What do you estimate for capex and how do you pay for it?

Question

I should start by saying that I am mostly looking at cash flow markets like Kansas City (KC), Ohio (OH) and Indianapolis (IN) and not higher priced markets like CA or NYC, so what I say depends heavily on that fact.

One of the biggest issues I have run into in trying to buy properties is how much to estimate for capital expenditures. I started by using the percent of rent method I have seen on many forum posts and checking my numbers against the 50% rule. The problem I see is that this starts to fall apart on lower priced homes once I start actually running real numbers for capex. A good example of these is explained in this article:

http://www.biggerpockets.com/renewsblog/2015/03/03/why-you-cant-make-money-on-30000-houses/

I have also seen and tend to agree with slightly smaller numbers I have heard from those with more experience than I of about $100 - $175 (slightly less than the article above).

However, considering that few properties meet these requirements on a rental basis alone I am wondering how most people that have long term buy and hold track records account for this major item? Do you just assume that appreciation will bail you out? What about other forms of equity such as debt pay down or equity value at purchase strategies? From the numbers I see it looks like doing this lets you clip the coupon over time at a very good rate. It’s a little risky if you get overextend but seems to work at least in theory if you can manage the leverage risks.

Just curious what others think of this thought process and what has been the experience from those with long hold times as I am looking at different strategies and am unsure which to choose.

Dmitri L. · Answer

If you want a purely math based approach:

1) Find out the replacement cost of each big ticket item in your local market, for the level of quality that you'd want - i.e. what kind of roof would you put on? do you put in a brand new water heater? get scratch and dent? etc

2) Divide each item's cost by its typical useful life (in months) - to get a monthly capx reserve value for that item

3) Add up all the results - to get a monthly capx reserve value for the property as a whole.

The result above would be what you would want to put aside assuming all items are like-new meaning they have their full life expectancy remaining. If any specific item is closer to half-way through, you would want to consider multiplying the capx reserve for that line item by 2x - to ensure you have enough saved up by the time it rolls around. For any items that have less than say a quarter of their useful life left, I would personally factor the full repair cost in right at acquisition.

Hope this helps

-Dmitri

William Robison · Answer

Hello @Charles Worth

In my opinion, much of this is going to be property specific.  I cant say that I would use a generalization on this as much as the analysis guys and gals would prefer.

In my experience, we renovate houses with the investor making the decisions.  If we know that the roof is older, but still has useful life remaining, then it is their decision to replace now or wait until slightly later.

Water heaters, furnaces, appliances, these are all the same decision process.

If you purchase from a good provider that is open and honest about showing the true condition of these expensive items, then you are better able to justify a lower or higher capex expectation.  In our model, we have the approach to take care of the cosmetics, but also just an importantly or more importantly really, are these mechanicals that can be costly into the future.

Understanding that a house will always need something well into the future is one thing, but getting an TRUE idea of the useful life remaining is a critical element.

We now use new appliances in our renovations rather than cheaper, used models.  We get a very basic warranty, but we also can have the expectation of lifespan.  If a water heater is beginning to rust at the bottom, or show other signs of aging, or the label just tells us that it is 10+ years old, we prefer to replace now than to deal with that call later.

In the end, your property professional should be a guide to the true elements of risk for a property over the next few years.

All the best with your investments.