Capital Expenditures (CapEx): Definition, Formula, Examples

Capital expenditure (CapEx) is a common term for many businesses and real estate investors. Understanding CapEx and how it’s calculated is important for knowing how much rent to charge each month to ensure long-term profitability. It can help you prepare for future maintenance expenses, and it’s also used by lenders when evaluating your business for a loan.

What Is Capital Expenditure?

Capital expenditure refers to money used by businesses to buy, upgrade, and maintain long-term physical assets. Also called fixed assets, these are items that businesses expect will improve their future cash flow.

A capital expenditure project could include buying a rental property or adding a new roof to an existing home. Another term for long-term or fixed assets is capital assets.

CapEx investments are long-term assets that are held on a company’s balance sheet for at least one year. They may also appear on the cash flow statement but are not included in the income statement.

CapEx vs. Capital Costs

The terms capital expenditure and capital costs refer to the same thing. Both mean spending money to buy, update, or repair fixed assets.

Types of Capital Expenditures

CapEx can be divided into two broad categories—maintenance and growth. A company could have different types of CapEx investments on its balance sheet. Here are some common examples:

Buildings and property

Many companies need office buildings, warehouses, factories, stores, and other buildings. They may also need to renovate existing properties. Buildings and property are among the most common capital assets that many companies purchase.

Upgrades to equipment

As technologies advance, many companies must periodically upgrade their equipment to stay competitive. A factory, for example, may need to upgrade its manufacturing equipment to increase its production rate and reduce downtime.

Software upgrades

Many companies rely on special software applications in their operations. A fast food restaurant, for example, may use a custom application to run its point-of-sale system. Paying for software upgrades may be necessary to ensure that bugs are fixed, and vulnerabilities are eliminated.

Computer equipment

Computers need to be periodically replaced or repaired as they wear out or become obsolete due to the emergence of new computing technologies.

Vehicles

Many companies need vehicles to transport finished goods and raw materials. Sometimes the vehicles are the focus of the business—like taxis, ambulances, and tow trucks.

Intangible assets

Capital expenditures don’t always have to be physical. They can also be intangible assets like brands, intellectual property, and goodwill. For example, a company could purchase the rights to a musician’s catalog of published works and earn royalties for many years.

CapEx vs. Operating Expenditures

Capital expenditures and operating expenditures (OpEx) are not the same thing. While a capital asset usually involves property, plant, and equipment, operating expenses (or revenue expenditures) include the normal costs of running a business. In real estate investing, mortgage payments or maintenance costs, such as paying to repair a leak in a property’s roof, are OpEx.

Capital expenditures are usually expensive and irregular while operating expenses occur on a consistent basis. Operating expenses often have a direct, measurable impact on your cash flow. Both capital expenditures and OpEx should be a part of your real estate investing budget.

Different businesses will have different operating expenses. As a real estate investor, OpEx may include:

• Utilities
• Advertising
• Property taxes
• Mortgage payments
• Property management fees
• Salaries (if you have employees)

You can subtract a property’s operating expenses from its monthly gross rental income to calculate the free cash flow. You can also do this annually to determine your annual net income.

Formula and How to Calculate CapEx

Calculating capital expenditures is not difficult. You need to know your business’s depreciation expense and property, plant, and equipment (PP&E). Property, plant, and equipment is an estimation of how much your long-term assets are worth.

The formula to calculate capital expenditures is not complex. You only need to add and subtract to complete it.

The formula to calculate capital expenditures is:

CapEx = current PP&E – prior PP&E + depreciation expense

CapEx on the Cash Flow and Balance Sheets

Since capital expenditures are assets that are expected to produce revenue, they are added to a business’s asset account on its financial statements. An asset account is a list of the assets a company owns. Examples of business asset accounts include cash, accounts receivable, land, and property.

The most common financial statements businesses and real estate investors use are the balance sheet, income statement, and cash flow statement. These documents are typically prepared at the end of an accounting period, such as a fiscal year, but they may also be prepared at other times to assess how a company is doing.

The balance sheet shows a company’s assets, liabilities, and shareholder’s equity at a specific point in time. The income and cash flow statements are both for a period of time that could be a month, six months, a year, or something else.

To illustrate how capital expenditures appear on your financial statements, let’s assume you buy a rental property for $200,000. Let’s also assume that you decide to replace the roof, which has an expected life of 10 years.

You estimate that replacing the roof will cost $10,000. Dividing $10,000 over 10 years will account for $1,000 of your property’s annual depreciation. On your financial statements, you deduct $1,000 from your property asset account each year for the next 10 years.

This accounting method is more accurate than showing only the initial expense of buying a fixed asset. It allows a business to account for the cost of a purchase and its value over time. Knowing the amount of annual depreciation is also necessary to figure the capital expenditure.

Examples of CapEx

There are many ways that a company could make capital expenditure investments. For example, a real estate investment company could purchase a new software system to help it keep track of its rental income and other aspects of property management. The software system is one of many CapEx assets that it owns.

Businesses could also invest in capital projects that help them improve their free cash flow. This will help improve a company’s income statement, making it more appealing to investors. An example could be a manufacturing company that purchases new machinery that increases production.

Another CapEx example could involve a company that buys several hundred new computers for its customer support personnel. The old computers are not operating as efficiently as they once did and cannot run the latest operating system.

Why Capital Expenditures Are Important

Performing a CapEx analysis on a potential investment can help you determine whether it has a good rate of return. It could help you determine, for example, whether buying a new investment property will increase your monthly income. It will help you determine whether the net CapEx is worth the financial risk or whether continuing with existing assets is the better choice.

Smart capital expenditures are beneficial to real estate businesses. They can help a business grow. Capital expenditures can help improve cash flows, greatly benefiting a company’s operations.

CapEx and Depreciation

An easy way to understand capital expenditures and depreciation is with a practical example. Let’s assume you own an investment property worth $500,000 and don’t have any other long-term fixed assets. Your PP&E in the first year of owning the house is $500,000.

Residential real estate is typically depreciated for 27.5 years, and you estimate that your annual amount of depreciation is $18,182. That means, in year two of owning the property, your PP&E drops to $481,818. Using these numbers, your capital expenditure is $0 (481,818 – 500,000 + 18,182).

At the end of each year, an additional $18,182 is added to the accumulated depreciation on the balance sheet. It’s important to point out that when we refer to depreciation, we refer to an accounting term. The depreciated value of an item is its book value and may not accurately represent its market value or useful life.

What Qualifies as a Capital Expenditure?

To qualify as a capital expenditure, a company must purchase a long-term asset expected to benefit the company financially. Long-term assets have an expected useful life of at least one year. Capital expenditure could also be an investment used to grow or maintain an existing asset.

For example, a new business could purchase an office building to house its operations. Although capital expenditures are usually physical assets, they can also be intangible assets, like patents, trademarks, and copyrights.

Capital Expenditures and Real Estate Investing

In real estate investing, the capital expenditure formula provides you with a way to assess the financial health of your business. If you underestimate a property’s CapEx, you may undervalue the total cost of ownership. This could result in a negative cash flow.

Let’s say you buy a $200,000 rental property, for example. You estimate the property’s operating expenses to be $1,000 monthly and rent it for $1,100 monthly. This means you’ll earn $100 a month.

But that simple calculation doesn’t factor in the total cost of ownership. You will eventually have to make capital expenditures to maintain the property. For example, you may have to replace the roof or buy new appliances.

Continuing with the previous example, you will earn $100 a month for 10 years for a total of $12,000. You then discover the property needs a new $13,000 roof. In this scenario, you don’t make any money. Instead, you lose $1,000.

The situation may have been different if you had accounted for capital expenditures. You spent $200,000 on the property, so your PP&E is $200,000. When you bought the home, an inspector said you’d need to replace the roof in 10-15 years. So, you factor in the cost of the new roof at $1,300 a year over 10 years.

Your property’s CapEx, therefore, is $213,000. That means you will need to charge more than $1,100 in monthly rent to cover the cost of replacing the house’s roof in 10 years and earn a profit.

How to Use CapEx in Real Estate Investing

As a real estate investor, you won’t always know when you’ll need to replace a property’s roof, repaint its exterior, or buy new appliances. That’s why estimating capital expenses can sometimes be challenging.

The best approach to estimating future investments in capital assets is to identify all fixed-asset items you might need to replace in 10-20 years, like HVAC units and water heaters. Make a list of their useful lives and then determine how long they can be used before replacing them.

Let’s say a water heater’s useful life is 8-12 years, and you buy an investment property with a two-year-old water heater. It’s a good practice to use the low end of an item’s useful life, so you estimate that you’ll need to replace the water heater in six years.

This will help you determine your monthly rent to maintain the house and earn a profit. This is why calculating capital expenditure in real estate investing is important. CapEx gives you the financial information you need to run a cash-flow-positive business.

Is CapEx an Asset or an Expense?

Capital expenditures are always listed as assets on the balance sheet. They are capital investments to maintain or purchase new assets for future growth.

Is CapEx Tax Deductible?

Capital expenditures are not tax deductible. Instead, they must be depreciated (have their book value gradually reduced) over time. The time required to depreciate an asset will vary. A single-family rental home, for example, may require 27.5 years, while a business vehicle may require five years.

Learn More About Capital Expenditures

Here are some additional articles to help you understand CapEx and how it affects real estate investing:

How to Estimate Future CapEx Expenses on a Rental Property

How Much Should You Budget for Reserves and CapEx?