Many real estate investors, brokers, and other real estate professionals don’t understand the meaning of a replacement reserve and therefore routinely omit it from their real estate analysis.
It is optional, however. Moreover it’s doubtful that its inclusion or exclusion will carry enough weight to make or break a prudent real estate investment decision.
Nonetheless, a replacement reserve is significant enough for analysts to at least understand and think about making a part of the real estate analysis and investment decision process.
In this article we’ll take a look at this reserve and how you would include it in a real estate analysis should you elect to do so.
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. 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 is not required to keep a property in service like routine maintenance and repair, utilities, property taxes, insurance, or management fees. Therefore replacement reserves are not a typical operating expense.
Rather, it’s 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.
The benefit for the real estate investor to be setting aside money for these future expenses will, of course, mean that the funds are available to the investor when the improvements are required. And because there is the reality that carpets and roofs do wear out and do need replacement from time to time, budgeting for these future expenses just makes good sense.
Okay, so where should you include this fund when creating your rental income property analysis?
Since the reserve is not an operating expense, I would recommend not including it along with the operating expenses. Foremost, because this would be treated as an annual expense that would affect the property’s net operating income (operating expenses are deducted from gross operating income to derive net operating income).
- Gross Operating Income
- less Operating Expenses
- equals Net Operating Income
Moreover, because net operating income is used to derive cap rate, the result would then skew this rate of return (albeit slightly).
- Net Operating Income
- divided by Sale Price
- equals Cap Rate
On the other hand, since it is a reserve for replacement of improvements attributable to the rental property, it would make sense for the 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 in turn seems the correct application.
- Net Operating Income
- less Replacement Reserve
- less Debt Service
- equals Cash Flow
- divided by Initial Investment
- equals Cash on Cash Return
Illustration (click image to enlarge)
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 use.
So You Know
ProAPOD Real Estate Investment Software does make a provision for replacement reserves in all three of it real estate investing software solutions.