How Much Money to Keep in Reserve as an Investor?

Mike: Welcome back to the flipnerd.com REI Classroom, where experts from across the real estate investing industry teach you quick lessons to take your business to the next level. And now, let’s meet today’s expert host.

Bill: Hi, I’m attorney Bill Bronchick, host to the popular Legalwiz.com, and the instructor for the REI Classroom. Today we’re going to talk about how to do cash reserves. Meaning, how much cash should you set aside in your real estate business.

Mike: This REI Classroom real estate lesson is sponsored by uglyopportunities.com.

Bill: Well, real estate like a business like any other, you should have a minimum amount of operating capital. Now, if you go to the Small Business Administration SBA website, they’ll tell you on average three to six months of reserves for expenses for a business. Well, that’s just all businesses. Let’s explore the specifics of real estate.

So for rentals, if you go out and buy rentals it’s pretty easy to do no money down. You’ve learned that already probably. But if you don’t have any reserves you’re going to get into trouble because even though the vacancy rate might be very small, if you have two properties and one is vacant, well, that’s 50% vacancy, or an unexpected repair or the city tells you you’ve got a dead tree, and it costs you 1,000 bucks to remove it, etc., etc.

So generally, you don’t want to buy rentals. Period. Unless you have some sort of cash reserve or a line of credit or a partner who can put up money etc. You want to make sure you have that cash reserve. Now, how much do you need? Well, think about it this way. The more properties you have, the less reserve per property you need. Now, you need more reserves, but less per property.

So most banks when they lend you money they’ll recommend six months of reserves to cover your mortgage payment. Now, there are also other expenses you’ve got your maintenance and repairers, etc. etc. So in terms of how much, I’d like to use the figure 25%. And banks use that often too. Meaning, if you’ve got $1,000 rent coming in, your expenses other than mortgage should be about 250 a month.

So if you look at it as your mortgage payment plus that 250, times six months, that would be fine. Now, if you have three, four, or five rentals, you don’t need six months because the law of averages works in. It means you have less potential vacancy and you can rob Peter to pay Paul amongst properties, one is performing one is not and so forth. So the more properties you have, the closer you’ll get to two to three months per property.

Now, some factors to consider also with rental properties and how much reserve are the age and condition of the property, obviously, the older the property and the less it’s been updated, then the more you’re going to want to put aside for maintenance. Remember maintenance, and then repairs are two different things. Repairs are what you fix when something is broken. Maintenance is something that’s long term.

For example, if the roof has 10 years of life left on it, and it costs five grand to replace that roof, then you should be putting aside $500 per year into a maintenance fund for that roof. So remember that the older it is and the more repairs that it needs, the more your expenses are going to be monthly.

The class of property makes a difference. So if you’re dealing in high-end A-class property, the ones that are really fancy and nice and new, probably you got very little maintenance. But if you get into C-class properties, the older properties built in the ’60s and ’70s, and lot of section 8 housing tenants, you’re going to end up with a little more wear and tear.

And then the type of tenant. Let’s face it. You can’t discriminate, but we’d all like to have an older married couple, empty nesters, old school, keep your place nice. And we don’t want 22-year-old single college kids who are going to have a party and wreck the place. But in terms of, you can anticipate your level of repairs by who is your typical tenant for the rental unit.

So if you’re typically renting to an older couple, it’ll be less expense monthly than maybe a single person, young single person in a C-class property that’s going to turn over regularly. Unless the person you’re renting to happens to be a handyman, then it may be different. Do a little work out for the repairs.

And what about loan payments? Well, if you have a fixed rate loan it’s always the same, but if you have an adjustable rate, then you’ve got to worry about whether the payment is going to go up or down and so forth, how often it adjusts, monthly, quarterly, yearly and so forth. And then finally, if you’re in some sort of association like a condo or townhome, then you want to make sure that you’ve got dialed in exactly what the HOA expenses cover and whether there’s a potential for a rise in costs and any potential assessments.

So if you look at the most recent financials of the HOA and a couple of minutes of the board meetings, you’ll get an idea. Maybe they’re talking about replacing roofs or driveways and so forth, then they’re going to have to assess people in the near future, you want to know that so you want to know what you’re getting into. Well, that’s for rentals. That gives you a pretty good idea for cash flow for rentals.

Now, the other end of the game is wholesaling. And wholesaling, you really don’t need a reserve. The only expense really is marketing to find motivated sellers and an occasional earnest money deposit. So therefore, wholesaling is a great business to get started if you don’t have any reserve and you can use that to generate a reserve to buy rental properties.

Now, the other type of property would be fix and flips. And in this market right now where things are moving quickly, and you could buy a property, clean it up, fix it up and sell it in under three months and close it. But you should plan on up to six months of holding costs because it is not always the case that the buyer closes in the first try. Sometimes you need extensions, sometimes the buyer can’t qualify, sometimes the buyer gets cold feet, and you get another buyer. So plan on up to six months of holding costs in reserve for fix and flips.

Also if you’re doing more than one flip, make sure you’ve got enough reserve for up to six months in any potential surprises for both properties. Let’s face it. It always takes longer than you think for repairs and it always costs more than you think. So make sure you have a little extra. In fact, I would say that it’s the opposite rule of rentals.

In rentals, the more you have, the less per property reserve. With fix and flips, I would say there’s more per property because if you run out of cash and all your money is tied up into three or four fix and flips, you could become a motivated seller. The one we’re all looking for to buy. So you don’t want to be in that boat.

And of course, if you happen to run low on funds, here are some suggestions on how to have that reserve fund. The first thing would be to sell assets. If you have any toys, that old Camaro sitting on four blocks on your front lawn that you’ve been working on for 10 years, maybe it’s time to sell that. Flip a few houses and buy a Corvette later. You can refi assets.

So you can refi home, you can refi some of your other rental properties or are other assets that you have, an equity line of credit against your home or against your rental properties to use in emergency. A personal line of credit or business line of credit from a bank.

Now, the three last ones I mentioned lines of credit, you should use those wisely. Meaning, you don’t want to put that money up into the properties unless you plan on getting it back out shortly. Meaning, it’s a fix and flip, you’re going to sell it, you’ll replenish it, or it’s a rental, and you’ll replenish it from rents coming up in the near future. Don’t let that money get tied up forever because then all you’re doing is borrowing for your properties more.

A loan from your 401(k) at work is another option. A loan from a friend or relative temporarily until you can get back on your feet. And in terms of when you get tight, a good tip is, be in communication with your creditors and vendors. They’ll understand. Especially like a fix and flip and you’ve got a six-month hard money loan, and you’re getting close, pick up the phone and call the lender.

Otherwise, if they don’t hear from you, they’re going to start slapping fines and late fees, and it’s going to become a mess. So be in communication with those people. Your vendors will understand. Many a time I had a contractor that I said, “Listen, I know I owe 10 grand, but I’ll give you 12 if you wait two weeks till we close,” and they’re just fine with that.

So keep in communication if you get low on funds. This is Bill Bronchick. I hope you’ve enjoyed this lesson, and join me for the next.

Mike: HomeVestors the We Buy Ugly Houses folks, is a franchise system of hundreds of real estate investors that have purchased over 65,000 houses. If you’d like to learn more about the most powerful real estate investing system in existence, whether you’re a pro looking to take your business to the next level or whether you have no experience at all but a burning passion to be successful in real estate investing, please visit flipnerd.com/ugly to learn more.

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