Why Older Properties Need a Reserve Account
A property can collect a lot of rent and still leave its owner with very little profit. That becomes especially clear when you’re managing an older property with aging systems and frequent repairs.
Let’s say a property collects $100,000 a month in revenue. The property was built in the late 1970s or 1980s, and expenses are averaging about 50% of the monthly revenue because of HVAC systems, water heaters, flooring, appliances, corroded pipes, and other big-ticket repairs and capital expenses.
That leaves $50,000 in the operating account.
But what does that $50,000 have to cover? It may need to pay for water heaters, HVAC systems, unit turns, labor to turn units, painting, flooring, a couple of new appliances, and utilities for common areas and vacant units—including electric, water, trash, and cable.
Now subtract a $35,000 mortgage payment. Before taxes and insurance, only $15,000 remains. Some or all of that may go toward property insurance and other expenses. That is not a healthy profit if every repair and replacement has to be paid directly from the operating account.
How quickly big expenses add up
Here are a few example costs:
- New indoor and outdoor HVAC units: $6,200
- Installed 40-gallon gas or electric water heater: $1,350
- Stove and refrigerator: $1,200
- New tub and surround, installed: $1,595
- Replacement exterior door: $800
Just one of each totals $11,145.
If a property had that combination of expenses every month for 12 months, the total would be $133,740 coming out of operating funds. That is a hypothetical example, but it shows how quickly a property’s cash flow can be consumed by major repairs and replacements.
That is why, when buying an older property, I believe an investor should have at least $500,000 in reserves—and potentially closer to $1 million, depending on the size, age, condition, and needs of the property. Those funds help keep major repairs from draining the operating account and making it harder to pay the mortgage, cover regular expenses, turn units, and distribute money to the owner.
Lenders should require reserves for older properties
In my opinion, lenders should require meaningful reserves when financing a property that is more than 15 years old. Age alone does not tell you everything about a building’s condition, but older properties are more likely to need significant repairs and replacements. The reserve requirement should reflect the property’s age, condition, number of units, inspection findings, and upcoming capital needs.
A reserve account is not extra profit and it is not money paid to the property manager. It is money set aside to help the property handle future needs without leaving the owner or manager scrambling for funds when a major expense comes up.
The hard conversation I need to have with investors
I need to get much better at asking investors about reserves during the interview process. I need to ask directly: How much money do you have available to fund repairs, unit turns, and capital expenses after closing?
And if the answer is that there is no reserve, I need to be willing to say no. Period.
Sir, if you don’t realize it takes money to make money, you can’t have everything if there isn’t enough in the pot to pay for it. You can have units turned and ready to rent, or you can pay the mortgage and other bills. You can also take an owner distribution—but if the money isn’t there, you may not be able to do all of those things at once.
If there are three chairs at the table and four people trying to sit down, somebody or something gets left out. In property management, it may be the repairs, the mortgage, the unit turns, or the owner distribution.
I’m a property manager, not a magician. Even a magician can’t pull extra money out of an empty pot.
I have told investors not to buy, to walk away, or to back out when I believed the financials were unreliable, there was no real value-add opportunity, or the area would not support the rent increases needed to make the numbers work. Some investors still choose to buy and expect the property manager to create a result the property’s finances cannot support.
What benefit would I get from telling someone not to buy an asset I would be paid to manage? Financially, it may not be in my interest. Morally, it is the right thing to do.
If you choose to proceed anyway, I can only do my best to manage the property—but I cannot promise strong results from an asset that does not have the money or the potential to produce them. Before you buy an older property, make sure there is enough money in reserve to handle the reality of owning it.
