Reserves

      Whether doing a cash flow analysis or a full-blown appraisal, we must know all costs of operating the property under consideration.
      There are basically two classes of expenditures involved in operating income property.  First, there are the expenses paid every month or periodically throughout the year.  Those paid every month include loan interest, utilities, and, if you employ an outside property  manager or a resident manager, management.  Those paid periodically throughout the year or once a year include property taxes, insurance, and maintenance.  The seller will usually provide reasonably accurate numbers for these, at least for the most recent year.
      The second type of expenditure is not paid monthly or even annually, but is paid only when a component requires extensive repair or replacement.  The period of time between repair or replacement may be several years or even one or more decades.  Included in this class of costs are exterior painting, re-carpeting, re-roofing, and new air conditioners.  These type items may not be included in expense information provided by the seller because (1) they may not have occurred during the year(s) for which provided or (2) the way in which his accounting is done.
      This second type of expenditure is often ignored when analyzing a property for possible purchase, sometimes even by experienced investors.  As you may remember, we did not include a reserve expense when we did the cash flow analysis in the previous lesson.  We were relatively safe in doing so for that example because we (1) were replacing carpet, (2) upgrading various major components, and (3) with the property being 15 years old, it is likely that the roof, appliances, and heating/cooling components still have relatively long useful lives.  In general though, ignoring reserves can result in serious problems when the landlord is told a few years after closing escrow that his building needs a new roof and that the cost will be $10,000, but the positive cash flow is only $100 per month.  When this happens, the landlord, hopefully, has a CD coming due soon or has a good credit card.  The latter option can, of course, greatly increase the cost of the new roof if the landlord must pay 20 percent interest on the slowly declining balance for a few years.
      As you can imagine, this problem can become substantially more critical if you are talking about a large apartment or commercial complex where the cost of a new roof might be $100,000 or more.
      The way that a prudent investor avoids this problem is to put away money from the cash flow each month so that he has enough saved up to pay for the re-roofing by the time that it is necessary.  Obviously, this same approach should be applied to each of all expected large future expenditures.  The terminology used for the cumulative amount put away is Reserve Account.  Depending upon the complexity of the property and the capabilities of the accounting system, there may be one Reserve Account or a separate account for each component of the property - e.g., a Roof Reserve Account.
      If the positive cash flow is not sufficient to fund the reserve account each month, the prudent owner will set aside funds from other sources.  Putting the reserve funds into an interest bearing account will help assure that the account needs will keep up with inflation.
      Performing the reserve account analysis prior to making an offer has the additional benefit of bringing to your attention deferred maintenance and other physical deficiencies and may indicate that you should further reduce the price you are willing to offer.  And, even if the lender does do a reserve analysis after you failed to do so, his more realistic analysis of the property may result in a failure to get a large enough loan for you to purchase the property.  This may kill the deal, meaning  that you wasted your time, that of the lender,  that of the seller, and that of any agents involved.
      When obtaining new financing for larger properties, the lender will almost certainly include a reserve account analysis when doing its own analysis and will require that the cash flow be sufficient to fund the reserve in addition to covering all other expenses.  Even if the lender does not explicitly include a reserve expense, he will accomplish the same thing by utilizing a larger debt coverage ratio in his qualification criteria.  This requirement will usually protect the investor against failing to consider the need for reserves.  However, for small properties - 1 to 4-family - the lender may not.  And, for seller financing, it will usually be up to the buyer to think about the issue no matter what the size or complexity of the property.
      Although we would like to have all the necessary information prior to making an offer, that is not always possible.  You or you agent will have to ask as many questions as possible and push for as much preliminary inspection as you can get.  You will not likely be able to inspect the interiors in detail prior to acceptance of your offer, but maybe there is a vacant unit that you can see.  Except for a flat roof, you may be able to inspect the roof from the ground (unless covered by snow).  You may be allowed to take a look a flat roof from on top and while there can take a look at the air conditioners.  If air conditioners are on the ground, they are easily available for a cursory inspection.  You can tell the condition of exterior paint, fences, and yards by walking past the property.  For components that you can't see ahead of time, you will have to make estimates.  For example, you may be able to get information about the age of carpeting and vinyl and when interiors of units were last painted, even though you can't view them.  In this case, you would estimate remaining life based on average life of the component, taking into account the type of property and what you might be able to determine about the tenants occupying the units from observing their yards, carport areas, porches, and even the conditions of the vehicles they drive.  You may even be able to catch glimpses of interior conditions when walking by, but be careful not to be taken for a peeping Tom.  None of these things take much time.
      Knowing the sizes of units, you will be able to estimate the cost of replacing carpet or repainting.  Keep in mind that, for smaller properties, such as we will consider in this example, it is not necessary to be exact.  Being off by a few hundred dollars per year is not going to make or break the viability of the property.
      So long as you put adequate contingencies into your offer, if your more accurate analysis after acceptance of the offer when you have more information available shows materially lesser value, you can renegotiate or back out of the deal.

Example
      For our example, we will assume that we have found a particular 15-year-old 4-plex that we are considering for purchase.  We will also assume that our inspection of the property shows that useful lives of major components are as follows:

• Roofing:  Typical life of the subject type of roof in the area is 25 years and there is no unusual deterioration, so assume remaining life is 10 years

• Heating/cooling systems:  Our air conditioning vendor tells us that the typical life of subject units is 25 years, so assume remaining life is 10 years

• Appliances:  Two units reportedly had dishwasher replaced about 2 years ago, other two are original.  Considering one should expect about 15 years out of the particular models, we should expect to replace two within the next year and two in about 13 years, for an average remaining life of 7 years for all four.  Range typically last for more than 25 years.

• Interior paint:  We assume that we will paint a unit every 2 years.  We also know that we can do the labor ourselves.

• Exterior paint:  Looking at the surfaces, we estimate painting can wait another 2 years.  We also know that we can do the labor ourselves.

• Carpeting & vinyl:  With two units reportedly redone 2 years ago, other two approximately  5 years ago, we estimate 4 years of average remaining life left on all units.

• Wood fencing:  Estimate remaining life is about 10 years.

We have determined that the replacement costs for the above major components are as follows:

• Roofing        $4,000

• Heating/cooling systems, per unit       $1,200

• Interior painting      $150 (doing it ourselves, so materials and equipment rental only)

• Exterior painting        $400 (doing it ourselves, so materials and equipment rental only)

• Average carpeting & vinyl, per unit       $1,000

• Dishwashers        $300 each

• Ranges        $325 each

• Wood fencing        $1,600

      Determining the annual reserve to set aside for each component is simple.  For the roof we need to accrue $4,000 in 10 years.  Thus, we need to accrue $400 per annum.  For the heating/cooling systems we need to accrue $4,800 in 10 years or  $480 per annum.  For the interior painting we need to accrue $150 in 2 years or $75 per annum.  For the exterior painting we need to accrue $400 in 2 years or $200 per annum.  For carpeting and vinyl we need to accrue $4,000 in  4 years or $1,000 per annum.  For dishwashers we need to accrue $1,200 in 7 years or $177.  For ranges we need to accrue $1,300 in 10 years or $130 per annum.  For wood fencing we need to accrue $1,600 in 10 years or $160 per annum.  So, adding everything up, we get 
    Annual reserve = $400 + $480 +$75 + $200 + $1,100 + $177 + $130 + $160 = $2,622 per annum, or approximately $219 per month.
      Note that we have used average life for many components in order to simply our example.  Particularly for more complex properties, one should, if possible, analyze individual unit components separately.
      One additional note regarding the above discussion.  Because the heating/cooling systems are older low-efficiency units, we may want to consider replacing them as soon as possible with new higher efficiency units.  This is particularly important if the owner is paying the electric bill, because the payback period is only a few years and gets shorter every year due to rapidly increasing electric rates.  Even if the tenants are paying the electric bills, lowering their utility costs significantly will allow larger future rent increases.  So, we might want to put aside additional funds each month in order to replace units much earlier than mandated by operating condition.  For detailed discussions regarding reduction of utility costs, including both electricity and water, visit our Reducing Utility Costs page.