One of the biggest mistakes I see investors make when financially evaluating an investment property is that they fail to include a capital expense budget for the property. When acquiring an investment property, it is critical that you have a capital expense budget as well as a recurring replacement reserve factored into the equity you will need to acquire the property and operate it effectively.
What is a capital expense budget?
A capital expense budget is a one-time amount that should be budgeted 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 recurring replacement reserve that is funded out of the property’s operations. A capital expense budget will help you avoid major expenses later on, or can be allocated to projects that can increase your ability to raise rents, lower expenses, and increase the value of the property. Each property is different, so it is your job to identify these items when you do your evaluations as they can greatly affect the returns on your investment dollars.
What should be included in the capital expense budget?
When we identify the items to include in our budgets, we look for items that are failing now or that could fail within a 3-5 year period. We also look at items that we can take care of immediately that will help us to increase rental rates or make it easier to lease or manage. Key items to look for and include in this budget are roof replacement, foundation repairs, deck replacements, landscaping, cabinets or appliance upgrades, flooring and paint to name a few. If you have a contractor on your team, they can be essential in helping you identify these items before putting in your offer. Failing to account for these capital budgets and recurring replacement reserves can leave you scrambling for cash when these items need to be repaired or replaced.
How is a capital budget different from a recurring replacement reserve?
A capital budget is different than a recurring replacement reserve because it is for major items that you have identified that you either want or need to take care of immediately, which you wouldn’t have the money to fund out of the operating expenses of the property. 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. The replacement reserve allows you to set aside money for future expenses that you know will occur so that you have the money to take care of them when they do happen.
Why do I need both a capital expense budget and a recurring replacement reserve?
A capital expense budget and a recurring replacement reserve are extremely important to have on any investment property. They allow you to account for future expenses up front when determining the investments return and offer price. They also allow you to plan how to take care of key items that will help you lease, increase rents, and manage your investment property more effectively and efficiently.