Owning an investment property is not all sunshine and roses. Furnaces go out, appliances break, emergencies happen. All these things cost money to fix. Sometimes lots of money. To prepare yourself for these one-off capital expenditures, it’s imperative to have a reserve fund set aside. Your reserves help cover these expenses when they come up because, yes, they eventually will come up.
A Rule of Thumb for Calculating Reserves
A typical rule of thumb when creating a basis for your reserves is to hold at least six months’ worth of rent in reserve for each unit you own, but the reality is that you’re never going to have too much in reserve. Six months should be considered just a starting point. You should keep these other considerations also in mind:
- Your annual capital improvement needs: It’s not possible to anticipate every expense you will encounter, but you can make informed estimates about a lot of components in your rental unit. You do this by completing a capital spending study. Start by determining the age of all components in the property, estimate their remaining useful lifespan, and estimate the cost of replacement. Lastly, break down these costs per year. This helps you understand roughly how much you should set aside each year for CapEx expenses.
- The number of units you own: If you own multiple units, you may not need to save 6 months of rent per unit, as it’s unlikely that all your units will encounter major expenses at the same time.
- Your turnover rate: If you have a high turnover rate, you may want to increase your reserves. Our experience is that turnovers generally cost anywhere from 1 to 4 months of rent just for repairs and improvements. Mortgages and other recurring expenses while vacant add additional reserve needs.
- Your depreciation rate: The IRS allows property investment owners to reduce their taxable income by deducting a portion of their property’s cost as an expense on their tax returns. Owners can depreciate for the property’s building value and any capital improvements they make to the property. This is a wealth-building incentive for investors, but the reason it’s allowed is because owners will, in fact, need to reinvest in their property to maintain its condition. One way to build up your reserves is to apply your annual IRS depreciation rate to your reserve fund each year.
Making major investments in your rental units can sting, but it’s important to remember that these are long-term investments that will serve you and your tenants well for years to come. As you consider how much money you need to set aside in a reserve fund for your properties, keep in mind that more is always better. At least 6 months of rent per unit is a starting point, but you should consider your specific units and needs when making your calculations.
To learn more about property investing in Franklin County and how a property management company like ours can help you be successful with your investment, contact us at RL Property Management.
