There’s no magic formula you can use to determine how much you should keep in reserve in your business as a real estate investor. When you rent properties, the four key factors to consider are the strength of the local rental market, eviction time line and cost, the age of the property, and the type of neighborhood.
Strength of the Local Rental Market
The lower the vacancy rates in your area, the fewer reserves you’ll need for vacancies. Your local newspaper or your city’s housing department may have articles or statistics on vacancy rates. You should, at a minimum, have enough cash reserves to pay for one month of vacancy per unit, which is only an 8 percent vacancy rate.
Even in a good market, you’ll deal with problem tenants who may stop paying rent and require an eviction. Good tenant screening will help solve this problem. If you plan to rent properties, you should always, without exception, do a rigorous background check on tenants. This includes reviewing credit reports, employment verification, references, and calling current and previous landlords.
Eviction Time Line and Cost
The length of time it takes to evict a tenant is relative to your cash reserves. In pro-tenant states like New York and Massachusetts, it could take months and thousands of dollars in legal fees to evict a tenant — all while you’re paying the mortgage. In addition, in our experience, collecting back rents or damages from tenants who’ve been evicted can be futile.
Age of the Property
With newer and recently renovated properties, you won’t need to anticipate many repairs in the first few years. As noted earlier, we recommend that you always hire a professional property inspector before you buy. Inspectors will go through the property with a fine-tooth comb, which helps ensure you’ll have no surprises later on. Another thing to keep in mind is that many utility companies offer a fixed monthly payment option so you don’t experience payment swings each season if you’re paying for heat, water, or other utilities as the landlord.
Type of Neighborhood
If you’re renting properties in low-income neighborhoods, you can expect the turnover to be much higher than in high-income areas. In addition, multi-unit buildings with small units and one-bedroom condos will attract more single people who tend to move more often than families do.
Rule of Thumb
A general rule-of-thumb is to have two to three months worth of the gross rent per unit. For example, if your property rents for $800 per month, then you should keep $2,400 in reserve in your real estate business's operating account.
This is so important to know and understand. In the 80’s, when my husband and I purchased several rental houses and multi-unit properties with little or no money down, we did not understand reserves or set asides. Taxes, and repairs came from his wages and always hurt. The income paid the mortgage and utilities and vacancies were usually very short, time-wise. However land-lording was much simpler then.
So take heed of this information and factor it into your business plan.
Cheri – that is so true. I see that happen to so many investors. Real estate investing must be treated like any other business.
That is an excellent post. I know of many investors who operates on zero reserves. It’s no coincidence that they suffered the most during this last recession.
Great article, more little tid-bits of info to keep in mind. A note about the eviction costs. One of the audio cd’s that I listen to regularly describes an experienced investor who said the total cost of an eviction, when you factor lost rent, advertising, damages, etc., is in the neighborhood of $3-$5K. All the more reason to have the best property mngmt possible
Great article. I am a new investor looking to start to purchase rental properties with little to no money down and this article was very helpful. In addition to these reserve fees, is there anyone out there that could advise me on start up costs? I need to know how much to prepare for such as lawyers, accountants, or property managing, anything of that nature. If anyone could offer advice from past experience I would greatly appreciate it. Thanks
Jarred — Aside from your down-payment, you should factor anywhere from 2% to 4% of the purchase price for your closing costs. If you have financing involved, then that may be closer to 5% depending on your lender or mortgage broker. Some fees are negotiable.
I have to agree with you Marco. A lot of people don’t think Real Estate Investing is a business, when it is. As a Real Estate Investing Coach, that’s one of the 1st thing I teach my students is to calculate how much money they are going to need for everything.
@Jarred, I am a Real Estate Investor in Las Vegas, and here’s a sample break down on how much you would need: Let me know if this helps and if you need any more information.
10% vacancy
10% miscs expenses
You will need to know the taxes
Get a good insurance agent to get you a quote on whatever you are investing in, Landlord policy
Home warranty
You will need to look up the taxes and HOA
In Vegas where I am from:
$550 a month rent condo
Vacancy $660.00 a yr or $55 a month
Misc expenses $660.00 a yr or $55.00 a month
Taxes $420 a yr $35 a month
HOA $1500 a yr or $125.00 mo
Home Warranty $450 a yr or $37.50 a month
Insurance $500 a yr (HIGH) $41.66 a month
Rent $6,600.00 a yr.
Expenses 4190.00 a yr
CASH FLOW $2,410.00 a yr or $200.83 a month
if it’s a rental unit at least 6 months rental income plus maintenance reserves. 1 year rental income to be safe. It’s also important where or in which entity you keep those reserves in. plan ahead
Real estate investing can be a great way to make an income if you understand the basic principles, but I think many times people rush into the market without a great understanding.