Lots of real estate conversations start with leverage and how much cash will be needed to get into the game. We mostly think of the cash needed as the funds needed for down payments, fees, and repairs. There is an additional component of how much cash a real estate investor should have. These are reserves or excess cash. The less cash you need in the acquisition may not mean you have more for another purchase. You want to keep some of that excess cash for the inevitable. Those unexpected, or even expected, expenses sure to be a part of the real estate experience.
Your Excess Cash
Excess cash is money you can afford to lose. It is not the cash you need to make this months car payment or put groceries on the table. Maybe it is the funds you have saved for your next vacation.
There are many advantages to owning real estate in an IRA but with that ownership also means your retirement funds are going to be needed for expenses. Are you comfortable with that?
Many gurus, who encourage you to buy real estate, fail to figure into their presentation the part about the expenses associated with the investment. A smart investor will be able to fund the inevitable.
Identifying how much excess cash you should hold is dependent on the following factors about the investment.
Investment Asset Grade
It seems reasonable to assume that an (A) grade asset should have less potential cash expense risk than a lower grade asset. (A) grade assets have cash demands. Plan for capital expenditures associated with replacement. You will need cash for those.
The higher returns most investors are seeking are found in lower grade assets. The lower the grade, the more excess cash reserves you should hold. (C) and (D) grade assets are located in areas that present outside risks beyond just wear and tear on the property.
Most real estate investments use leverage in their purchase. Leverage means borrowing funds in some capacity and incurring regular obligations and interest. Debt service will be the base expense you must be able to cover each and every month.
In addition to your standard non-owner occupied homeowners insurance, seriously consider having a personal liability umbrella insurance policy. They are relatively inexpensive (around $500 per year) but will provide protection from expenses no amount of excess cash will cover.
There are many moving parts to a real estate property. Items like furnaces, roofs, water heaters and drainage systems. These components and systems age and break. When they break, the investor may blow a year of profits in their replacement. Being prepared for these inevitable items is why the investor holds excess cash.
Community associations use something called reserve accounting and it is not a bad idea for your buy and hold investments. Simply identify these major components of the property and estimate their remaining useful life. Look at how much it will cost to replace the component and divide by the remaining life. The monthly number equals excess cash you should be accumulating to cover future capital expenditures.
For example – the roof has 5 years left and a new one will cost $4000. That is 60 months of life remaining. $4000 divided by 60 months means for that component you should be setting aside $67 a month.
Evictions and Vacancies
It will happen to you at some point in time. The tenants will either be late or just stop making their rent payments. Your debtors will not care that you have no rent income or excess funds to make your debt obligations. Payments will still be due.
Part of your excess cash needs to be for the inevitable periods of vacancy where no rent income is being produced.
Even more frustrating is to have a major component (like a furnace) go out while your tenants are not paying the rent. Guess what the legal system says? The tenant still has rights of habitability. If the tenant has not had their date in court then the landlord is still responsible for keeping the home habitable.
Be prepared because the landlord Gods have a funny way of making these things happen all at once.
HOA Related Expenses
If your investment is located in a planned community, the expenses associated with an HOA will have to be paid monthly or quarterly. These expenses need to be a part of your excess cash calculations.
A word of caution. Before buying, always be clear on whether the association is funded correctly or if there are any upcoming assessments.
When projecting a buy-sell transaction, assume whatever could go wrong in your planning and budgeting will go wrong. Excess cash to fund these surprises is crucial to stay on your production timeline.
Flipping projects are often full of surprises. Think twice about starting one without knowing where you will turn for excess cash.
Once you are in the real estate game it is inevitable new opportunities will find you. With no excess cash, you will either go outside good practices to fund these opportunities, or just feel compelled to have to pass.
Where to Go For Excess Cash When You’re Short of Funds?
How much excess cash should an investor hold? For most investors it is unlikely we ever have enough excess cash. It is important to start with basic sound principles. Then, if the situation dictates, have a plan B or C.
Most financial planners discuss having an emergency fund to cover 3 to 6 months of expenses. Those expenses need to cover at minimum your debt obligations for the real estate. Ideally, you might have more to cover major capital expenditures or other items listed above.
Before making your real estate investment, line up at least one source of available emergency cash. This could be a second mortgage on your personal residence or a personal line of credit from a lender or private lender (think family or friend). Structure this credit so it has minimal fees and you are only paying interest if you need to access it.
The Excess Cash That You Really Do Not Want to Use
401-K or Other Taxable Accounts
Sure, it is tempting to look at the large sum of money sitting in your company sponsored retirement plan. Before thinking too hard about it, educate yourself on whether your real estate investing use would be taxable or not. Also, what penalties will you incur.
When you look at the additional costs, you will likely be glad that you did not plan to use one of these accounts as your excess cash for your real estate investments.
Not so many years ago, credit cards offered a convenient way to access short-term cash. With low introductory interest rates, a new credit card could be opened and used to fund an emergency expense.
Most credit cards today charge rather large fees for cash advances. Be sure you realize that there is more to the card incentive than just a low rate. There is likely a 3-5% fee added on the cash advance.