TBT: Ask Marco – How Much Cash Should I Keep In Reserve For My Rental Properties?

Hello my friends. Welcome back to Passive Real Estate Investing where we dive into the world of real estate investing among other related topics. To help you with your real estate investing journey, today we’re doing something a little different. We’re going to take a trip down memory lane and showcase an important episode from the past on what we call our throwback Thursday episode. Now, whether you’ve been with us since the beginning, which goes back to 2015, or you’re tuning in for the first time, this episode is a must listen, we are revisiting one of our more popular episodes from the past, and believe me, what we discussed back then, whether it’s six months ago or six years ago, is just as relevant today. So sit back, relax, and let’s rewind the clock for this great episode. Enjoy.

Today’s question is a cool one and it comes from Clint and he asks the basic question of how much cash should I keep in reserve for my rental properties. This is a good question. It hasn’t come up in a long time. Interestingly enough, maybe I’ve talked about it on previous episodes, and in terms of my general rule of thumb, I’ll share that with you here in a couple of minutes, but let me read his question and give you some comments before I get to that. So Clint says, hi Marco. I’ve been listening to the podcast for a few months now. Thank you for all the great info and you’re welcome my wife and I own a single-family rental home in Kansas city and are starting plans to acquire three to five more properties in Kansas city within the next year and plan to continue expanding our portfolio further after that I’ve read and heard a lot of various ideas on how much should be kept in reserves to weather unexpected hard times or vacancies.

And I’m curious to know what your take or philosophy is on that. And how do you scale that reserve as you acquire more properties? For example, if I decided to hold six months of reserve on our current single-family residential property, it seems like it would be a significant chunk of idle cash. If I carry that same logic to five to 10 plus properties, and that’s a very good point. And that’s where you have to essentially determine how much to keep in how much to scale back. He goes on to say for context on our situation, I’m looking into using a heat lock or a cashout refi on our principal residence here in Las Vegas to fund that these next investments since we have equity built up in the home and are currently limited on available cash, I want to make sure I don’t overextend and put us into a significant bind.

Thank you again for the podcast, the advice and the time sincerely – Clint.

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Throwback Thursday Episode (The episode originally took place in the year 2021)

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You’re very welcome. So first of all, I love Kansas City, Missouri. I’ve got five properties there myself, and it has been a very strong market for the last five-plus years. I think it’s a great place going forward too. And we don’t always have inventory there, but most of the time we have inventory in Kansas City. So if that’s a market that anybody’s interested in, just check in with your investment counselor here and we can tell you what is available and what’s coming up back to your question about how much should I keep in reserve for my rental properties? So this is a darn good question because you definitely want reserves. The question is, is how much and how much is too much. And at what point do I scale that back?

So let me begin by saying that there really is no magic formula that you can use to determine how much you should keep in reserve in your business as a real estate investor. When you rent these properties, the four key factors that you should consider at least at a high level are the strength of the local rental market, the eviction timeline, and cost, which is often state-specific the age of the property and any deferred maintenance items that you’re carrying with that property and the type of neighborhood, which determines the general demographics of the tenants that you serve. And therefore what to expect on average over the long term from behavior in that tenant base. So the strength of the local market, generally speaking, the lower, the vacancy rates in a particular area, the fewer in reserve you’ll need for future vacancies. And you can find this information online or through the city’s housing department.

They typically carry statistics on vacancy rates. And certainly property management companies will know that from the various areas within the market, but you should at a minimum have enough cash reserves to pay for at least a minimum one month’s worth of vacancy. And that’s normally budgeted into most proformas, you know, by default, we use 5% and you can adjust that up or down on our website. I always like to use 5% is just the starting point and then bump it up. If I feel the need to 8% would represent one month, one vacant month per year. I like to make the assumption and you can certainly do the math and figure these averages out. If you have more than one property, you can just look at how they’re performing over time and do a calculation as to how many months of vacancy you have over time.

So if you have tenants that stay on average three years, well then your average vacancy rate is probably closer to 3%. So 8% would certainly be a conservative number. And on the high side, I like to assume that one month of vacancy for every two years, that’s just kind of my rule of thumb. So that would mean 4%. I use 5% as my starting point. And that’s what we use on our website. When you look at the proformas and the calculators for each property, it’s just by default 5%. So even in a good market, you’ll deal with problem tenants who may stop paying rent. Now this doesn’t happen very often, but you know, sometimes a good tenant just flakes out, something happens a life situation. It could be something serious and often these are personal situations, but you know, good tenant screening certainly helps. And this is not necessarily your responsibilities or property managers, but a rigorous background check on the tenants, you know, including reviews of credit reports, employment verification references two and a half to three times, their income over whatever your monthly rent is.

And, you know, checking with current and previous landlords, all that stuff is what your property managers will be doing. But proper screening leads to better quality tenants, which lends to having greater tenants that stay longer periods of time. The eviction timeline and cost is very much state-specific in pro-tenant States like, you know, New York, California, Massachusetts, in some cases, it, it can take longer periods of time, sometimes months. And the accumulated fees of forcing someone out might be a thousand or $2,000. Now, again, this is not to scare you. It just happens, but it doesn’t happen very often, but you have to understand, you have carrying costs, right? You have a monthly mortgage payment, your principal interest tax insurance, that is a monthly expense. That could be 500, 800 a thousand dollars a month. So you want to make sure you’re budgeting for that if, and when it happens.

So the age of the property, clearly with new construction, which we have a lot of right now, especially throughout the state of Florida and sometimes in other States, but with newer and like new properties and recently renovated properties stuff that we generally call turnkey properties, at least at the time when you’re purchasing them, you know, you won’t need to anticipate many, if any repairs during the first few years, the only variable there is just having the unfortunate situation of having a bad tenant. But as I noted earlier, you know, we recommend that you always hire professional property managers and do professional inspections when you’re doing your due diligence before you actually purchase the property. So just having a professional property inspector go through with a fine-tooth comb will help to ensure that you have no surprises later on, but there are always will be things that come up as time goes on.

And so you want a budget for those things. So the types of neighborhood, if you’re renting properties in low-income neighborhoods, often what we just generally classify as C class neighborhoods and certainly D class neighborhoods. But you know, when you’re in the C class neighborhoods plus or minus, you can expect turnover rates to be higher, sometimes much higher than high-income areas. So it’s just socioeconomic ladder. As you get into better areas and better neighborhoods, you have more professionals, higher-income earners, people that really are focused on protecting and building their credit and having a good reputation and not being evicted and having all kinds of life problems. And, you know, even in multiunit buildings, if you’ve got plexes of some kind, the smaller the units, especially the one-bedroom condos, and one-bedroom units tend to lend themselves more to single person tenants who tend to move more often.

So they’re certainly more transient. So just keep in mind, you know, where your property’s located when you’re trying to budget these reserves, are they in a class B class C class neighborhoods you’ll probably have to budget higher if you have a lot of C class neighborhood properties less. So if you’re in a class higher, more premium type of neighborhoods. So with all that said, here’s my general rule of thumb. My general rule of thumb is to have two to three months’ worth of gross rent, poor per unit. So if, if you’ve got a thousand dollars per month in rent, generally speaking, you’ll want two to $3,000 of reserves for that property, that unit, if you want to be very conservative, especially in the beginning, maybe budget four months worth. So $4,000 based on a $1,000 per month rental. Now that’s up to you what your comfort level is.

And then the four items I just talked about here in terms of the age of the property and the type of neighborhood, I think in the beginning, it’s a good idea to budget on the higher side, go with four months worth of gross rent for your first property and probably your second and third. But then we get into your second question here about how do you scale that? So you don’t have large chunks of idle cash sitting around when you have a portfolio of five or 10 or more properties. Well, that’s really the smart question here, because you don’t want to carry a large chunk of idle cash sitting around because that is not only depreciating, but it’s investible cash and it’s money that you want to invest. So how do you scale that back? Well, there’s no magic formula here and I can’t say I actually have a rule of thumb for it, but I’ll make one up.

Actually. Here’s how I would kind of process that. I’m just making some assumptions here. Let’s just hype pathetically say that you have built a portfolio of 10 properties and they’re all within one company, one LLC. Now you wouldn’t do that in reality, but let’s just say you did for simplicity. What I would do is scale back as you grow. So the first one, two or three properties, maybe shoot for four months worth of gross rent, but three would be my minimum in the beginning. And then as you build your portfolio beyond three, when you get to four or five and more continue to scale that back to the point where you’re maybe averaging two months’ worth of gross rent per unit across your portfolio, you can make it less. If you just want to have that feeling of comfort and safety, make it more now, here’s why you would scale it back.

The main reason is you don’t want, as you said, significant chunks of idle cash sitting around, because if you’ve got $50,000 of cash sitting around, because you’ve got 25 rental properties at a thousand dollars a month, and you’ve got $25,000 sitting around or $50,000 sitting around. Well, a lot of that could be investible. It’s enough to pick up at least one more property if not two. But the other thing too is, and this is kind of how I’ve explained it in the past, the likelihood of you having to replace a water heater or have multiple vacancies across your portfolio at the same time, meaning the same month is not very likely. The vacancies are going to happen over time, but they’ll be peppered based upon lease expiration dates or situations with your tenants. So they’ll happen sporadically and randomly at different times throughout the year and not necessarily in the same year, but least is expire at different times throughout the year.

So vacancies don’t happen all at the same time in the same month. Number two, you don’t have repairs come up at the same time or in the same month each and every year. Again, those are spread out and sporadic and somewhat random. So knowing that you’re going to have these ebbs and flows, you can scale it back. You don’t have to have three or four months worth of rent for every single property. You scale that back and have three quarters, half of that, maybe a quarter that’s being aggressive. But then what you do is if a maintenance repair item comes up, you pay for it from your operating capital, those reserves. And once that property is stabilized, again, you continue to build up those cash reserves, not just from that one property, but I guess collectively from your portfolio, because somehow someway they’re all flowing up into the LLC that holds all these properties, or maybe the holding company that is above the holding LLCs, but they’re there in your operations somewhere.

So you replenish what you spend to cover the vacancy or to cover the repair from the overall cash flows from your property. Assuming you have it structured that way. Most people are going to have it structured that way or something very similar to, but the point here is you just replenish what you’ve spent from the reserves from the next months or future cash flows from these properties until you’ve rebuilt that reserve back up to the watermark that you want to hold and carry for those properties. So that’s a lot that I’ve kind of thrown out at you, but I think it was clear and I’m assuming that it made sense. So anyway, Clint, I hope that helps you. And for all the listeners listening to this, I hope that was understandable. So again, there’s no magic number here, but these rules of thumb, I think hold quite well and serve most investors as well.

So there you go. All right, well, thank you for the question.

I hope you enjoyed this week’s throwback Thursday episode. If you haven’t already, remember to subscribe so you don’t miss out on a single episode. If you have a question about real estate investing or finance, simply go to passiverealestateinvesting.com and click the Ask Marco button. . I read all of them, I reply to many of them, and sometimes I cover them on the show, and I’m gonna try and do more of that. So, I am going to encourage you to go to passiverealestateinvesting.com and submit your question for Ask Marco.  Lastly, help us share the show with other like-minded people that you know who can benefit from it as well. Just visit us on your platform. Most of you are on iTunes and leave us a rating and review. I would greatly appreciate it. I read them all and I will thank you in advance. And that is it for today. Thanks for listening. I will see you on our next episode.

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