Guys, when five years ago I first started writing articles on the subject of real estate investing, I struggled to chose what to write about. It was difficult to know what you would find interesting.
Today, I never have to wonder what my titles should be. Indeed, all I have to do is answer the multitude of questions that come at me every day. And among, the most commonly asked questions are those having to do with anticipating the costs of owning and operating rental property.
Attempting to explain this complex subject in its’ entirety within the confines of one blog post is simply futile. There is just too much information. So, for now, let us focus on something called CapEx.
Question: How much CapEx should I set aside?
Answer: Keep reading…
Let’s start with the basics
What is CapEx in Real Estate Investing?
CapEx is an acronym for Capital Expense. In the course of operating life of an income-producing asset, lots of stuff breaks and needs fixed. Sometimes things break due to reaching their effective useful life, while other times things break due to excessive usage. Regardless, in order for the building to continue functioning as intended, those mechanicals that break must either be fixed or replaced.
Well, there are very specific accounting guidelines to this, but for simplicity’s sake – if you can fix it, it’s a repair/maintenance cost. However, if you have to replace it, then depending on what it is, the replacement cost for the item could be considered a capital expense. And generally speaking, all of the big ticket items fall under CapEx.
So, things like roofs, siding, windows/doors, flooring coverings, HVAC, water heaters, lighting and plumbing fixtures, and more, are all considered CapEx. You can fix and patch these, but at some point it’s cheaper in the long run to just install a new piece of equipment. Welcome to the wonderful world of CapEx. As my good friend, Serge S. says – “the gift that keeps on giving…”
Two Types of CapEx Numbers
For the purposes of underwriting of income property, there are two types of CapEx numbers you have to keep on mind.
1. Up-front CapEx
The easy number to track is the upfront CapEx – this is the money that you have to deploy immediately (within the first 12 months of ownership), to fix the most pressing items without which the property cannot function as intended.
Understand, if your investment strategy is anything like mine, then what you are doing is buying mismanaged assets and then creating value by improving them. Well, in this scenario, a certain amount of cash is going to go out the door to fix roofs, plumbing, windows pretty much immediately upon acquisition, and you must allocate and track this CapEx somewhere within your underwriting.
2. CapEx Reserve
Realizing that all mechanicals eventually reach the end of their useful lifespan, and will eventually need to be replaced, it makes sense that we set some money aside every month and year (out of our cash flow) in order to capitalize those future expenses. Even when starting out with a brand new building, or one that has been completely re-positioned, we still need to anticipate that equipment will need to be replaced eventually.
Where things get tricky is knowing exactly how much to set aside, so let’s talk about it…
Amortizing the Costs – Basic concept
Let us say, for example, that we have a 4-plex whereby each unit has its’ own furnace and central AC. Well, at some point in the future each one of these HVAC systems will need to be replaced. They are likely not going to all need replaced all at once, but they will indeed have to all be replaced at some point.
So – if you are starting out with 4 new HVAC systems, and we assume that each one of these will last for approximately 15 years, at which point it will become cheaper to replace it rather than fix it, then we have to put aside the replacement cost for all 4 furnaces in the bank over the next 15 years so we are ready to deploy when needed. And if a replacement unit will cost $3,000 installed, we would have to set aside $200/year for each one of these HVAC units.
Furthermore, since due to the inflation of both materials and labor, what cost $3,000 today might cost $4,000 in 15 years, more than likely we should set aside more than $200/year/unit.
Naturally, when buying this 4-plex we have to evaluate all 4 of the HVAC systems to make a reasonable guess at how much useful life still exists in each one of them. If, for instance, the previous owner replaced one unit 5 years ago, and another one last year, we can make adjustments to how much we hold back.
So – How Much Do You Need for CapEx?
Well, up-front CapEx is a function of what the building needs in order to bring it into good working order. And as to CapEx reserves, what you need to do as part of your underwriting process is to scrutinize all of the equipment to determine useful life. Based upon this, you can work the numbers backwards, inflate them to compensate for price inflation, and ascertain how much to set aside out of the cash flow to cover these expenses as they come up.
As a rule of thumb, the smaller the building, the higher this number is expected to be due to a lack of efficiency of purchasing power and labor cost. And, naturally, the older the building, the higher the expected CapEx. The amount also depends on the types of systems in the building.
As far as a range, this could be anywhere from $250/year/door to $1,000/year/door. I set aside $500/year/door, and as my assets get older, I am compelled to either sell, or raise what I hold back for CapEx…
Hope this helps, guys.
Feel free to leave your comments below…