Unless Your Richard Kiel…
If you didn’t catch that last reference, perhaps you’re not a James Bond fan? Richard Kiel played the James Bond villain Jaws in a couple of the James bond moves (The Spy Who Loved Me
And even if you did catch the reference, you’re probably wondering how the heck this applies to Real Estate?
The answer is part of the problem. When it comes to a Real Estate asset like a rental property you’ll find that your money, or equity, is trapped in your property. You don’t realize that equity until you sell and while it may add to your net worth, it’s not money you can quickly or easily access. Which is the problem.
A sudden downturn in the economy (caused by oil dropping to $50 a barrel around here), unexpected repairs (that roof that suddenly started leaking) or an increase in vacancies (large local employers laying off staff or shutting down) can all have a huge effect on your cash flow as a landlord.
That’s where having access to that equity, or by having cash reserves in place can help.
Borrowing From The Experts
One way to prepare for instances like this is to hoard money during the good times, but that may not be the best solution for everyone. Another option is to borrow from what expert property managers do.
In this example condo boards. They are forced to be experts in planning future expenses.
Now personally I’ve had some horrible experiences with condo boards, but there are always some benefits somewhere and the concept of reserve funds is one of those.
If you’re not familiar with a reserve fund it’s a process that condo boards use to build up funds for planned (and sometimes unplanned) expenses. In my are it’s law for a condo building to have a Reserve Fund Study completed that outlines projected expenses for the next 25 years on the building.
This study needs to be completed by a company that professionally reviews everything and includes breakdowns on upcoming expenses such as new windows, roofs, ongoing maintenance along with taking into account other future expenses such as tax increases and more.
Now I’m not suggesting you need a professionally completed reserve fund study done for your rental property, but it wouldn’t hurt to take a longer term look at your property and plan for the future so you’re not caught by surprise.
By taking an approach in advance to deal with this, you hopefully won’t be caught in the position of having all your equity stuck in the property, having no money handy and you stuck figuring out whether bricks go best with ketchup or mustard for dinner.
So What Can You Do To Prepare?
One option you can use is starting with a reserve fund. We often would budget right from the start an additional $5,000 as part of the float for a property.
This was required up front money and made sure we were prepared moving forward for unexpected expenses.
Another option I know several investors use is to not withdraw any funds from the incoming cash flow for the first six months to a year depending on the profitability of the property. As an example, if you have $500 cash flow per month from your fully rented property, leaving that $500 to build up for ten months could give you a $5,000 reserve.
Another way to proceed might be utilizing a bit of both. Maybe you’ve just bought a new property, you only have $2,000 to start the fund, you still have $500 cash flow, but rather than taking all $500, you take $300 for ten months to build up your reserve. Or $200 for 15 months.
Or maybe you have a brand new roof already and your biggest upcoming expense might only be an appliance, so maybe you only look at a $2,000 reserve. It just doesn’t hurt to prepare.
But Don’t Over Prepare
Now this works fine when you have one or two properties, but if you start expanding your portfolio there gets to be a time where you have a lot of money sitting there not working for you.
If you have five properties each with $5,000 set aside you’re looking at $25,000 that you could likely use some of to either expand your portfolio further or find some other use for.
If you had ten properties that becomes $50,000 and after that it gets even crazier. So while it’s good to have that reserve, when you start getting bigger, you may want to consider other options. Or even start that way.
Even if you only have a single property, there are still other options to consider.
Setting up a line of credit on your personal residence can give you quick access to cash in the need of a major repair without incurring any major costs when it’s not needed. This will give you ready access to funds rather than locking up your own cash.
Depending on how long you’ve owned your rental property there may be an option to put a secured line of credit on your rental as well (a secured line of credit is attached or “secured” to the equity in your investment property helping to protect the lender). Secured lines of credit tend to have lower interest rates, but it may be more problematic getting one on a rental property and it may require additional equity.
Credit cards can work to cover unexpected expenses, but this usually means a very high cost of borrowing and is probably one of the least desired options. But it’s an option!
The important thing is to plan ahead for those times of need so you don’t become the needy one!
Do you have reserves set up? Options like Lines of Credit? Share your safety net with the others and we can all benefit! I always love to hear your feedback.
Hi Bill,
I was just starting out in the real estate investing business when I went to RBC for the rental financing because I was a long time RBC client. I gained some additional insights by the third property and used a mortgage broker to get financing. Like you said, if I consider ever moving to a different lender, I don’t want to be saddled with too much on the credit lines, and face additional costs of getting out. I don’t think I would ever use these Homeline Plans for funding down payments for additional rental properties. That could end up as an unhappy marriage… I would be better off using my HELOC on my principal residence or getting a HELOC for the third rental property after the equity has gone up in a couple of years. What are your thoughts?
Thanks again,
Glen
Hi Glen,
As you mentioned it may be a better option for your primary or possibly one rental property, but too many and it does cost you extra in the long run, although they never seem to mention that….
The important part is simply having access to emergency money when needed for your properties. While there is no magic number, and depending on the condition of your property, if you had access to $10,000 via your Home Equity Line of Credit (HELOC) that would cover two properties fairly well in most cases, if you had access to $25,000 that would be a real safety net with plenty of reserve plus unless you are accessing it, it’s at no additional costs to you.
I guess at this point it wouldn;t hurt to mention most “professionals” suggest having access to six months worth of savings in case of a financial emergency in your life. Access to Lines of Credit (LOC) can help with this as can easily accessed assets like stocks of bonds that can be sold can also help.
Final point of note as you are in Canada it appears, they are changing the rules on how debt servicing is calculated when it comes to Lines of Credit. Now even if you have a zero balance the entire amount you could potentially access on the LOC is calculated against you.
For some people, perhaps even you, it is like adding an extra $50,000 of debt against you, even when you aren’t using or accessing it and it can cause you some future headaches if you intend on purchasing another rental. You may need to discuss this with your broker if you plan on adding to your portfolio. If you do that now it will give you additional time to change things as needed or make adjustments to your portfolio to ensure you get where you want to go!
Regards,
Bill
I have 3 rental properties, and 2 of them were financed with an RBC Homeline Plan. The Homeline plan is a mortgage with a re-advancable line of credit attached to it. As I pay down the mortgage principal, the line of credit dollar amount goes up by the corresponding dollar amount. So in a few short years I have the equity at my disposal for my reserve fund. I am also keeping all of my monthly cash flow in the real estate chequing account for now, until I have a decent reserve built up. Thanks for the article Bill.
Hi Glen,
Thanks for the comment, mortgage products like yours definitely can be beneficial. the only thing you have to watch is if you move the mortgage to another lender you may face additional costs as it’s treated as two separate items on the title and each item will have costs, plus of course paying them out where applicable.
But as long as you have a plan, it makes it work! And it sounds like you have a plan!!
Bill
Hi Bill,
I’m confused now.
I have a similar mortgage, where my line of credit increases as I pay off my mortgage.
The bank did an appraisal of my house. The equity that I’ve accumulated let me get new line of credit with, let’s say, $50,000.
Now I planned to use it for purchasing another property, but you said “…if you move the mortgage to another lender you may face additional costs as it’s treated as two separate items on the title and each item will have costs”. Does it apply to my situation too? I don’t want to have no choice when it comes to time to renew my mortgage. What would be a proper way to use line of credit in this case?
Thanks.
Sorry for the confusion Igor, this may require a complete article to go over, the only problem being, I’m not sure how valid this is everywhere.
With readers from around the world and hundreds if not thousands of thousands of different mortgage products out there for people there isn’t any specific mortgage perfect for everyone’s situation.
This is in regard to loans to property owners that consist of a split between a Line of Credit (LOC) and a Mortgage where the Line of Credit increases as the mortgage gets paid down, but never exceeds the original total of both.
Just to clarify Initially the loan and mortgage may consist of a $200,000 mortgage and a $25,000 LOC. As the mortgage is paid down and more equity is built into the property some specific mortgages automatically turn that equity into that LOC without the homeowner having to reapply to increase it.
So potentially in five years (really really rough numbers, to make this easier) perhaps $25,000 of the mortgage has been paid down leaving the mortgage total at $175,000. At the same time each year the LOC money available has increased and based on the $25,000 decrease on the mortgage, the LOC is now at $50,000.
This is an awesome way to build up an emergency fund or to have access to extra equity that you could leverage to purchase additional rental properties.
There was always the issue of how these setups would cost more if you moved them from your current lender to another. Rather than simply transferring your mortgage to a new lender who could possibly have a better rate, who could have a mortgage better suited to your needs, or perhaps the service was horrible with your old lender, now you faced additional fees to move the mortgage.
These fees were the cost of dealing with two components of a loan on a property versus one single loan. So out of the gate a transfer on a normal mortgage would normally be free, or the new lender would absorb it, now there may be another $750 to $1,500 or even more in fees that would eat up any savings offered by a slightly lower rate.
In the grand scheme of things, not that huge of an issue on a potentially $300,000 property.
However, the big issues, at least here in Canada, is the rules have changed on how peoples debt is calculated when it comes to getting financing. Before it was based on how much credit you used. So if you had a $50,000 LOC and the balance was $1,000 owing your debt was based on the payments for that $1,000 which works out to be pretty close to negligible.
Now it’s based on servicing the entire amount of debt, even if you’re not using it. So if you have a $50,000 LOC, they base it on your ability to pay that amount each month if it was fully utilized. Your amount of monthly debt servicing would jump from $30 to $1,500 even though nothing changed for you.
If you have two, or three properties, each with one of the mortgage explained above, after five years you would be responsible for an extra $150,000 worth of payments, even if you aren’t using them. Those payments affect how much you can borrow going forward and can drastically hinder your ability to expand your portfolio. Again take note, this is a Canadian thing, I am unsure if the same rules are in force in other countries or regions, but it shows the rules can change, often just to protect the banks more and all they do is make things harder for you.
Bottom line, if you plan to build a portfolio of properties, you need to understand the current rules, how changes to the rules can affect you long term and you need to know how you need to adjust along the way to protect your interests and your long term plan.
Does this help clarify things? Or did I just make it murkier for everyone?
Bill