In the preceding section of this real estate investment blog surrounding “The BIG Decision,” we delved into the relationship and relative importance of your mortgage pre-approval, as well as your downpayment. Both play a vital role when determining which investment strategy best suits your investment criteria. The bottom line is: regardless of the amount you have been pre-approved for, you are required to pay a certain percentage of the purchase price as a downpayment to satisfy your financial institution’s lending criteria.
In addition to how much you are able to spend, it is crucial to better understand how much of a risk you are willing to take with that money. Furthermore, the savvy investor should understand that the initial cost of purchasing a property is far from the end of the saving cycle. It is imperative that you continue to set aside a reasonable proportion of your monthly net income for unavoidable, upcoming expenses.
This is where the topics of Risk Tolerance and Capital Reserves come into play:
Your level of risk tolerance is something you need to be very aware of as an investor. Risk can come in many forms and degrees, so take the time to assess the following and ask yourself the attached questions:
- Timing – How long can I afford my property to be vacant for? What is my holding period? When do I need to start seeing positive cash flows or a resale profit?
- Capital – Can I afford to lose all of this capital if the project fails? Do I have enough capital reserves for ongoing expenses, unforeseen costs, etc.?
- Profit – Does the risk equal the potential reward? Would I rather make a large profit and potentially lose it all in the process, or would I rather make significantly less with little chance of failure?
Once you have answered these questions it should start to become evident where your threshold for risk lies. Match your risk tolerance with your budget and you have now successfully narrowed your investment options to certain property types that best compliment your investment goals, all while staying aware of your comfort level of risk.
The amount of cash you have available to you after purchasing a property and getting it into a rentable state would dictate the magnitude of your capital reserves. Seasoned investors will understand the importance of keeping appropriate capital reserves, but many newbies will completely overlook this crucial step. As a general rule, you should have and continue to be saving a minimum of 5% of your total annual rental income to set aside as capital reserves for future property related expenses. Condominium corporations are required by governing legislation to keep a minimum reserve fund of 5%, which truly speaks volumes to the necessity of such reserves. Many items are negotiable, and therefore, dependent on rental contracts, but in most cases the Landlord will be responsible for the cost of:
- a new roof
- HVAC replacement
- new windows
- structural repairs
- snow removal
- lawn care and landscaping
It is imperative to be restrained enough to actually save capital every month, as the “I’ll just save more next month” mentality will get you in trouble fast. Remember, as a Landlord involved in a binding agreement with your Tenant, you are legally bound to fulfill your end of the contract. These reserves are really meant to cover capital costs (i.e. new roof), as opposed to operating costs (snow removal) which should already be accounted for on your income statement . If you can’t hold your end of the bargain due to a lack of reserve funds, you face losing your Tenant and future litigation. So always make sure to set up a separate reserve fund account where 5% – 10% of total monthly income is automatically siphoned out of monthly net income. Then, when you need to spend thousands on a new HVAC system, the money is already sitting there to ensure that you can fix it immediately. Otherwise, the inability of a Landlord to ensure that the Tenant is able to live at a habitable temperature within your property would be a direct violation of the Residential Tenancies Act (RTA). In this case, the Tenant would have grounds for Early Termination without penalty and could possibly sue the Landlord for damages. It is also always best to consult a solicitor for legal disputes.