Overlooking these expenses will kill your investment goals before you even sign the loan papers
One of the most overlooked aspects of acquiring a multifamily investment property is adequately accounting for capital expense items and recurring replacements that the investment property needs in order for you to reach your investment goals (See “The Importance of Having a Capital Expense Budget When Buying a Property“). Overlooking these expenses will kill your investment before you even sign the loan papers.
Capital Expense Budgets and Replacement Reserves Defined
The replacement reserve is for recurring replacements that you will have to take care of on a normal basis, such as replacing flooring or old appliances that have reached their end of life, and replacing items such as air conditioners or roofs several years down the road. In contrast, a capital expense budget is a one-time amount that you should budget for when acquiring a property. This is a repair expense or an expense to upgrade key components of the property that cannot be covered by the typical replacement reserve.
To meet your investment goals, you need an accurate capital expense budget and recurring replacement reserve, and you need to use them in your financial analysis and underwriting of the property you wish to acquire. Failing to account for a capital expense budget and recurring replacement reserve will leave you scrambling for cash when items break down, and it will make it very difficult to reach your investment goals when these items break down that should have been targeted for replacement up front.
Accounting for Capital Expense Budget and Recurring Replacement Reserve
One of the first things you need to know is how much should be set aside for your Capital Expense Budget. A good way to figure out the capital expense budget amount is to have a contractor inspect the property with you before you put in your offer, and put together a list of all the items that should be replaced over the next three to five years or your investment time frame and an estimate of the costs to do so. Then you can take that total amount and subtract out the recurring replacement reserve amount for each of those three to five years or your investment time frame. The amount left is what you will need to fund your capital budget (Total Capital Needs minus Replacement Reserve multiplied by Years before items need to be replaced).
For example, you walk a 40 unit property with your contractor and figure out that the roofs need to be replaced, it needs to be painted, and half the appliances are in need of replacement. You figure the total cost to fix those items is $150K and know you can only set aside $300 per unit per year or $12,000 per year ($300 x 40) into the replacement reserve, you know that you will only have $60K over those five years to work with from your recurring replacement reserve, and you will need a $90K ($150K minus$60K) capital budget to take care of the other items that would be impossible to fund out of the operations of the property without severely affecting the cash flow and investor returns. Therefore, you want to include that number in your evaluation of the property and adjust your offer accordingly to make sure you can reach your desired return. If you can’t make the returns after accounting for the capital expenses, you should pass on the opportunity.
Each property is different, so it is important to look for these items when walking a property and putting together your offer. If you do not feel you have the skills to identify these costs, it’s always recommended to have an experienced contractor on your team who can help you identify them. There are some rules of thumb that we use when evaluating a property. For a capital expense budget we account for at least $1000 a unit on every property. For older properties with a lot of deferred maintenance it can be over $5000 a unit and for new properties it can be as low as $1000 per unit, but for most properties we budget $2000-$3500 per unit for a capital expense budget.
How much should I set aside for a recurring replacement reserve?
For a recurring replacement reserve most lending institutions will make you set aside $250 per unit per year for a newer property and $300 per unit per year for an older property. I have seen as much as $400 per unit in areas such as coastal cities, where assets are exposed to more elements. When you talk to your lenders, make sure to ask them if they escrow for these funds or if you will need to set them aside, and how much they require you to set aside for their financing. Even if they do not escrow for these capital budgets, it is essential that you set funds aside for these normal expenses that arise when owning a property.
We typically find it much easier to fund the capital expense budget when putting together the funding to buy the property. If you are raising money from investors, it is almost always easier to raise this money up front, rather than trying to go back after closing to put this money together. The recurring replacement reserve is funded out of the operations of the property on a monthly basis. For example, if you have a 40 unit apartment complex and a $300 per unit replacement reserve per year, you would take the $12,000 per year and divide by 12 months, setting aside $1000 per month to fund the recurring replacement reserve out of the monthly operations of the property.
Having a capital expense budget in addition to a capital replacement reserve before submitting an offer can help you account for all expenses and necessary capital required to close up front, allowing you to meet your investment return goals. If you do not account for these expenses up front it can leave you scrambling for more cash when large repairs and expenses are needed on your property, falling short of your investment goals.