Rainy Day Fund for Real Estate Investors
Clifford A. Hockley
In these economic times we all need to consider whether or not we have enough money set aside to cover our expenses. Many financial planners suggest three to six months pay as a good guideline.
As a real estate investor, setting aside a reserve fund is always a good practice. Not only is the economy unpredictable, so are the weather and your tenants. How do we evaluate how much to set aside? Let’s review some of our risks.
Economy
In an economic downturn real estate investors are faced with high unemployment, unpredictable interest rates and lack of financial liquidity, none of which we could have forecast. Inevitably, the lack of work means landlords lose tenants as tenants lose their jobs. Layoffs also mean that people are moving in together. Together these challenges mean that there are fewer tenants. This means a higher vacancy rate and, landlords will inevitably lower their rent and offer rent concessions in order to keep cash flow coming in. This rent reduction means lower returns for investors. This occurred in 2002 and is now occurring in 2009.
Weather
Worldwide, buildings are at risk for tornadoes, hurricanes, typhoons, summer storms, flooding, freezing, very hot temperatures, sandstorms, and snow storms; which then create downed trees, power outages, roof leaks and building envelope failures. These weather challenges create building repairs that may necessitate the use of insurance for repairs. Cash needs occur when an owner has high deductibles or the insurance will not cover a claim.
Tenants
Tenants are not always gentle with the use of their living spaces. Some tenants are victims of domestic violence, which may cause property damage; other tenants may not be familiar with the correct etiquette for living in an apartment and caring for the property and they can inadvertently damage the property. Finally, rental units are designed to cater to people who are in transition. Tenants tend to move in and out and this constant turnover causes damage to properties.
Other Risks
Of course, there is the unexpected. We see fires set by vagrants, people crashing cars into buildings, children getting behind a wheel of a car and losing control. We see electrical fires caused by mis-wiring, old wiring, electric blankets that short out for example. We also see plumbing that fails due to poor installation or electrolysis. Finally, we are also constantly faced with governmental agencies setting new standards for landlords. Examples here include; increased inspections of drywells, inspections of properties to make sure they comply with the American with Disabilities Act, continual code changes and currently a strong governmental push to reduce the use of electricity.
Regular maintenance and operations needs
We have major property expenses that need to be addressed as part of regular operations, such as tenant improvements, leasing fees, building renovations, pests control and other capital expenses.
Insurance and bank reserves
Many of the above risks can be insured for, so that when a huge expense occurs you have the ability to find some help. In addition, some financial institutions set aside a capital reserve as part of your loan structure, to help an investor overcome these challenges.
Rainy day fund
At this point you are probably saying, “Why invest in real estate there is too much risk.” As my father in law Sid Bluestone used to say, “There is risk when you walk across the street”. So how do we adjust? We review all of the above risks. When we buy a property we take the precautions to try to eliminate risk. We hire inspectors to make sure a property is built to current code, and that everything works. We hire engineers to make sure we do not have environmental hazards. We review the history of a property and see how it has operated in the past.
We learn from others, previous investments and underwrite a property conservatively. We buy insurance for huge risks and we screen tenants carefully to make sure we are not buying ourselves a headache. Finally we set aside some money to self insure. No one can forecast all of the expenses a property might have. So we self insure with a rainy day fund. We make sure we have at minimum a couple of mortgage payments, a couple of insurance deductibles, and some extra cash for those unexpected things. In that way when we go to sleep at night we know we have built a buffer that will help us buy time as we adjust to any of the risks we will encounter.
Don’t stop to think, start your rainy day fund today.
Here are some tips how to get started:
Put found Money aside
- Tax refund
- Insurance refund
- Laundry money from the vendor who is giving you an advance on your laundry room
- Repairs that come in under budget
- Put money in a money market fund
- Fund the reserves starting with analyzing your major repairs (maybe roof and asphalt), estimating the remaining life of the component and setting aside some of the $ every month.
