The Vacancy and the Repair

Two expenses are certain in the rental business and unpredictable in their timing. A unit sits empty. Something breaks that cannot wait. Every landlord who has held property for a decade has met both, usually in the same year, and often in the same month.

The reserve is the money set aside for those two events. It is the least interesting part of a portfolio and the part that decides whether a bad year is an inconvenience or the beginning of a forced sale. This page sets out how the number is arrived at, where the money belongs, and what it is not for.

What is the reserve actually for?

For the gap between when money leaves and when money arrives. That is the whole of it, and stating it that plainly keeps the reserve from being asked to do other jobs.

A vacancy is not a loss of profit. It is a month in which the mortgage, the taxes, the insurance and the utilities all arrive on schedule and the rent does not. A repair is not an investment in the property. It is a bill that has to be paid before a tenant can live there. Both are cash flow events, and cash flow events are settled with cash.

What the reserve is not for is an opportunity. The deposit on the next building, the renovation that raises the rent, the partner who needs to be bought out: those are good uses of capital and they are not this money. Landlords who spend the reserve on an opportunity have not made a mistake of judgement about the opportunity. They have made a mistake about which pocket it came from.

How is the number arrived at?

By adding your own costs, not by applying somebody else's percentage.

Take every property. Add the monthly carrying cost of each one: mortgage payment, property tax divided by twelve, insurance divided by twelve, any utilities you pay, condominium fees, and management if you use it. That is the monthly figure the portfolio consumes with no rent arriving at all.

Decide how many of those months you want covered. Three is thin for a portfolio of any size. Six is comfortable. The right answer depends on how many doors you have, how stable the tenancies are, and whether your household income depends on the rent or merely enjoys it.

Then add one repair. Not a general repairs budget. The single largest item plausibly due within five years: a roof, a furnace, a service panel, a foundation crack that a report has already flagged. Landlords underweight this because the small repairs are the ones they remember, and it is the large one that empties an account.

Add the two and you have a reserve figure derived from your buildings. Any percentage of rent quoted by someone who has not seen them is a number from nothing, however confidently it is offered.

Where should the money sit?

In an account, at an institution separate from the one holding your operating money, reachable the same week and tested at least once.

Separate matters more than the rate does. Money that shares an account with rental income is spent as though it were rental income, and the reason is that a single balance is a single decision and the reserve loses every argument against a visible need. A separate account makes the reserve a deliberate withdrawal and not an invisible one.

Tested matters because the first time you move a large sum should not be the day the furnace fails. Transfer limits exist, holds exist, and an account you opened online and never used is an account with a verification step you have not done. Move a modest amount in and back out once, note how long it took, and the question is settled.

The reserve loses ground to inflation. That is not a flaw in the plan. It is the price of certainty, and certainty is the entire product a reserve sells.

Does an undrawn credit facility count?

As a second layer, yes. As the reserve itself, no.

An undrawn line of credit is the cheapest optionality available to a Canadian landlord: it costs nothing while it sits there and it is large. Every established investor should have one, and having one is not a substitute for having cash.

The reason is what happens in a bad year. A facility is a commitment subject to review, and it is reviewed most attentively when values soften, when the lender's appetite for rental exposure narrows, or when your own file changes. Those are the conditions under which vacancies cluster. A reserve that can be reduced by a third party in the month you need it is a reserve with a condition attached, and conditions are precisely what a reserve is supposed to remove.

Hold both. Use the facility for the large planned item and the cash for the unplanned one. Refill the cash before refilling anything else.

What about the contract?

It sits underneath the reserve, and the distinction between the two layers is the single most misapplied idea in this subject.

A participating whole life contract accumulates value slowly and that value can be reached by policy loan on a written request. That is useful for capital with no date on it. It is poor for a furnace in February, because a furnace in February needs a card or a transfer, not correspondence with an insurer, and because drawing on a capacity built over a decade to cover an expense that recurs every few years empties the slower layer to do the faster layer's job.

The two layers answer different questions. The reserve answers what happens this month. The contract answers what happens to the capital that is left over after the reserve is full, the expensive debt is gone and the next deposit is set aside. An investor funding a contract before the reserve exists has built the second storey before the first.

Where each place capital can wait stands on its attributes is set out in where capital waits between properties.

What counts as a vacancy, and what does one actually cost?

More than the missing rent, which is the number landlords quote and the smallest part of the figure.

A vacancy begins the day the rent stops and not the day the unit is empty. A tenant who gives notice on the first and leaves on the last day of the month has already started the clock, because the replacement search, the cleaning and any work between tenancies all sit in front of the next rent cheque. Landlords who count from the day the keys come back understate the exposure by several weeks.

The cost is the carrying cost plus the turnover cost. Carrying is the mortgage, taxes, insurance and utilities that arrive regardless. Turnover is the cleaning, the paint, the small repairs a departing tenant leaves behind, the advertising, the hours spent showing the unit, and the credit checks. In many markets the turnover cost alone equals a month of rent, which is why a landlord who churns tenants at a slightly higher rent often earns less than one who keeps a good tenant at a slightly lower one.

The honest planning number is therefore not one month. It is one month of carrying plus one month of turnover, per vacancy, and a portfolio of six units should expect more than one of those per year on any normal turnover rate. That arithmetic is what moves a reserve from three months to six.

What does a repair cost that a budget usually misses?

The one that arrives with a deadline attached, because a deadline removes your ability to shop.

Most repairs can be scheduled. A quote is obtained, a second quote is obtained, the work happens next month and the price is competitive. The repairs that damage a portfolio are the ones where a tenant is entitled to something today: heat in winter, water, a locking door, a habitable unit after a leak. Provincial residential tenancy rules give a tenant remedies when those fail, and the remedies work on the tenant's timeline and not on yours.

An emergency call costs more than the same work scheduled, sometimes substantially more, and it is paid to whoever is available and not to whoever you would have chosen. That premium is invisible in a budget built from ordinary quotes, and it is the difference between a reserve that holds and one that does not.

There is a second cost that is easy to forget. A repair that is deferred does not stay the same size. A roof that leaks damages a ceiling, and the ceiling damages a floor, and by the time the work is done the invoice is for three trades and not one. Reserves exist so that deferral is a choice and not the only option.

How does the reserve get rebuilt?

On a schedule, out of cash flow, before anything else is paid.

The month after a reserve is drawn is the month a landlord feels wealthy. The crisis has passed, the tenant is in, the rent is arriving, and the account balance is the only thing that is wrong. The temptation is to defer the rebuilding until after the next improvement or the next deposit, and the deferral is how a landlord arrives at the following bad year with nothing behind them.

The rule that works is mechanical. A fixed transfer, on the same day every month, into the reserve account, treated like a mortgage payment and not a preference. It continues until the reserve is back at the figure you calculated, and then it stops, because a reserve that grows forever is money that should be working.

Two habits protect this. Increase the transfer after a rent increase, and do not let the increase be absorbed into spending. And recalculate the reserve figure every time a property is added, because the number was derived from the portfolio and the portfolio changed.

What does the tax treatment look like?

The reserve itself has no special status, and that surprises people who expect it to.

Money held in an account earns interest, and interest is taxed as ordinary income at your marginal rate in the year it is earned, whether or not you touch it. There is no shelter for a landlord's reserve as such. The expenses it pays are treated on their own terms: a current expense that keeps a property in the condition it was in is generally deductible in the year, under the income earning test in section 18(1)(a) of the Income Tax Act, while an outlay that betters the property or extends its life is generally capital and is added to the cost and not deducted.

That distinction between a repair and an improvement is where the arguments happen, and it is decided on the facts of the work and not on what the invoice is called. Keep the invoices, keep the photographs, and put the question to a CPA in the year the work is done. The practice does not give tax advice and this page is not tax advice.

What does a partner or a corporation change?

The arithmetic stays the same and the governance does not.

A property held with a partner produces a reserve that belongs to two people, and two people have to agree about three things before the money is needed. Who contributes, and in what proportion. Who may withdraw, and up to what amount without asking. And what happens when one partner cannot make a contribution in a bad year. Every one of those is easy to settle over coffee while the building is full and impossible to settle by text message on the day the boiler fails.

Write it into the co-ownership or shareholders' agreement, and do not leave it as a shared understanding. A lawyer drafting that agreement will ask about the reserve if prompted and will not raise it unprompted, because most agreements are written around the exit and not around the ordinary year.

A corporation changes where the money sits and not how much of it there should be. Reserve held inside the corporation is funded with dollars taxed at the corporate rate and is exposed to corporate creditors. Reserve held personally is funded with after tax dollars and is not. Interest earned inside a corporation is passive income, which has its own consequences for a small business, and that is a question for a CPA and not a question a website resolves.

What does not change is the priority. A corporate landlord with no reserve and a contract in force has the same problem as a personal one, dressed differently.

What if the reserve has never existed?

Then it is the first thing to build, ahead of every other use of a dollar in the portfolio, and the honest version of the advice is that this is unglamorous and takes a year or two.

Start with one month of carrying cost. Not the full figure, which is discouraging enough to prevent anyone from starting, but one month, accumulated by a fixed transfer. One month covers most single events and it changes the character of a vacancy from an emergency to an inconvenience.

Then extend. Two months, then three, then the figure the calculation produced. Each step buys a category of problem out of your life permanently, and the order matters because the first month is worth more than the sixth.

Nothing else should be started while this is running. Not a contract, not a renovation that is not necessary, nor a deposit on a fifth property. That sentence is the least popular one on this page and it is the one most likely to be right.

Who this applies to, and who it does not

It applies to every landlord with a mortgage, which is nearly all of them. A portfolio carrying debt has fixed obligations that do not pause when the income does, and the reserve is what stands between those two facts.

It applies with more force to a landlord whose household income depends on the rent, because a vacancy then hits both sides of the ledger at once, and to a landlord with a single property, because there is no second building to absorb the bad month.

It applies with less force to a landlord who owns free and clear and whose household income is unrelated to the portfolio. The obligations are smaller, the consequences are slower, and a thinner reserve is defensible. Even there, a repair still has to be paid in the month it happens.

What none of this changes is the order. The reserve is first. The contract that the rest of this section describes is later, and it is described in full on the real estate investors page, with its limits collected in what a policy loan cannot do for an investor.