Tip #48

How to Build an Emergency Fund for your Rental Properties

Written on February 27, 2015 by , updated on February 28, 2015

Emergency FundA savings account. An emergency fund. The piggy bank. Whatever you call it, most of us think it is wise to have some extra cash saved up for a rainy day.

We all seem to understand that “life” happens, but it’s still frustrating when the car’s transmission drops out in unison with a job loss, or an expensive root canal.

If you have an emergency fund, unexpected expenses aren’t so scary.

Dave Ramsey is a financial radio show host, and he has been a huge inspiration in my personal financial life. Of all his advice, I think his best recommendation is to build an emergency fund of 3-6 months worth of expenses.

Though Dave is considered a “personal finance” coach, I think his advice is still applicable for businesses, especially in the rental industry.

Step 1: Separate your Bank Accounts

Most small asset landlords don’t really view their rentals as a business, and as such, they manage it as an extension of their personal finances. After all, it’s easier that way, but it’s riskier and sometimes illegal to commingle funds.

It’s best to separate your bank accounts, and for some, it’s even wise to create a business entity for the rental business.

In fact, most states require a landlord to store the tenant’s security deposit in a separate bank account, so that the funds are not commingled with personal money, or deposits from other tenants.

Related: How to Handle Security Deposits Properly

I believe that landlords should have a variety of bank accounts, separate from personal accounts, in order to successfully operate their rental business.

Every landlord should have:

  1. An operating account
    You’ll deposit rent, and pay the mortgages, taxes, insurance and other expenses, for all your properties, from this account.
  2. A security deposit account for each rental unit
    You’ll need one bank account (with checkwriting privileges), for each unit you own. Deposit the tenant’s security deposit into this account, and leave it there until the end of the lease. Cozy can collect the deposit and send it to a separate account for you, automatically!
  3. An emergency fund account all the properties
    This is a single savings or money market account that acts as your safety net. You can combine this money with your operating account if you’d prefer, as long as you don’t overspend it away.

Step 2: Build a Realistic Emergency Fund

Like a personal savings, I suggest you build an emergency fund to handle all unexpected repairs and help mitigate your vacancy losses.

But how much should I have in the emergency fund?

The more properties you have, the more can go wrong – but the good news is that it won’t all go wrong simultaneously.

This is why I recommend at least three months worth of expenses for at least half of your properties.

If you only have a few units (1-10), your rent is limited, and major repairs will consume a higher percentage of the overall income.

As you grow your portfolio to more than 10-15 units, you are essentially diversifying your assets, and each property becomes a smaller percentage of the whole pie.

As such, I think the formula can then be adjusted to a minimum of three months worth of expenses for a third of your properties. This is essentially, the total is one month’s expenses for the sum of all your properties.

Calculate a Minimum Emergency Fund

To calculate a small asset emergency fund (1-10 units), add up the following expenses for all of your properties:

  • monthly mortgages
  • taxes
  • insurance premiums
  • condo fees
  • operating utilities

Then, multiple it by three, and then cut the total in half to reveal your minimum emergency fund.

Notice that I did not include repair costs or service fees (like landscaping), because if the money train stops moving, the first thing to get cut is the gardener and nonessential fixes.

You should, however, always include utilities because you have a legal obligation to keep the lights and heat on even if the tenant fails to pay rent.

Related: Landlord-Tenant State Laws and Regulations

The Formulas

Mortgage Costs (PITI) + Condo Fees + Utilities =
1 month of expenses per property

then

((Monthly Expenses for all Units) x 3) / 2 = Minimum Emergency Fund

Small Portfolio Example:

If the total monthly PITI + Fees + Utilities for my four units = $12,000, and I multiplied that by 3 months, my fully funded 3 month emergency fund would be $36,000.

However, since all four units won’t need repairs or experience vacancies at the exact same time, I divide it by half, thereby making my minimum emergency fund = $18,000.

Large Portfolio Example:

If I have 20 units, and the total monthly expenses equal $40,000, then multiplied by 3 months, my fully funded 3 month emergency fund would be $120,000. Since a larger portfolio is more diversified, and carries less risk, I need less cash to insure an emergency.

Dividing it by one-third (instead of one half), would reveal my minimum emergency fund to be $40,000 (essentially, a one month buffer if everything goes wrong at the same time).

Funding the Account

Now, for the tricky part.

How do I fund the account?

The answer is simple to say, but hard to execute.  Here are a couple of methods to get the cash for an emergency fund:

  • Set a budget within your monthly income/expense, and save up the money.
  • Sell a property and save the profit.
  • Manage the properties yourself (via Cozy), and set aside 10% of the monthly rental income (in lieu of hiring a property manager).

Step 3: Remember to Rebuild

Remember, the goal is to keep this minimum amount in your account at all times. If you pull from this savings, or go below this minimum threshold, be sure to rebuild it as fast as you can.

If you have quite a few older properties, typically have a lot of vacancy (20% or more), or are just risk averse, you should consider changing the calculation to cover 6 month’s of expenses – essentially, doubling your emergency fund.

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