Unexpected things can happen any time. When it happens, an emergency fund can be the key to get out of the difficult situation. It’s the same in the real estate industry. What is an emergency fund in real estate? What are the benefits of real estate?
There are two types of real estate emergency funds. For house flippers, you should keep 10% of the rehab budget on hand for emergencies. For rental properties, I argue keeping an emergency fund totaling 15% of annual rents (broken down at 5% fix-ups, 5% vacancies, and 5% for capital improvements).
In the following article, I’ll dive deeper into real estate emergency funds. Specifically, I’ll cover each of the following topics:
- Emergency Funds for House Flippers
- Debt-specific Emergency Funds
- Rental Property Emergency Funds
- Final Thoughts on Real Estate Emergency Funds
Emergency Funds for House Flippers
As stated above, two types of emergency funds exist when it comes to residential real estate, and I’ll talk about the first one here: the house-flipper rehab emergency fund.
When flipping houses, you obviously want to develop a detailed rehab budget. However, as with any budget, a rehab one is a projection. In other words, plenty of things can happen that force a flipper to bust the budget. For example, all of the following items could disrupt initial plans:
- Unexpected expenses: Prior to purchasing a property to flip, investors should walk the property with a certified contractor and complete an actual inspection. However, despite these due diligence measures, unexpected expenses still arise. You may not notice out-of-code wiring during an inspection, but once you tear down the drywall, needing to bring previously undiscovered faulty wiring up to code can be a huge expense.
- Something breaks: Unfortunately, things can break in between closing on a property and completing the rehab. If your water heater or HVAC system breaks, you’ll need to pay thousands of dollars to repair them before listing the property for sale.
- Extended holding period: During the rehab process, house flippers need to pay certain holding costs separately from the actual rehab costs. Some of these items include insurance, utilities, property taxes, and loan interest. Despite your best plans, sometimes rehabs just take longer than expected, meaning that investors need to pay more in holding costs than initially budgeted.
Any – or all – of the above events could take a deal from profitable to a loss without an emergency fund. If your budget calls for a $20,000 net profit, a combination of unexpected code violation expenses and appliance repairs could quickly surpass that amount, leaving the investor paying for the loss out of pocket.
Consequently, I recommend a rehab emergency fund. While different investors argue different amounts, I use the rule of thumb that you should set aside 10% of the rehab budget as an emergency fund. So, if you have a $100,000 rehab budget, you should set aside $10,000 to cover emergency expenses.
And, with a rehab emergency fund, this amount doesn’t necessarily need to be in cash (minus the exception outlined in the next section). You can keep a designated credit card that you don’t use for anything else, or a line of credit, or even a family member willing to extend a short-term loan. Bottom line, you need to make sure that you can pay for these expenses when they arise.
Debt-specific Emergency Funds
As alluded to above, one portion of your rehab emergency fund needs to be kept in cash. More precisely, when using debt to finance a rehab, you need to allocate some portion of your rehab emergency fund to debt servicing, as lenders typically only accept cash payments.
If your rehab period extends beyond the initial timeline, you’ll still need to pay the above holding costs, regardless of the actual rehab. And, during this unexpected delay, you absolutely do not want to default on a loan. But, if you don’t have the cash on hand to service your debt, this absolutely can happen, with the lender foreclosing on your property – and you left with nothing.
While loan terms differ, with some having fixed payments during a rehab and others requiring interest payments on the principal actually drawn to date, rehabbers should be able to at least calculate minimum monthly debt payments during the rehab period.
Once you confirm these minimum amounts, I recommend keeping between three and six months’ of payments on hand as cash. That way, regardless of what happens with your rehab timeline, you at least won’t need to worry about defaulting on your loan.
Rental Property Emergency Funds
The next major category of real estate emergency fund pertains to rental properties. When evaluating a potential investment property, investors should absolutely incorporate a reserve emergency fund into their analysis. Things break, units stand empty, capital improvements need to be made – all of these items cost money.
If you have an emergency fund, you can pay all of the above expenses from that fund. As such, whenever something goes wrong, you don’t take an immediate hit to your cash flow. Rather, you have funds earmarked that you can use to pay for these expenses.
Okay Ryan, I get the theory, but how much should I actually set aside?
Once again, experience has provided me another rule of thumb to figure out how large of an emergency fund I should have on hand for a rental property:
- 5% of annual rents for fix-ups / maintenance.
- 5% of annual rents for vacancies.
- 5% of annual rents for capital improvements.
Doing the math, this means that I want to have 15% of annual rents set aside as an emergency fund for investment properties. For example, if I own a duplex and charge $1,000 monthly rent per unit, that totals $24,000 in annual rent ($1,000/mo x 2 units x 12 months). As such, I’d shoot to have a minimum of $3,600 in an emergency account for this property ($24,000 x 15%).
And, I highly recommend opening a separate savings account to house these funds. Mentally, it’s just easier to not spend this money on non-emergency items if it’s separated. Financially, during a refinance, many lenders mandate a reserve fund of a certain amount, and they’ll likely want to see it separated from your property’s operating funds.
Funding-wise, new investors often tell me they just don’t have enough extra cash to establish an emergency fund. While I argue investors should factor this fund into their initial purchase, it’s not the end of the world if you need to play catch-up. Let’s use the above example of a $3,600 target fund. If you can’t fund it immediately, set up a monthly automatic bank transfer. If you can afford $200/mo, you can fund this in a year and a half (unless you need to tap into it in the interim).
In other words, a rental property emergency fund doesn’t need to be all-or-nothing. Having anything beats having nothing when it comes to a reserve.
Final Thoughts on Real Estate Emergency Funds
At the end of the day, you don’t need emergency funds when it comes to real estate. But, they definitely help you sleep at night! And, a well-planned emergency fund can keep your deals profitable, even when they face unexpected challenges. As such, regardless of whether you’re flipping houses or purchasing rental properties, I highly recommend you use some sort of logical system (as opposed to emotion), to calculate and establish an emergency fund.