Most multifamily investors understand that a property needs upgrades and renovations overtime. Aside from regular operating costs associated with maintenance and repairs, there are usually bigger ticket items. Often considered “meat on the bone” by investors, these areas of potential improvement are referred to as “capital expenditures.” But the question isn’t whether or not a property needs any money injected into it. It’s “what are the big ticket items?” and “are they worth it?”
We’re digging into all of this below.
What is Capex? Why Does It Matter?
Capital expenditures (often abbreviated as CapEx) refer to any of the big investments of capital into a commercial property. These investments are used to extend the property’s economic life, and to increase the value of the property. Now would be a good time to distinguish between the two types of expenses at a property.
Operating Expenses (aka OpEx) are any expenses relating to maintenance, repairs, or payroll.
CapEx includes only big ticket replacements, renovations, and repairs. These expenses are less frequent and more expensive than regular OpEx.
While OpEx is factored in when calculating the capitalization rate and net operating income of a property, CapEx is not. This is due to the fact that CapEx, like the type of debt, is significantly contingent on the operator’s business plan.
CapEx serves an important purpose. It allows investors to improve the lives of the residents at the property, while also increasing the value of the asset itself.
Important Note: Every expense must have a useful life of at least one year in order to be considered CapEx. Also, the IRS treats CapEx differently from OpEx. CapEx expenses can’t be immediately deducted in the year they are incurred. Instead, these expenses need to be capitalized and depreciated over the useful life of the item, and the investor can recover the cost of CapEx through these depreciation deductions. The depreciation schedule varies based on the type of CapEx.
OpEx, on the other hand, is fully deductible in the year the expense is incurred. This means investors can subtract these expenses from the property’s taxable income in the same year, essentially writing off these expenses that year.
Here’s the formula for calculating CapEx:
CapEx = PP&E + Current Depreciation
*PP&E = the difference between the property, plant, and equipment expenses on a yearly basis.
Types and Examples of Capex?
So what are some examples of CapEx? There’s a wide range of different ways an operator could spend money in this category, but we’re only going to mention a few common examples.
These types of expenses can be separated into three different categories: Exterior, Interior, and Mechanical.
Exterior:
Roof repair or replacement
Siding replacement
Tuck Pointing (repair mortar joints between bricks or stones with a narrow ridge of lime putty or fine lime mortar).
Landscaping
Window Replacement
Foundation Repair
Major parking repair or replacement
Replacing gutters
Interior:
Replacing the floors
Appliance upgrades
Kitchen remodeling
Bathroom remodeling
Carpet/Paint
Replacement for lighting/plumbing/hardware fixtures
Mechanical:
Electrical systems
Water heater replacement
Replacing boilers
Meanwhile, OpEx includes:
Property staff payroll
Property taxes
Legal fees
Marketing and advertising expenses
Insurance
So as you can see, CapEx expenses cover a wide range of different items at a commercial property. This is why investors are able to be creative in their approach, and why one business plan might look different from another.
As we mentioned earlier, these are big ticket items, meaning they aren’t cheap. Some are obviously more expensive than others, and you need access to sizable amounts of capital to fund them. So the question is - how do you budget for CapEx?
Budgeting for Cap Ex?
There are various ways an investor can fund their CapEx budget. Some investors choose to finance these expenses with a loan, while others raise the capital upfront from investors or partners, and others choose to bank on the cash flow the property produces in order to pay for their CapEx expenses.
Raising the capital upfront is the most common method. Usually, the general partners secure financing in the form of a loan from a bank, but this only covers a percentage of the asset’s total value (and the purchase price).
For example, let’s say the lender loans 75% loan-to-value. That means that the investor needs to come up with the remaining amount along with their pre-estimated CapEx budget, which is oftentimes raised from passive investors.
The financing option is pretty self-explanatory. Some lenders offer funds as a percentage of the total cost, factoring in both the property value and the capital investment, known as loan-to-cost.
The riskiest method of funding a CapEx budget is to bank on cash flow from the property. This means the investor is not relying on any third-party investor or lender to pay for the CapEx. All it takes is one misstep or miscalculation to throw a major wrench in their business plan.
Here are some questions an investor should contemplate when it comes to CapEx:
How long will this project take?
How profitable will it be once it’s completed, and for how long?
Will this project help mitigate risk of future expenses?
Will this project be profitable year after year
As for how to calculate the CapEx budget, there are multiple ways to do it. Which one to use is ultimately at the discretion of the investor.
Net Operating Income Percentage
Property Value Percentage
Current item age and the cost of replacement
Fixed budget per unit
Many investors set aside cash reserves for CapEx since these expenses tend to be big. This is sort of like putting money aside for a rainy day, even if you don’t expect to have to start the project for years. This ensures that the investor has access to the capital needed to complete the CapEx project if they need it. Many lenders have minimum reserve requirements, and some will keep the reserves and release them through monthly payments in order to make the asset collateral against their own loan.
CapEx is a way operators can invest in the property, because it usually leads to increases in the revenue the property generates. It also helps operators control costs.
Final Thoughts
Capital expenditures (CapEx) in multifamily real estate extend the property's life and increase value. Unlike operating expenses (OpEx), CapEx requires planning, but it empowers investors to enhance communities and control costs. Careful budgeting, creative approaches, and emotional investment in residents drive long-term success.
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