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Commercial real estate is considered as one of the most reliable long-term investments you can make. This is because well-run commercial properties generate residual income and appreciate in value over time. However, it’s not all sunshine. Even the most well-managed property has critical systems that will eventually require major maintenance or worse — replacement. The cost for this work is known as a capital expense, and every real estate investor must set aside money to pay for it. Once this money is set aside, it is known as a capital expenditure reserve or CapEx reserve.
What are Capital Expenditures?
A capital expenditure is any repair, installation or upgrade that will extend the life of a given property. The main difference between a capital expenditure and routine maintenance is that routine maintenance only restores a broken or malfunctioning system to its original working condition. For example, replacing the valve on a leaky faucet is a routine repair, whereas upgrading the plumbing for the entire building from galvanized lead pipe to copper pipe is a capital expenditure.
This is because fixing the leaky faucet only returns the sink to its normal function, but upgrading to copper pipes will result in better water flow, more consistent water temperature and improved water service for the entire building. Common examples of other capital expenses include the following:
- Roof replacement
- Replacing existing electrical wiring with new insulated conduit
- Replacing single-pane windows with energy efficient double-paned glass
- Adding solar panels to the roof
- Converting toilets and shower heads to low-flow models
- Installing new flooring
- Installing a new sprinkler system
- Installing new appliances
- Furnishing rental apartments
- Installing a new security system
Why are Capital Expenditures Important?
Capital expenditures are important because of the long-term improvements they make to the investment property. These improvements make properties more user-friendly and more desirable to potential renters, which translates to higher rents and higher net operating income (NOI). Additionally, capital expenditures, such as installing solar roof panels or upgrading to copper piping, can drastically lower the owners’ outlay for utilities and/or qualify them for rebates from local utility companies. Again, this will increase the property’s NOI and reduce the amount of money real estate investors must budget annually for maintenance in their operating budgets.
As discussed in the opening section, the cost of capital expenditures can be very high, but capital expenditures are unavoidable. An aging, badly leaking roof on a 10,000-square-foot building must be replaced because if the owner doesn’t do it, the vacant space won’t be rented, which means there is no money to be made off the building. Worse still, if the roof isn’t repaired, the building could be declared uninhabitable by the local government. This means that the owner can’t collect rent or must refund rents paid and allow tenants to break their leases without penalty. These are all disaster scenarios for any commercial landlord.
The high cost of most capital expenditures necessitates that commercial property owners set aside money from their buildings’ NOI for CapEx reserves. Think of it as a rainy day fund. No matter how many consecutive days of sunshine you may have, it’s going to rain one day, and if you have no money in your rainy day fund, you could well find yourself in the position of having to divert monthly rental income meant for other expenses such as insurance or property management to a major repair.
Worse still, many capital expenditures cost so much money that it’s impossible to rob Peter to pay Paul in order to cover them. After mortgage and expenses are taken out of a property’s gross monthly income, there may well not be enough money available to cover a large capital expenditure such as replacing the roof on that 10,000-square-foot building. This could force the property owner to take out a loan on the building, which increases debt service and eats into the owner’s cash flow after expenses.
On top of that, there are many capital expenditures that owners are required to make. Lenders such as Fannie Mae and Freddie Mac can require owners to upgrade existing fixtures to their requirements in order to stay in compliance with their loan terms.
Capital Expenditures Cover Depreciation
All cars depreciate over time because of constant use and a flow of newer, more modern inventory coming on the market. Believe it or not, real estate is the same way, and that’s why capital expenditures are necessary. They cover the cost of depreciation. Every major system that makes an investment property viable — plumbing, electrical and roof — will eventually fail or need replacement at some point during the property’s lifetime. That’s why it’s essential for property owners to set aside money for capital expenditures. Because if they don’t have money set aside for these eventualities, the high cost of capital expenditures could force them into a premature sale.
Can a Normal Business Have Capital Expenditures?
The short answer to that question is yes, absolutely. When Verizon upgrades its entire cell phone network from 4G to 5G, that’s a classic example of a capital expense. Another example of a capital expenditure for a normal business would be Target upgrading all its point of sales (POS) systems at the checkout terminals.
Additionally, in cases where you own a business that’s operating on a triple-net lease, you need to have a CapEx reserve because you will be responsible for a share of any capital expenditures that become necessary during your lease term. Lastly, if you should buy the building where your business is located, you’ll definitely need CapEx reserves as the property owner.
Who Saves CapEx Money?
You as a principal owner, your partners or anyone else with an equity share in your property must tuck away money for CapEx reserves. Remember, all the money collected from rents is not profit. Before you can realize any net cash flow from an income property, it is absolutely critical to set aside a CapEx reserve fund and contribute to it regularly.
The same goes for a non real estate-related business. The failure to establish and maintain CapEx reserves by any property owner or business eventually will threaten the livelihood of the business itself. It’s not a question of if, but when a major capital expense will need to be paid.
What do you do With CapEx Money?
CapEx reserves should be maintained in a separate account with a firewall between them and any operating funds so that it is only available for CapEx-related projects. If you do make the decision to invest CapEx funds, they should be put into something as safe and low-risk as possible.
Obviously, lower-risk investments have lower returns, but if you are properly adding to your CapEx reserves on a regular basis, you are growing them already. So, you really only want a safe investment to raise the reserves by a small amount. The idea is to grow CapEx reserves by saving them — not investing a small amount of money to grow them by playing the market.
How Much CapEx Money do you Need?
A good rule of thumb is to maintain a CapEx reserve equivalent to 10% of a property or business’s annual income. So, a property or business making $1 million per year should have a CapEx reserve of at least $100,000. However, every business is different so it’s a good idea to research what other similar businesses are setting aside and use that as a guide.
Benzinga also has a handy CapEx reserve calculator tool that may help clarify the question.
Real Estate CapEx Calculator
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