Create a reserve?

Question

Hello all,

The last few weeks I have been busy with rehab work on my properties and getting them ready for tenants. One question I am struggling with implementing the 50% rule. I am not sure how to go about it.

One of my rentals is a duplex and will rent for $625 each unit for total monthly rent of $1,250. With the 50% rule, I will have $625 left for P&I, but I am struggling with the other $625 for maintenance. Once I pay insurance, taxes and other expenses from this $625, do I keep the remainder in a savings account or let's say once I reserve reaches $5,000 for this duplex, then I can start including the other $625 in my cash flow as well. What do you guys do?

Thanks!

Rich Schroeder · Answer

I'm sure you'll get all kinds of different answers, but I'll share with you what I do. I put 7 units at a time in each LLC. Each LLC has its own savings/checking account. Once reserves hit $15,000 for an LLC (this is my estimate of 2 large expenses that could happen at once), I start pulling out the extra money as "cash flow". I reinvest that money, but would feel comfortable spending it on a personal level. Having said all that, the 50% rule is pretty accurate, so I haven't found that there is a ton of money left over, based on a long term average. On a short term basis, it sometimes appears that there is a LOT of money left over, but it never fails....it does get used eventually.

Bill Gulley · Answer

Reserves for real estate investments are as unique as the property is compared to other investments, in other words, think of using rules of thumb as one might do for an investment portfolio would be very different than having the same equity at risk in real estate. As mentioned, reserves are in the eye of the beholder. If you have a property that is located in an area where vandalism is the sport of the day, you can't really tie a set reserve to any index, like property value or rents, it will have to come from experience with that property. Being in a financial positiomn to cover any uninsured damage is the goal, if you can do that from day one without a "sinking fund" startegy, all well and good, but if you can't, I suggest you set aside all that you can initially and establish your reserve as quiclkly as you can (hopefully before your fisrt lease is over). What you need to assess is the risk of wear and tear as well as damage that is uninsurable for each property and then assess the risk in light of the probability of losses occuring at or near the same time on other properties. Never think that since you have quality "maintenance free" properties in great locations that you won't have any expense in the first or first few years. Things happen, like a fire and no insurance company will pay you for the total cost of repairs without you kicking in for a deductable or other exclusions of some kind! Things break in brand new buildings too! Bottom line, your reserves will depend on your financial ability to cover an uninsured loss. If you have to rely on those reserves, setting aside too much limits your ability to operate, too little, and you may lose money in future rents as it may take more time for repairs or to cover the loss. Good luck, Bill

Steve Babiak · Answer

I like what Rich said for the most part; the actual number where to stop is always going to be debatable - so I won't touch that :wink: Now, you can also be creative in the types of funds you utilize to cover "reserves" (not saying that you should or shouldn't do this, just putting the ideas out there). Things like lines of credit and credit cards can be called upon in emergency situations. Likewise for taking loans or early withdrawals from retirement plans (not the same as SDIRA), although if you go this route you will need to deduct penalties for early withdrawal and for paying income taxes in the year the money was taken out (so the entire amount in retirement funds cannot be considered, but something like 60% of it can). So, you might actually be sitting on some "reserves" without even realizing it.

Sharad M. · Answer

Thanks guys for all great replies. What I plan to do is set aside 50% of gross monthly rent in a savings account for a year, and use the other 50% for P&I and my "cash flow". After a year of putting aside 50% of gross monthly rent in savings for each of my properties, I will inspect the property to see if I should continue setting aside 50% in savings or start using that for more properties.

Bryan Hancock · Answer

I think that lines of credit are perfect for this. The problem is that they are subject to the bankâ€™s lending whims and can be cutâ€¦as has happened to almost all of the real estate investors I know recently. Nothing trumps quasi-liquid assets for â€œreserves,â€ but the liquidity carries an opportunity cost price tag. The â€œkeep your powder dryâ€ versus â€œkeep your money workingâ€ decision isnâ€™t an easy one to balance as your portfolio grows IMO. From what I have seen most of the wealthy real estate investors err on the side of keeping their powder dry once they have amassed a certain amount of wealth. This is likely a function of risk tolerance, planned reduced effort, and some tax planning. Many of the folks I have talked to have had to take risk to amass this wealth though and this requires taking more risk with less in reserve. There is only so much equity to spread around while you are growing a portfolio. To me this question is really about asset allocation and speaks to why different investors value assets differently. This is also why I think that any â€œruleâ€ is made to be broken. Peopleâ€™s equity has different values based on where they are in their investing career and desire to grow.

Bryan Hancock · Answer

I have asked this question on BP in 10 different ways and nobody ever bites. The truth is that the answer to this question depends largely on your personal circumstances. If you have a good job that kicks off a ton of extra money each month and/or credit lines to weather big capex items you can spend/invest the money and not keep it in reserves. If a big item will sink you then you need to keep the reserves and err on the side of caution. If you are already worth a ton of money then I wouldnâ€™t budget too much for a roof on a building, but I would include it in your deal analysis. I keep around 10% of my net worth liquid in cash or cash equivalents. We have credit lines to draw from so I am comfortable with this number. I have also heard that keeping 10% of your long-term debt liquid is a good rule of thumb too. Hope that helpsâ€¦this is a risk/reward question and you likely wonâ€™t get a great answer because it depends on your circumstances.

Rich Schroeder · Answer

I only invest in SFH's, so it is 7 SFH's. thanks, -Rich

Sharad M. · Answer

Thanks Rich for the reply. I appreciate it. When you say you put 7 units at a time in each LLC, do you mean 7 rental properties or 7 individual units? If you don't mind, can you please expand on that a bit? Thanks!