Why Real Estate Investors Use a Replacement Reserve

A Replacement Reserve is a method of setting aside funds (usually in a bank account) to cover a rental property's anticipated (though inevitable) future capital improvement expenses such as the replacement of a roof, carpets, air conditioning and heating equipment, appliances and other electrical or mechanical equipment, wood decks, parking lot and so forth.

The idea is straightforward: routinely put aside some amount of cash now to help cover some expense you know will eventually be required in the future. It is, after all, a reality that items such as carpets and roofs will eventually wear out, and thus will need replacement from time to time.

Okay, but that type of money management is just common sense and not particularly anything new. So what makes the "replacement reserve" a method unique enough that real estate investors should consider accounting for it? Because it was conceived to be used by investors during the property analysis stage—before the purchase is made. In other words, it provides investors with the option to measure the investment property's profitability based upon the likelihood of future capital improvements before making the investment.

Here's how it works.

The allocation of funds for potential capital improvement expenses is not required to keep a property in service. So it's not an operating expense.

Therefore, I would recommend not including it with the operating expenses because this would, in turn, reduce the property's net operating income and subsequently skew the cap rate computation.

On the other hand, since it is a reserve for replacement of improvements attributable to the rental property it does make sense for the real estate investor to consider it as a deduction from the property's annual cash flow. This would then impact the investor's cash-on-cash return, which seems appropriate.

Here's where to include it.

Here's where you might fit it into your real estate analysis:

• Gross Operating Income
• less Operating Expenses
• equals Net Operating Income
• less Replacement Reserve
• less Debt Service
• equals Cash Flow

The following image of my APOD shows you where I like to include the replacement reserve. In this case, I entered it as $300 per unit annually based on 100 units. So the result is $30,000 annually (see below).

Rule of Thumb

How much money should be set aside for replacement reserves depends on the age of the property and the investor's particular investment strategy. To get a better idea of what amounts are set aside in your local market area, though, you might make a call to a local appraiser or bank and see what method and allowance they currently are using.

But bear in mind that it's doubtful that the inclusion or exclusion of this reserve will carry enough weight to make or break a prudent real estate investment decision, so it is optional.

So You Know

ProAPOD Agent 6 and Executive 10 real estate analysis software solutions each compute a replacement reserve automatically based upon your data entries. Both solutions allow you to enter either as an "annual dollar amount", "percent of gross operating income", or "dollar amount per unit per year".

Here's to your real estate investing success.