Today, I want to talk about what I see is the missing piece of most real estate investment financial analyses – reserves for replacement.
Understanding Reserves and Replacements
Reserves for replacement are line items, usually in the net operating income calculation, where we budget for things that have predictable service lives. These are things that wear out, like air conditioning, a roof, appliances, and things like paint. They have a predictable life in rental property, and we can budget for them. So often, when I see the financial statements of investors who are looking to purchase properties, I see no line items for reserves and replacements. Or, it’s a ridiculous amount, like $50 or $75. It’s just not realistic.
Using Reserves for Replacements: An Example
If you want to get a true and realistic picture of the return you’re going to get on a potential property, you have to have the reserves for replacements number included. I recently toured one of the properties we manage, and this property provides an extreme example of the importance of reserves for replacements.
Six months ago, this was a two bedroom, one bathroom, wood-frame home. The investor owned it for 20 years. We told him it needed a new roof. The siding was also shot and the plumbing needed to be replaced; probably the electric, too. The kitchen and bathroom were from the 1940s.
We didn’t want to do all that work because it’s only an 800-square foot property. So, we recommended selling it in a 1031 exchange, and finding something better, or tearing it down and building a new home.
This particular investor likes this part of town, which is up and coming. It’s good to stay in the neighborhood. So, we connected him with a good local builder. We tore the house down, and now we’re building a three bedroom home, plus an office, and a two car garage. It should be back on the rental market in the next 30 days.
Increasing ROI: The Advantage of Reserves for Replacement
The advantage here is that we will almost double the rent. So, we have increased the income. Plus, we’re reducing expenses. The home is being built with a hurricane-rated roof, as well as impact resistant doors and windows. Modern electric and plumbing systems mean the insurance costs go down, and maintenance expenses will stay low. This property should produce much more income than the old property.
This is a good example of the fact that houses wear out, and their systems also wear out. You have to budget for those when you do your financial analyses.