Should Real Estate Investors Consider a Replacement Reserve?
Replacement reserve is a fund routinely accounted for by experienced real estate investors in rental income property cash flow projections but at the same is often overlooked by many novice investors, brokers and agents because they don't understand its meaning or purpose.
Nonetheless, a replacement reserve is significant enough for investors and analysts to at least consider making a part of the real estate analysis and investment decision process. So in this article we'll take a look at this reserve and hopefully can shed enough light on it for you to think about.
Replacement reserve is a method of setting aside funds (usually in a bank account) to cover a rental property's anticipated (inevitable) future capital improvement expenses such as the replacement of a roof, carpets, air conditioning and heating equipment, appliances and other electrical or mechanical equipment, wood decks, parking lot, and so forth.
It's not required to keep a property in service so it's not an operating expense, and it's doubtful that its inclusion or exclusion will carry enough weight to make or break a prudent real estate investment decision, so it is optional.
Still, it is an allocation of funds for the future major expenses eventually required to replace components that would lengthen a property's life, make it more useful, or increase its value, so it does provide a benefit.
The reality is that carpets and roofs do wear out and do need replacement from time to time. Therefore the benefit for the real estate investor to be setting aside money for these future expenses means that the funds are available to the investor when the improvements are required.
Okay, so where should you account for a replacement reserve in your real estate analysis?
Since the reserve is not an operating expense I would recommend not including it with the operating expenses because this would be treated as an annual expense that would affect the property's net operating income and subsequently would skew the cap rate computation.
On the other hand, since it is a reserve for replacement of improvements attributable to the rental property it does make sense for the real estate investor to consider it as a deduction from the property's annual cash flow. This would then impact the investor's cash-on-cash return which seems appropriate.
Here's how it should look in your real estate analysis:
- Net Operating Income
- - Replacement Reserve
- - Debt Service
- = Cash Flow
Rule of Thumb
How much money should be set aside for replacement reserves depends on the age of the property and the investor's particular investment strategy. To get a better idea of what amounts are set aside in your local market area, though, you might make a call to a local appraiser or bank and see what method and allowance they currently are using.
Although it can be computed as an annual dollar amount (like property taxes) or as a percent of gross operating income (like property management), I typically allotted $300 per unit per year as a replacement reserve.
Here's to your real estate investing success.