Investors: Think It’s OK to Skimp on CapEx? Here’s Why That Could Cost You BIG.
If there is one metric that is more difficult to understand than the rest, it’s CapEx. I certainly did not have enough appreciation for CapEx 10 years ago, and from the forums and many posts on the blog, it is painfully apparent to me that most people lack understanding and respect for CapEx and what it can (and does) do!
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Many of you know that I am relocating my family from Ohio to Arizona. I remember exactly how it happened. Patrisha and I were crossing the street, on our way from a coffee shop to pick up kids from school. All of a sudden, right there in the middle of the street, she says to me, “We have to move. Kids need more opportunity than Lima can offer. We need more opportunity than Lima can offer. And I’m tired of driving for an hour to get anywhere. So figure it out!”
Nice, I thought to myself. Easy for you to say, I thought to myself. But at the end of the day, I am as tired of the damn snow, sleet, and dirt as the next guy. I am tired of declining population and stagnant incomes. I am tired of fighting tooth and nail for every $10,000 on the balance sheet because the market never goes anywhere. And finally, you just don’t argue with the boss, and that’s just the end of that.
So, we are moving to Arizona, where the kids are number 10 and 11 on the waiting list at what I figure is one of the best schools in the country, and you can’t spit on a map without hitting a Kumon center, an organic farm, or a Whole Foods. What I do with real estate is beside the point — I’ll figure it out.
As part of this relocation, I put my primary on the market, and I am selling one of the buildings — a six-plex. I bought the building distressed about five years ago. Two units were vacant. One of the roofs needed replacing immediately. One of the baths needed to be completely gutted. Appliances, flooring, paint — lots of work.
Having done the work, however, this has been a very stable building. There has been very little turnover. People in the building are “home,” and while there is regular maintenance (naturally), there has been little economic loss. Not a single eviction in 5 years.
Considering the amount of delayed maintenance that I had to tackle when I bought this thing, some items were put on the back burner. I knew they would need to be done with time, but I would rather take the hit out of the cash flow than up front.
Some of the biggest items are sliding patio doors and windows. And this building has big bay windows in four out of the six units, which are special order items.
I’ve been fixing a few things every year. And slated for this year were one sliding door and one more big window. I suppose these are choice items because you can caulk, and caulk, and caulk. But the thing about CapEx is that it is directly related to economic losses. Why? Because nicer units attract nicer tenants, and nicer tenants don’t typically need to be evicted; they don’t trash your place at move-out, and they pay on time.
So, while I could keep caulking the old wood windows, at the end of the day, the cost of replacing them is less in the long run than trying to collect rent from tenants who are OK with crappy apartments. CapEx, my friends, is a necessary expense just like paying property taxes, and it is important to understand this!
So, I am selling this building. It is a 40-minute drive from Lima, and as such, it is less than ideal for my Lima infrastructure. Everything else in my portfolio is within a five-mile radius and easy for my handyman to get to, but this six-unit is sort of an outlier.
Interestingly — and this illustrates the power of real estate — the portfolio note on this asset is adjusting down by about 2% this month after five years. If I were to keep this building, I have the option of pushing the amortization back to 20 years, and in combination with a lower interest rate, this would free up about $5,000 of cash flow.
So, either I get $5,000 more cash flow, or I sell the building and get some capital gains, which I could to AZ with me. It’s not whether I win or lose, but which way I win. And that is the power of real estate — even in the armpit of the world that is Lima, Ohio. In the words of one Brian Burke, “If you can do this in Lima, imagine what you could do in a real market.”
I am under contract, and here is a list of CapEx that is happening. Some of this was planned, and some just came up unplanned. I had my team inspect the property ahead of seller's inspection, and this was what they found:
- Bay window replacement (planned)
- Sliding patio door replacement (planned)
- Refrigerator replacement (unplanned)
- Stove replacement (unplanned)
- Two screen doors (unplanned)
- Carpet re-stretch (unplanned)
Whether I remain as the owner of the building or I sell, these items need done. Some of the items are definitely CapEx. Other items are better thought of as tenant retention program. But who cares what classification? Stuff needs to get done!
And interestingly, the refrigerator and stove are in the apartment that I remodeled immediately upon acquisition. With all of the money I had to spend, I remember looking at those appliance and noting that it’s just a matter of time. That time is now.
Property is made up of physical components. Those physical components get old and eventually reach the end of their useful life — the moment in time when spending money trying to fix the thing is either not possible or is prohibitive. All components eventually get there and need replaced.
So, you better be setting money aside out of your cash flow! The difficult part about this is that when you are new, you wouldn’t know how much this stuff costs. That’s when you read this article — ’cause we’ve done the numbers for you!
Investors: Do you agree with this assessment on CapEx? Have you ever been burned by deferring maintenance for too long?
Leave your comments below!