You’ve saved some money and want to buy a rental property. But, how much can you afford to spend? How much do you need to keep on hand? How much money is enough?
You’ve got questions, and we’ve got answers. Here are the five Ws of reserve funds every real estate investor should know:
WHO: Who are we talking about?
You, the real estate investor or aspiring investor.
You’re the one who has decided to accelerate your path to financial independence or retirement through residential real estate.
You are also the one who needs to make the down payment on a new property and pay the bills associated with being a landlord. So you are the one who needs to establish a reserve account.
WHAT: What are Cash Reserves?
Cash reserves are the funds you set aside to cover expenses associated with your investment property.
Consider your cash reserves as an emergency fund dedicated to your real estate investments. Having cash set aside means you can react quickly to whatever expenses pop up.
A good rule of thumb for a reserve account is setting aside the equivalent of one to three months’ rent. You may be safe sitting on the lower end of that range if you own multiple properties. It is unlikely that they will all have vacancies or significant expenses simultaneously, which helps keep your reserve needs low. However, if your property is older or you know some of the systems or major appliances are nearing the end of their expected useful life, you should beef things up and push closer to or even over that three-month target.
The great thing is that if your reserve cash grows to be more than necessary, the only problem you’ll have is figuring out what to do with the extra money you have saved. One great solution to that problem is using the money for a down payment on your next investment property.
WHEN: When Should I Start Building Cash Reserves?
Ideally, today. Prioritize building your savings even before you buy a property.
As soon as you decide to purchase an investment property, start building your reserves. Don’t wait to start setting money aside until after you’ve stretched out the hand cramp from signing all those closing documents. Begin setting aside a small amount of money every month or from every paycheck as soon as you get serious about securing your future through real estate investing. That allows you to grow your reserve fund gradually and have it in place from day one.
WHERE: Where Should I Hold These Reserve Funds?
Somewhere safe and accessible.
No, that doesn’t mean stuffed under your mattress or buried in the backyard. It also doesn’t mean investing in the newest speculative Cryptocurrency. Because it is difficult to anticipate when you will need to tap these funds, you want to avoid putting yourself in a position where you have to sell a volatile stock when it has just taken a significant loss. Invest them conservatively.
You also don’t want them tied up anywhere it will be difficult to withdraw them quickly. Investing in your cousin’s new restaurant may feel like a good bet, but if you need $5,000 for a critical roof repair, that could be a problem. If it takes weeks to access your funds, that’s not a suitable emergency plan. Those are weeks you don’t have when it’s raining in your tenant’s closet.
Look for liquid investments and account types. Consider high-yield savings accounts as a solid option. You can access your reserve cash within hours with a savings account or mutual fund. That means it’s available whenever you need it. If you feel compelled to invest this money, look for conservative mutual funds with lower risk profiles.
Why: Why Do I Need Reserve Savings If I’m Collecting Rent?
Because expenses can be lumpy, meaning they will occasionally surpass rent amounts.
Most months, you should have enough positive cash flow to pay for moderate expenses with the rental income from your properties. However, a more significant need may occasionally take the profits from several months’ rent. That’s when you use your cash reserves.
These saved funds will also come into play if you have a vacancy between tenants. You’ll still need to pay your mortgage and may even have turnover-related expenses like cleaning fees or marketing expenses. You can pay for those using your reserve funds.
The answer to the question of how to avoid financial stress from your rental properties is simple: build and hold sufficient cash reserves. That money provides an insurance fund that you can use to cover emergencies. That means you can stop asking yourself what happens if something goes wrong and start worrying about more important things like what you should have delivered from Postmates or whether to go to a movie or catch a game on TV.