By Cliff Hockley, President of Bluestone and Hockley Real Estate Services
Executive Director, SVN | Bluestone and Hockley
Who expected a COVID -19 virus and planned for it? Who expected the government to tell residential and commercial tenants that they did not have to pay their rents? Who saved enough money in their property reserves to cover mortgage payments for three to six months or longer? No one. But some cautious investors have taken steps to protect their investments.
Cautious investors typically do not overleverage when it comes to borrowing money to purchase real estate. In other words, they tend to keep a ratio of fifty percent leverage over their total portfolio. This is typically achieved one of three ways:
- Put at least thirty percent down on a purchase, rather than ten or twenty percent.
- Appreciation increases the valuation of real estate investments every day. This obviously does not happen in down markets, but over the ten-year lifespan of a typical real estate investment, real headway can be made as income, and thereby your property valuation, increases every year.
- Set aside cash to fund reserves. There is no one rule of thumb regarding the percentage of reserves that should be set aside, but it is important to consider the following:
- If taxes and insurance reserves are not escrowed by the lender, a separate reserve should be established.
- Capital expenses (new roof, asphalt repairs, HVAC replacements, tenant improvements, and commercial leasing fees) have a way of adding up. Saving five to ten percent of the property’s annual income is a good goal.
- Typically, vacancy loss and turnover expenses are included in most income and expense projections, but if not, plans should be made according to local market conditions. (Most appraisers assume a five percent vacancy rate.)
- Industry guidelines recommend three months of mortgage payments be saved in reserves.
While this may feel like a lot of savings, and it is, all properties should have reserves. It may take a year or more to save, but you’ll probably sleep better at night and you’ll be prepared for both the expected and unexpected.
While inclement weather is often unpredictable, we know to expect it occasionally. But we could not have forecasted a pandemic, nor could we have forecasted the government telling us that tenants don’t need to pay their rent. This is a huge challenge for landlords.
There is good news and there is bad news when it relates to COVID-19. The good news is that most tenants are paying rent or at least a portion of the rent. The bad news is not enough tenants are paying, which severely impacts a landlord’s ability to pay all the bills, unless a reserve fund was created ahead of time.
It is never too late to start putting money aside, especially if you are not living off the income generated by the property. As you begin to put a 2021 budget together, I encourage you to think seriously about creating significant reserves.