As I said in my previous post, not even your BFF will ask you how much you need to set aside for vacancy and collection reserves. Why? Because most folks think that if you keep your rents low enough you will never have to worry about keeping renters.....NOT!
Setting your rents below market rent accomplishes two things:
1) You make less money.
2) You send a message to prospective tenants
that says either: "I'm clueless" OR "I'm desperate"
I didn't start renting my properties because I wanted to, I became a landlord because I wanted to move and it wasn't a good time to sell my house.
I decided upon the rent amount by figuring out how much monthly income I needed to cover my mortgage. I thought that I could "catch" a renter quick with low rent, and then raise the rent over time to eventually make more money than I was paying monthly on my mortgage.
My first tenant stayed for a year and a half. Unfortunately I didn't "visit" them while they were living there because I didn't want to "bother" them. When they left I discovered that they had poured a 15' x 20' concrete pad in the back yard for a dog kennel, dug up the back yard to install a sprinkler system that never worked properly, painted the living room wall deep burgundy, and allowed their children to create wall murals with permanent markers.
I set out with vigor to "clean up a little" so that I could "quickly" get it rented to someone else. A week later I was still sleeping on the living room floor in my sleeping bag amid paint and ammonia fumes.
Pop quiz: How many coats of primer and white paint does it take to cover DEEP BURGUNDY? If you said 1 coat of primer and one coat of paint you would be wrong. That first time I used 1 coat of latex primer and three coats of latex paint. It was also winter and it took fore-v-e-r for the paint to dry.
Let's take a moment now to add up the cost of "cleaning up" the house to rent again. I'll use a minimum of 8 hours a day for 7 days even though I was up at 6 am and didn't go to sleep until 9-10 pm every night. At minimum wage - I think it was $6 at the time - it cost me $336 in labor. I spent a minimum of $350 on supplies and repairs which means that to "clean up a little" cost a total of $690 rounded. REMEMBER at this point it was still vacant!!!
Let's pretend that it only took me two more weeks to advertise the rental, interview the prospective tenants, followup on their credit references (don't skip this part), and find a qualified tenant. I think I was renting the unit for $1,100 per month, so by the time I found a tenant I'd lost about $900 in rent.
After all was said and done I'd accumulated $1,250 in expenses due to the vacancy of my rental unit......about 9.5% of my annual income from this property.
Let's for a moment imagine that I had been smart and set aside 5% every month for vacancy and collections. After a year and a half I would have $990 to help offset the cost of vacancy. Let's keep imagining, and pretend that I had not discounted the rent and received ONLY $50 more every month for the 18 months that it was rented. After a year and a half I would have accumulated $1,035 toward vacancy and collection expenses and I'm only out of pocket $215. Cha-Ching!
The moral to this story is, take time to find out what the "market rent" is for your rental unit, there are plenty of qualified Real Estate professionals in your area who can help you figure this out. Then set aside a minimum of 5% of the actual rent you receive each month for inevitable vacancy and collection expenses.