Reserves and the APOD

[Jeremy K.]

Hello to all..How do you or should you incorporate reserve funds into the APOD when figuring out what a property is worth? Since technically it is not an expense (at least I believe not) but a capital investment that gets capitalized on the balance sheet. Would the expected cost be figured into the normal property anlaysis (50%-2% rule, cap rate, etc..)?

I realize that the cost of these items (new stove, fridge, carpet, etc..) will lower my bank account. As of now, my excel template that I have does not take any reserves expenditures into account. I do have an amount set-up that I will start with and I do have it factored into my cash on cash return. Just not positive on what do do for the cash actually payed out for items.

Any help will be appreciated!

Thanks

Jeremy

[Jon Holdman]

I'm not sure if you're asking from a pre-purchase evaluation question or a post purchase accounting question.

Pre purchase, the "50% rule" is a reasonable estimate of vacancy, expenses, and capital over the long term for a number of units. Unless you know there is something that's going to push up this number, just use 50%. If you start slicing into a bunch of different categories, its tempting to tweak each one down just a little and end up under estimating total expenses.

For post-purchase accounting, there is your cash flow and there are taxes. Any money you send out reduces your bank account. "Cash flow" is whats left after you subtract all the outflows from the income. Vacancy is the simplest. It doesn't show up at all. You just never collect the money. Capital items require you to spend the money all at once, reducing your cash flow. But for taxes, those items have to be depreciated over several years. So, even though it might spend $1000 on a five year capital item in one year, you could only deduct $200 each year from your income for tax purposes. Some money you spend reduces your cash flow, but doesn't affect taxes at all. The principle part of your payment, for example. And some that affects taxes doesn't come out of your pocket, like the depreciation on the initial purchase and improvements.

Cash on cash return can vary widely from year to year. When you spend that $1000, your cash flow is lower that year. Next year you don't have any expenses like that and your cash flow is higher. The estimates you make pre-purchase with the 50% rule smooth this out over many years, and so aren't very reliable for predicting any particular year.