How much should I, as a landlord, save up for property renovations?

Question

I co-own a set of rental properties in California with a family member. Rent control is set at 5%, though there are exceptions in our location if you improve a unit -- under those circumstances, you can raise the rent up to 10%.

We are currently completing a renovation of one unit (as well as paying for some expensive turnovers, since we have a number of unexpected post-Covid vacancies).

We saved up for this renovation in a somewhat ad hoc manner. We had (arbitrarily) targeted about 10% of yearly revenue in savings to put towards improvements, and we have had to make up any difference between our savings and the costs of the renovation and turnovers out of monthly income.

My question is: is the 10% of yearly revenue a reasonable amount to target in savings with an eye towards improving the properties? We are going to end up spending something closer to 25% of yearly revenue this year between the renovation and the turnovers, and I would prefer to do these kinds of upgrades in a more planned-out manner going forward.

How should I be approaching the problem of how to save up and plan for renovations going forward?

Answer 1

The answer to the question how much you need to save is: It depends.

You need to do an analysis of each property. Roof, appliances, heating/AC, water heater, sump pump, repaving of the driveway. Your list will be specific for each property. You need to estimate how often they need to be replaced, and how much useful lifetime they have left. You will also have to get an estimate replacement cost. Don't forget labor.

You see HOA's and condo boards do this analysis all the time. They setup a capital reserve to cover these large/expensive items. They get the estimates, start saving the money, and then revisit their study every few years.

You want to do that kind of study. If you want to update things that aren't broken, then you need to factor that into your estimates.

There are also expenses between tenants: paint, carpet, etc.

Answer 2

There's no set rule that I've found to be very agreeable. You can budget by taking cost over expected life of each expense if you like, but it takes a fair bit of work and has to be updated with some frequency. I've had appliances far outlive their expected life and others not make it half as long as expected, so while it might average out I found it not worthwhile.

I just keep about six month's rent per property set aside and in general I don't worry about planning beyond that. I treat it like an emergency fund, use it as needed and then replenish as quickly as I can. So far it has been more than enough to cover turnover expenses, repairs, minor renovations, new appliances.

If my buffer was insufficient or I had a major renovation planned I'd be inclined to borrow rather than save up cash, since rates are quite agreeable and it smooths out cashflow.

Answer 3

My question is: is the 10% of yearly revenue a reasonable amount to target in savings with an eye towards improving the properties?

That's impossible to answer, because it depends on the location.

A landlord's revenue is rent. The problem of using rent as a basis for saving towards renovations is that:

• Some locations have a high rent to house price ratio, other locations have a low rent to house price ratio. Surely you don't want the future of your property depending on the expensiveness of the area (unless the area is so cheap it doesn't make sense to renovate)
• In some locations, the land is by far the largest part of house prices. In other locations, the cost of land is (nearly or exactly) zero and the cost of a house only consists of the cost to build it. In fact, there can be an order of magnitude of difference in house prices, mainly due to this. Just compare some rural area to New York, San Francisco or similar. Houses do need renovations, but land doesn't. While there can be slight differences in cost to construct (which affects the price of renovations too), the differences are not as large as differences in house prices because land doesn't need renovations.

My usual rule of thumb is: you should save annually 2% of the cost to construct a new house every year to finance renovations. This means that in an accounting software, you would depreciate the house in 50 years. (Contrary to a popular myth, houses do not appreciate -- they depreciate).

This means that a house on leased land that costs 2500 euros per square meter, you should save 50 euros per square meter per year. Note that as cost to construct increases due to inflation, so should your savings.

If you buy a new house that's not on leased land in an expensive area, you might perhaps expect to pay 6000 euros per square meter. That consists of 3500 euros per square meter (land) and 2500 euros per square meter (house). The amount you should save is the same, because land doesn't need renovations.

For example, I pay 139 euros per year per square meter for my kind-of-rental house. Saving 10% of that would be 13.9 euros per year per square meter, not at all enough for renovations. So that's probably the reason why I live in this kind-of-rental property: it's just so cheap.

Answer 4

you need to figure out your incomes from the properties, at a realistic level, and then add this to the rest of the annual operating costs. make sure you and the other partner in this venture at the bare minimum have an LLC in place. The LLC holds the insurance and all other regular expenses in its name, so that both of you are protected from liability, provided you are fulfilling your obligations of the Limited Liability Corporation. At this point, any funds not paid into your two incomes go into the LLC's accounts and is held to pay taxes and any necessary repairs renovations or improvements. Remember,the LLC can still be sued, even though you are protected in most instances so you and your partner don't want the LLC's holdings to get too large, so at this point, you NEED to consult an investment attorney about protecting those excess funds. California is a disaster rich region, that can leave a landlord open to lawsuits at the slip of a tongue, so I would also look into the legality of requiring tenants to maintain renters insurance, just to ensure they are protected and don't come after you in case of flood fire earthquake tsunami and so forth. People are too litigious today. And you need to make sure your butt is covered.

Now with this all in mind, you can repair, update and replace appliances as you see fit. Typically rent control doesn't apply to empty properties, and once done, you either have a rent scale or market value you have to stick to, and rent control limits your ability to raise the rent, which is why it is important to keep the properties up with funds being available all along. This also keeps tenants happy and proud of their HOME, which in turn, generates an attitude of a personal need to take care of the place they live