By Robert L. Cain
“Wow! $10,000! I kind of knew the roof was on its last legs when I bought this place, but I never found out how wobbly the legs were or how much it would cost to fix it. What a surprise!
There are no good surprises in real estate. I think I say that somewhere during the presentation every time I do a speech or seminar. I know I did when I was doing a seminar on the “11 Rules of Real Estate Investing” when I spoke to an organization in Missouri a number of years ago. But this time, when I said that, a woman in the class piped up and said, “Oh, no, I got a good surprise.” Then she recounted that after she had bought the property, she discovered there were beautiful hardwood floors under the wall-to-wall carpet.
Even though I didn’t say it, my first thought was why was that a surprise? Didn’t you check the flooring before you plopped your money down? Suppose it hadn’t been “beautiful hardwood floors”? What if it had been rotten flooring that was made to feel sturdy by some 1/4-inch plywood reinforcement? That would have been a surprise, too, and you wouldn’t have bragged about that one.
My point is this: when we buy a property, there should be no surprises. That’s why we have property inspectors and engineers to tell us what, if any, problems there are that might crop up down the road, or even next week. Once we know those, we can factor in those costs to our profit calculations.
“Wow, a $10,000 roof” should never be “What a surprise!!!!” Rather, from day one, the replacement cost amortization should have been a budget line item. Even if the replacement cost had been factored into the price, the cost of the roof needs to be factored into the budget.
How can we set this up, then? We need a reserve account where we stick money that is reserved specifically for replacing things that wear out, such as roofs, dishwashers, HVAC, and refrigerators. That money comes out right after the mortgage payments and gets tucked securely away where we won’t be tempted to spend it on anything else.
Here’s an example of how to do that.
Say when we bought the property, we knew that the roof had about 10 years of its 20-year life left and after consulting our trusty roofing contractor, found out that its replacement cost would be $10,000. That means we have to factor in $10,000 divided by 10 years, divided by 12 for each month. Thus, the reserve per month needs to be 10,000/10/12, which equals $83.33 per month.
Then that money needs a specific accounting. Get out your property management software, create an “Reserve” account, and start adding items. So for example, this item would be set up something like this:
Item Property Address Current Life Expected Life Replacement cost Balance
Roof 1234 Main St. 10 years 20 years $10,000
The software should calculate the declining balance if you tell it to.
Now, how about appliances? The same technique works. But here we might have multiple appliances in individual properties. For example, there might be a four-plex with dishwashers of varying ages in each unit. Dishwashers cost around $300 for a builders’ model, probably what we want to install. Thus, a one-year-old dishwasher would have eight of its nine-year life ahead of it. So the line item would be 300/8/12 which equals $3.13 a month in reserve. By the same token, a dishwasher with only two years left on its life would be accounted for with 300/2/12, which equals $12.50 a month.
It’s important to separate out each of the items for each property, not just so we know where we are, but also for tax purposes.
Understand that I am not an accountant and, moreover, that I am “accounting indifferent.” I have gotten this information from people who know how all this works. Fortunately, we all have access to those individuals, and they love doing this stuff. They can be saviors in keeping us from losing our shirts on repair and replacement costs and avoiding “surprises” that never should have been surprises in the first place.
I repeat my mantra, “There are no good surprises in real estate.” If something is a surprise, we have not been diligent. That applies not only to repairs and maintenance, but tenants. But tenants are a subject for another time. The major lesson here is that we need to question everything. That’s one giant step to successful property management and investing.