It’s easy to manage your portfolio when you’re flush with cash and your investments are doing well.
However experienced investors know that every real estate cycle has its ups and downs; only by planning for both can your portfolio weather higher vacancy rates, stiffer financing terms, and other obstacles.
Rather than hoping you’ll never find yourself in this position, your best bet is to enact several provisions to strengthen your portfolio and prepare for darker times.
Set Aside A Large Enough Cash Reserve
Although the economy is doing better, there are certainly many investors out there who remember the lean times.
Cash reserves, or setting aside money from your profit in order to cover unexpected expenses, is an essential part of owning any type of commercial real estate property. Unexpected expenses can occur at any time, not just during an economic downturn, which is why it’s essential you be prepared for vacancies, large capital expenditures, and even destructive weather events.
However many investors are unclear about exactly how much they need to set aside.
When you consider the fact that insufficient cash reserves can force you to accept less-than-ideal tenants, delay essential repairs and maintenance, or skimp on the quality of services, then it’s easy to see how not setting aside enough money to protect your property can have an immediate impact on the value of your income property.
One way to think about it is to ask yourself how much you would need to set aside to ensure an investment isn’t at risk; then multiply that amount to cover each investment.
The Bare Minimum: PITI vs Six Month Cash Reserve
The bare amount experts recommend you set aside include what it would cost you to pay PITI (Loan principal, interest, taxes, and insurance), and maintenance and capital repairs for three months for each property. This is considered the standard amount for most lenders, who will ask to see this amount when you apply for a loan on a property.
Other investors recommend putting aside a six-month cash reserve, with the caveat that you need to consider how long you plan on keeping the property.
If for example, you plan on selling the property after a few years and the property is still fairly new, then there is no need to set aside funds for say, a new roof. In the same vein, although you should maintain separate books for each property, whether you decide to keep separate accounts depends on whether you prefer the money earns the highest rate or stays separate for easier tracking.
Some investors keep a separate account for each investment, depositing all funds into that investment’s account until it reaches a six-month cash reserve. At that point, any additional money can be diverted and used for investing in other properties.
What Expenses Should You Plan For?
If you’ve done your due diligence then you already know what repairs and maintenance need to be done on the property. Make a list of all the repairs needed, and then add on the repairs that you’d like to have done within the next 10 years, or the period of time you plan on holding the property.
The easiest way to do this is to use a due diligence list since you’ll want to include everything inside and outside of the building that may need to be repaired within the period of time you’ll be owning the property.
Another important factor you’ll need to take into account is insurance deductibles. Generally, you should keep between $800 – $1,000 set aside for every five policies; if you’re just starting out you need to make sure you have the insurance deductible for the property set aside.
Weed Out Bad Leases
In the commercial real estate, and especially with triple net properties, the value of your property is heavily dependent on the leases held by tenants.
While there are numerous advantages to having tenants that stay long-term, that is only true if these same tenant leases maximize your profit.
That means that when lease renewal comes up, you’ll want to make sure to carefully examine lease terms, keeping an eye out for clauses that increase your liability or give you less leverage with the tenant.
Check to make sure your tenant is still in a good position financially; things can change drastically after just a few years, and you need to make sure your tenant can still cover your rent. Non-credit tenants require even greater safety measures, in particular, a personal guarantee on the lease.
Co-tenancy clauses are also critical if you own a property other than a multifamily. In this case, you want to make sure there is no option to renege on the lease if a major anchor tenant leaves; not only do you risk losing that tenant, but you risk other tenants leaving as well.
Another important factor during lease renewal is the adjustment of rent to meet market prices.
Pay Attention To The Language Of The Lease
Pay close attention to whether the language of the lease specifies the market rent as being based on “similar unimproved properties” (good for the tenant, but not for you), or “similarly improved properties.” This area tends to be a sticky one with tenants – for obvious reasons – however, at the very least, you should make sure that the tenant pays at least as much as they paid when they entered the premises.
Both of these suggestions will help you take pro-active steps to protect your portfolio, however, don’t forget that every portfolio should be reviewed on at least a yearly basis in order to ensure each income property meets your investment goals.