Don’t let your rental turn into a cash eating monster! Have reserves (money) in the bank.
Hi guys! We’re back with a new article for you.
We have a burning question that we want to ask…What is your biggest nightmare when it comes to real estate?
We bet we know!
For us, it was the idea of creating a cash eating monster machine that always wants more. We used to look at our accounts and wonder where all the money was going. Why on earth did the gurus say real estate was a good idea?!?
Our reality was closer to how cookie monster used to devour cookies.
Owning rental property can feel like you bought a cash eating monster…#landlord problems Click To Tweet
It was sad because we dreamed of being property owners and the reality was not matching up with the rosy stories we heard.
Here’s the real on real estate: it’s a low margin cash intensive business.
There it is…we said it. *crowd goes silent*
Wait, don’t leave the page…we promise it gets better. (in the long run… not so much in the short-term)
Seriously. Real estate is cash intensive and it does produce relatively low margins. It is still a great business and offers a ton of advantages over other industries. You just have to know the little known secret that everyone conveniently forgets about.
You know, money in the bank, cash, savings, whatever you want to call it. You need to have money available at the ready for when ish hits the fan. It always does.
Just like in your personal finances though, it seems that items are more expensive when you don’t have money than when you do. Have you ever saved up for a large purchase then gotten a discount? How about when you’re low on cash an *suddenly* your car needs a repair that costs more than it’s worth? Thanks Murphy’s Law.
Well the same thing happens in business. Especially in real estate. When we talked about this before, we were focused on the savings tactics, not on the overall philosophy.
Why reserves are important
Reserves serve two purposes on your real estate investing business. First, as a property owner renting units to tenants, you are responsible for the upkeep and maintenance of the property. That means if the toilet clogs, it’s your responsibility to fix it.
This means that you need to save some of the profit every month to have money to cover incidental repairs.
The second purpose of reserves is to give you a sense of control over your business. We talked about how using a personal escrow account (insert link) can help us feel more in control of irregular, somewhat expected expenses in our personal budgets. This is no different.
Stuff breaks. Life happens, Toilets clog. (sorry for all the toilet references!) It’s all a part of being a property owner and real estate investor. Like many things in life, however, we can estimate reasonable annual repair amounts for each unit and determine how much we should have available for when a repair happens. Sometimes your reserve account may not be enough and you’ll have to increase it. The point is, if you have a pool of money to draw from, the sporadic expenses will not feel so draining to your business.
What having reserves means for your business
Put simply, having reserves means that you do not have to worry about your real estate investment becoming a cash eating monster. The purpose of reserves is to cover minor repairs associated with daily living.
Catastrophic events would be covered by insurance. It may be a good idea to determine how much your deductible would be, and make sure you have at least that must money available for each unit you own, in addition to a certain budgeted amount of repairs.
Here’s an example:
Let’s say you bought a house and it has a mortgage payment of $500/mo. For easy math, let’s also say that the rent is $1000/mo. This means that after the mortgage is paid, you have $500/mo remaining.
This is not profit. We repeat this is not profit. Did you read that? The $500/mo is NOT profit.
The $500/mo is your operating income. Instead of using the entire $500/mo to take your sweetheart out for a nice dinner, we suggest putting some money aside for reserves and other incidentals.
The exact amount you choose to put away is up to you. Most people suggest somewhere between 5-25% in reserves. Where you choose to set the line of demarcation is totally up to you and your comfort level. For instance, if you pre-funded your reserve account with $10,000, there may not be a reason to save 25% monthly. However, if your reserve account is not so healthy, it may be wise to delay substantial profits until the business can build up its reserves.
For our business, we set aside 20% of the gross rent for reserves, take 2% as profit and use 78% of the income as operating income. We are working to grow our reserve accounts so we are taking a modest 2% profit until the account reaches our goal amount.
Peace of mind
This is probably the most important reason of all to have reserves. Money troubles are no joke. Money is the leading cause of divorce in the United States and is a constant source of worry for many.
Credit cards are another option to cover unexpected repairs. Used appropriately, credit cards can allow you the flexibility to resolve an issue quickly while also giving you airline miles and other rewards points. There are a number of great cards out there, and the Starwood Preferred American Express is one of our favorites. Remember to be prudent when using credit cards and consider your full financial situation before using credit as a primary resource for funds.
We suggest taking prudent steps to make sure you remain in the black before diving in with real estate investing. If you haven’t yet read the Richest Man in Babylon or Profit First, we highly encourage you to do so. It is important to remember to pay yourself first both in business and in your personal life. If you don’t, you risk being able to maintain your property and your sanity.
We want financial independence and so do you. Real liberty isn’t being worried about money or how to keep the ship sailing. Let us know if you’d like more on this topic. We’d love to share more best practices and what we have learned along the way.
As always, make sure any investment you’re considering makes good financial sense. How good are you at evaluating rental property? We could all use a little help. Download the rental property evaluator to double-check your numbers. Invest with confidence.