Private real estate affords investors considerable control over their investment, from how and when properties are bought and sold to how assets are managed. One of the trade-offs for this control is the cost of owning real estate.
A way that investors budget for these ownership costs is through reserves, which include capital expenditures (aka CapEx) and other expenses. Investors should set aside a certain amount of money to cover these costs.
When budgeted for appropriately, these reserves can minimize or eliminate financial stress if an unexpected event occurs. That said, it is important to have the foresight to budget for reserves.
The Fundamentals of Reserves and CapEx
Reserves are savings—often a percentage of rental income—set aside by investors to cover future financial costs related to a property. There are different classifications of reserves. And it is a smart budgeting practice to use reserves for their specific classification, rather than as a general fund.
For example, strategic reserves often range anywhere from 10 percent to 30 percent, depending on a variety of factors. If an investor sets aside a total of 25 percent percent each month for reserves, a typical breakdown might be: 10 for for CapEx, 8 percent for vacancy coverage, and 7 percent for repairs and routine maintenance.
In real estate, CapEx refers to significant but occasional expenses related to owning a property, including replacing or repairing a roof, HVAC or plumbing system, paving a driveway, or replacing large appliances.
Most capital expenditures occur less than once a year, so when broken down by month, the amount looks more manageable. Routine repairs and maintenance are sometimes referred to as operating expenditures, or OpEx. Factors such as the condition and age of the property as well as investment strategy can impact the total amount of reserves and where they are allocated. This is especially true with regard to CapEx and OpEx.
For a better assessment of how much money should be set aside in the reserves fund and allocated for each specific purpose, real estate investors may want to hire a building engineer to analyze the property. That way, investors can better determine the useful life of each part of the property and what the potential expenses are so they can budget more accurately.
Calculating which items will need to be replaced/repaired, when they will likely need replacement/repair, and how much it will cost to replace/repair them will lay the groundwork for establishing workable OpEx and CapEx funds that are within budget.
Additional line items might be included in reserves, depending on how the property is operated and owner preferences. For example, if an owner is managing a property themselves and, thus, not regularly paying a set fee to a third-party property manager, they may reserve a specific percentage of income each month for potential management expenses.
Keeping It All in Perspective
While budgeting for reserves and CapEx may seem like a way to chip away at profits and liquidity month to month, this process actually frees up real estate investors from worrying about how to pay for the unexpected expense.
CapEx and other planned-for expenses shouldn’t be viewed as a burden for owning property. Instead, investors should keep in mind that CapEx, when claimed as an expense and as depreciation, can be used as a tax advantage. Therefore, it behooves property owners to keep careful records of expenses like these. (They can come in handy at tax time.)
Knowing that these expenses are in the budget and accounted for not only serves as an insurance policy for property owners, but also can help formulate and enact a well planned, optimized investment strategy.
Any tips you have for budgeting your reserves each month?
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