Replacement reserve is a fund that often gets overlooked by a real estate investor during the evaluation process of a rental income property mostly because most new investors to real estate aren’t aware of it. But it is important, and it is worthy of discussion, so let’s take a look.
Replacement reserve is a method of setting aside funds (usually in a bank account) that are used to pay for a property’s anticipated future expenses or capital improvements. Like the replacement of a roof, carpets, air conditioning and heating equipment, appliances and other electrical or mechanical equipment, wood decks, parking lot, etc.
Replacement reserve isn’t for the typical operating expenses required to keep a property in service like routine maintenance and repair, utilities, property taxes, insurance, or management fees. It is an allocation of funds for the future major expenses required to replace components that would lengthen a property’s life, make it more useful, or increase its value.
Though few rental income property owners actually have a special savings account where this money is set aside (also known as a “sinking fund”), it’s still a good idea to pay attention to replacement reserves and budget for it in a proforma cash flow statement when evaluating a multifamily income property. Banks always do.
Moreover, there is the reality that carpets and roofs do wear out and do need replacement from time to time. So budgeting for those future expenses just makes good sense.
Okay, but what allowance for replacement reserves should you make?
It depends on the age of the property and your particular investment strategy. Some allow about 3 to 5 percent of gross scheduled income (3%-5% of GSI); others about three to four hundred dollars per unit per year ($300-400 per unit per year); and others about two to three dollars per square foot ($2.00-3.00 PSF).
The method and allowance is up to you. If you’re not sure, make a call to a local appraiser or bank and see what method and allowance they use.
The point is not to ignore replacement reserve, and as a real estate investor always be sure that the property evaluation reports you are presented (or create for yourself) make an allowance for it.
You can preview a sample APOD that shows how replacement reserve gets computed into the income and expense report.
