One of the most mis-understood and often overlooked condition of owning a small income property is the Reserves for Replacements (RFR’s), or what is sometimes referred to as “Replacement Reserves”. In commercial real estate transactions, replacement reserves are often mandatory and added to proformas for lending purposes, this to maintain the major components of a property during the life of the loan. This is especially true with larger commercial developments, including apartment communities and high-rise developments. Interestingly, this is rarely seen with small investment properties.
So, what are Reserves for Replacement, aka RFR’s, anyway? RFR’s are funds set aside to take care of long-term building component costs that occur during the ownership of an investment, and typically long before physical improvements wear out. For small investment and multi-family properties, typically single-family homes or properties with up to about 16 units, there no strict rules of what must be included within the reserve, but not setting a clear expectation can and will lead to higher operating costs. That said, a good starting point for your reserves will include the following; kitchen appliances, the hot water heater, the central air-conditioning unit, all interior carpet or flooring, interior and exterior paint, roof shingles or tiles, exterior siding, garage door opener(s), and when needed, built-in pool, deck and built-in grill equipment. Typically, plumbing and electrical are not considered in an RFR document; except when the property is nearing the 30-40 year mark in physical age. When a property is nearing this physical age, an investor or Property Manager need to be more cautious and should assume upcoming repairs. In other words, not if the repairs will be needed, but when.
The reason for having an RFR is two-fold. First, many building components typically included in an RFR are designed to address the ascetics of the property, such as carpet, paint and appliances. Not only is this done to ensure the property remains well maintained, but also to ensure maximum rental income when owned as an investment. It’s common knowledge that the quickest way to rent a property and attain maximum rent is to replace the (C)arpet, (A)ppliances and then (P)aint the interior walls, or CAP. Just like a new car, everyone loves the smell of new carpet, appliances and paint, and when a renter has the option of choosing between two competing rentals, the one with new CAP will most often win the day, even when rent is slightly higher.
The second reason for having a well-documented RFR is budgeting. Whether you are an investor or a property manager for an investor, knowing what repairs are going to be needed, and when, is crucial. If, for example, kitchen appliances are ten to fifteen years old, you can bet they will need to be replaced soon. If you have a 20 year old HVAC unit sitting on your roof, and it’s already been through 20 blistering summers, be prepared to have some hefty expenses coming soon.
If you own an investment property and you don’t have a documented RFR, get one. There’s no hard and set rules on the life-span of appliances, particularly for higher priced appliances which can last many years longer than the average appliance, but by creating a list of the property’s major components, you can estimate the amount of funds that will be needed by dividing total costs by the number of estimated years of functional life. For example, if you purchase a stove today, and it costs $500, and it’s expected to have a 15-year life, then $500/15 = $33.00. $33.00 becomes the reserve or RFR amount set aside for each of the next 15 years. If it costs you $2,000 to install new carpet in your duplex, and the carpet needs to be replaced every 3 years, then $2,000/3 = $667 annually. $667 needs to be placed into your reserves account for each of the next three years. Do this for each of the major components of the property, and you’ll have a solid, evenly balanced replacement reserve. This should ensure you don’t have any unexpected “gotcha” moments in managing an investment.
There are numerous sources for learning more about replacement reserves, but a call to your local appraiser or home inspector will shed insight about what needs to be included in your reserves, and how you can better prepare in advance for future property operating costs. You can also run a quick Google search for “average life span of kitchen appliances”, “how long should carpet last in a rental property” or “reserves for replacement worksheet”. All will provide additional information beyond the scope of this article.