Why Landlords Should Consider Using a Sinking Fund
All landlords face the same dilemma: They own a rental building that will, someday, be in need of repair or capital replacement. It may be a roof, siding, air conditioning and heating equipment, carpets, or some other replacement, but it does represent a future expenditure that the landlord will one day have to address and spend money.
To deal with this future cost (and they must) landlords may decide to wait until the problem arises than scramble for the money. Of course this is not a prudent real estate investing strategy so it is certainly not recommended. Others may decide to react now and set aside a single lump sum of cash into an account as a reserve. This is by far the better approach, but let's take it a step further with a method known as sinking fund accounting.
In short, sinking fund is a method of setting aside funds by making uniform deposits (usually in a bank account) to pay for those anticipated future expenses or capital improvements.
In other words, rather than putting aside a single lump sum of cash into an account as reserve now, one could opt instead to to meet that objective with a sinking fund that can be "feed" with periodic payments. And because the sinking fund is calculated with the assumption that the money being set aside will earn interest, it offers the investor a better alternative.
How it Works
Based upon the number of equal deposits you would like to plan for each year, the type and amount of interest each deposit yields, and the desired full amount you want to collect and when, the sinking fund factor computes the amount of each uniform deposit you must start making to collect that desired sum.
P = 1 / Sn
P = Cash flow payments of equal size at equal intervals
Sn = Future value of a series of annuity cash flows
Let's say you want $10,000 available in four years to replace the roof on your five-unit apartment complex. You decide to start making uniform monthly deposits into an account that yields 2.25% annual interest compounded monthly and want to know how much each deposit should be. By applying the formula, you will know that each deposit must be $198.92.
So You Know
Our approach to sinking fund in this article focused primarily on its use to real estate investors and the future expenses they anticipate for their buildings. But it should be noted that it can be used to calculate payments toward any future expense such as a vacation, college tuition fund, and so on.
Here's to your real estate investing success.