each one?

[Costin I.]

@David Nacco - first make sure to account for the following expenses in your calculations:

1) Mortgage
2) Mortgage insurance (PMI or MIP) or FHA Risk base
3) Property Taxes
4) City Taxes
5) HOA (Home Owner's Association) Dues and Fees and Assessments
6) Insurance
a) Property Hazard Insurance (0.3-0.45%)
b) Flood Insurance
c) Earthquake Insurance
d) Umbrella Insurance
7) Vacancy Rate (usually 8% - the equivalent to one month a year, or 5-6% if multifamily and/or if experienced, if not use 8%)
8) Utilities (you’ll have these if your tenant is not covering them and/or during vacancy)
a) Water § Sewer § Garbage
b) Electricity
c) Natural Gas
d) Propane
9) General Maintenance (usually 5%)
a) Upkeep § Landscaping
b) Snow removal
c) Repairs
d) New Appliances
e) Make ready
10) Capital Expenditures (usually 5%, higher is the property is old and obsolete, less if fully rehabbed and all mechanicals and roof are new)
11) Property Management (8%, even if you self manage, your time still has value and there might be a time when you'll want to be completely hands off or you'll not be able to do it, vacation, retirement, etc.), including...
a) Office Supplies (e.g. stamps, envelopes)
b) Software
c) Gas/Mileage
d) Advertising + Payroll
e) Concessions
f) Lease loss
g) Lease renewal fees
12) Lawyer/Law office/Legal fees
13) Accounting/Bookkeeping/CPA/Tax preparer/Tax advisor

Second, like you said it depends on the property, if older you'll need larger reserves. Therefore maintain a spreadsheet with the lifetime expectancy and incoming likely replacements and make sure you have that covered. You don't need to replace working mechanicals at their expected lifetime term, but you better have the reserves placed aside after as they can fail at any moment after.

The "set minimum" depends on the state of the property and expected repairs. A cheap Class C or D property might still require expensive repairs (like replacing the roof or water heater might cost as much as on a B property) so using a percentage of rent for it it might not be wise and reflect reality. 

You can keep the reserves all in same place if you don't want to complicate yourself with different bank accounts - just use software to track the expenses and reserves per each property so that you know at any time with ease how much you have incoming and outgoing and reserves for each one.

Once you have several properties, you can relax a bit the reserve contributions. For example, for the first 3-5 properties you set aside the "full" reserves amount. For the next 3-5 properties you can set only 75%-85% of the full amount required. And from 10 and up, you can set only 50%-60% - all predicated on the idea that hopefully will not all break loose at the same time. Again, if you maintain that spreadsheet, you should be able to forecast the reserves flow against the expected repairs/replacements flow and prepare accordingly. Again, you don't need to replace working mechanicals at their expected lifetime term, but you better have the reserves placed aside after as they can fail at any moment after. You can have several "good" years when nothing happens, followed by a year with 3 HVAC failures requiring replacement, 2 long vacancies + 2 serious make ready that will suck all the reserves and cashflow and push you into trouble if not careful.

And last, I suggest you run regularly a "stress test" on your portfolio - what happens if you have X amount of vacancy at the same time, accumulated with Y of roofs replacements or HVACs in the same period? Will you have enough reserves to weather Z months of no rent incoming, covering debt payments and other expenses? What will be the breaking point in different scenarios?