Up for a debate? Prove me wrong.

OP

Cleveland, OH · Member since 2017 · 161 posts · 38 votes

9y

Another reason I believe CapEx is more of a "Personal-Preference" kind of thing... I own a duplex collecting $1000 in rent. You own a SFH collecting $750 in rent. Both homes were built the same year, and are both of equal value. Approximately the same size as well. I pay $200 for Capex. You pay $150. It makes no sense to deduct CapEx based on monthly income.. "But a duplex has twice the windows and Cabinets" etc. Okay! I own 1 SFH collecting $850/mo You own 1 SFH collecting $775/mo Both same year, same value, same size. It makes no sense to me. Again, not trying to sound ignorant or uneducated! I just like to compare results so I can further enhance my strategic thinking!

OP

Cleveland, OH · Member since 2017 · 161 posts · 38 votes

9y

@Shawn Greeves Haha yes I have heard of it! Thanks for the feedback. I do over analyze things, but not to the point that A decision is never made. I appreciate the constructive-criticism.

OP

Cleveland, OH · Member since 2017 · 161 posts · 38 votes

9y

I just want to be super sure that's all haha.

Shawn Greeves

Wholesaler · Chesterfield, MO · Member since 2015 · 41 posts · 37 votes

9y

I have done 3000 deals in the last 20 years and have NEVER thought that hard on a deal.

Like I said If the deals right it's right PULL THE TRIGGER!!!!

5 Reply

Ozzy SirimsiBusiness Member

Real Estate Agent · Baltimore, MD · Member since 2016 · 1k+ posts · 782 votes

9y

They are just references, you make your own numbers. You research how much a roof cost ,and slowly you can save that money in small numbers, or big numbers. I do agree Brandon's numbers high, but he says that he plays safe anyway. You can create your own rules.

OP

Cleveland, OH · Member since 2017 · 161 posts · 38 votes

9y

@Ozzy Sirimsi Thanks A Lot! Ok. Very inspirational. You're right. My agent tells me I over think things. Just thought I would reachout one last time for self- reassurance before we close on this house. I'm just nervous. Haha thanks again for the support!

Andrew Johnson

Real Estate Investor · Encinitas, CA · Member since 2016 · 3k+ posts · 3k+ votes

9y

Joshua Hollandsworth Your posit assumes that you have funds to "pay out of pocket". The driving factor of cap-ex budgeting (in my opinion) is to ensure that the property cash-flows after those expenses, i.e. "self supports". Dipping into your pocket whenever there's a cap-ex expense is just robbing Peter to pay Paul. And having to keep your pockets full enough to be able to dip into just means you're storing the cap-ex "fund" in your person checking account instead of an account dedicated to your properties. But if you're a buy-and-hold investor you're looking for how the property will fair over a 20+ year period. Being able to cash-flow after self-supporting matters. Roofing does cost a lot. Some people don't think it because their "new roof" experience is having someone slap a 3rd layer of asphalt shingles on. It's a different ballgame when you're actually doing a full reroof. You can underestimate the cost if you like but it's going to be what it's going to be. You can screen tenants all you want but if you have enough units for a long enough time you'll get some challenging ones. Maybe (and I mean maybe) you can get better tenant by renting your $1,000 rental for $800. But then you're taking an economic top-line loss for expense savings. Overall, the reality is that there's nothing "wrong" with your numbers. They "should" work. Start owning property and you'll realize that it doesn't quite work that way. There's no good reason the water heater should break early but it does. There's no way I'd stuff who-knows-what down a garbage disposal but your tenant does. You've never lost the keys to your home in your life but your tenant does. But do save your post. Buy 10 units and come back to it 5 years from now. I'll tell you this, on any given year I have some units that perform better than my pro-forma and some that perform worse. I can't "guess" which units will end up better vs. worse. The only thing I know with absolute certainly is that my pro-formas will be wrong!

5 Reply

Michael Bracken

Investor · Garland, TX · Member since 2015 · 110 posts · 43 votes

9y

Joshua Hollandsworth If I understand you correctly your saying " why have a cash reserve if your going to budget for capex" or the opposite "why have a cash reserve?"

Michael Bracken

Investor · Garland, TX · Member since 2015 · 110 posts · 43 votes

9y

Have you ever paid for plumming? 5k on a SFH is change. Investment lenders want to see cash reserves for a reason. You got to have reserves and budget for capex for a lender to consider your property to be a great asset. 🤑

OP

Cleveland, OH · Member since 2017 · 161 posts · 38 votes

9y

Thanks, Andrew. @Michael Bracken No It came out wrong... what I mean is, If i have a cash reserve, I may not need to stress AS MUCH over CapEx.

Michael Bracken

Investor · Garland, TX · Member since 2015 · 110 posts · 43 votes

9y

Joshua Hollandsworth You are a smart guy for sure. I only wright short posts with short answers🚀 But when you say NOT AS MUCH saving for capex that's just code for NOT AS MUCH saving for capex. Hopefully that will be good. But we should save hope for the future not for real estate 🏡 right? 😇

David Faulkner

Investor · Orange County, CA · Member since 2015 · 2k+ posts · 3k+ votes

9y

Let's give this explanation a try. First, I absolutely agree with you that trying to calculate CapEx as a percentage of gross rents is completely bogus, laughable analysis. When the roof goes out it will cost money and that money has to come from somewhere, but the roofing contractor will not first ask you what the place rents for before calculating his bid.

Now, as to the other part, these things will happen and will cost money and that money will have to come from somewhere ... why not out of reserves? Ok, say you have $5k reserves on a SFR. Let's use the same roof example, and say it will cost $7k to replace the roof ... so you take $5k out of your reserves, and you have to cover an additional $2k "out of pocket" ... well, what if you don't have the additional $2k in your pocket at the time? What do you do then? Don't fix the roof? Let it leak destroying your tenant's furniture and the inside of your property? Then the tenant moves out and the rental income stops, and if you couldn't afford the extra $2k out of pocket before, now you REALLY can't cover it because you now have negative cash flow.

Let's be nice, and say that you can cover the $2k out of pocket. So you fix the roof. Now you have $0 in reserves and a nice brand spankin' new roof ... does that mean that new roof or something else won't eventually break and need to be replaced? How will you pay for those other things? How do you refill those reserves if you don't take out a CapEx expense every month to add to your reserves, whether you actually spend it that month or not?

To further illustrate the point and how I'd advise managing it, let's look at another common mistake I hear all the time here on BP. Say you bought a "turnkey" property, everything is brand new, replaced, remodeled, etc. (it usually isn't really, but let's be nice and say it is). So, you don't need any CapEx expense because it is all new, right? WRONG! In this case, you could get away with a lower initial amount in your CapEx reserve account, but not the amount you put away towards those reserves every month as CapEx expense. All that new stuff will still wear out and eventually need to be replaced. So, add up the expense to replace all that new stuff and normalize it by the expected operational lifetime to replace all that new stuff to come up with $/mo average (over the lifetime) CapEx expense ... add some reasonable margin and that is how much you put away towards your CapEx reserve fund every month ... notice that it has NOTHING to do with what the place will rent for, only to do with what it will cost to replace all that new stuff and how long it will last before it needs to be replaced. It does not matter that you may not actually use that expense each and every month to fix stuff ... sometimes you will use more and most months you will use less, but if you did your analysis correctly the average over a long term hold should come out right and you should add some margin in case you are off by a bit. This way, you don't get "caught with your pants down" and get into a death spiral as described above with a leaky roof that you can't afford to fix.

One more thing to consider ... I can promise you that CapEx will keep up with inflation, but I can make no such promise without further analysis that your rents, and therefore cash flow, and prices will keep up with inflation. If you buy into a declining market, just because the year one cash flow looks great on paper, then you can get yourself into a "value trap" whereby your rents go down over time on an inflation adjusted basis, and eventually all your cash flow and more gets consumed with CapEx which does keep up, and by the time you realize this you can't sell at profit because prices have also not kept up with inflation. These things do not happen over night and by analyzing the long term average historic trend in rents and prices over multiple cycles (spanning decades), you can spot these sort of traps. On the other hand, there are markets that start out with very low or even negative cash flow, but rents and prices consistently exceed inflation ... just looking at the year one numbers you may pass these markets by. So, my advice is to look at all income and expenses (including CapEx) over the lifetime of the investment, not just the first year, before deciding on buying or not and let that inform your strategy, hold period, etc.

... and you thought your post was long ... but if you are looking for a detailed breakdown, then there you go ...

3 Reply

Brent Coombs

Investor · Cleveland, OH · Member since 2015 · 6k+ posts · 2k+ votes

9y

@Joshua Hollandsworth, to take your premise to its extreme: why have ANY reserves? Why not just spend ALL of your rental income as it comes in, and have a shiny Credit Card to take care of those pesky expenses? Put simply: Cash Flow Analysis DOESN'T care where your money's kept!

But you'd better determine realistically: over time, what IS the monthly average for (all) costs?...

David Grabiner

Investor · Chattanooga, TN · Member since 2016 · 146 posts · 108 votes

9y

@Joshua Hollandsworth The initial calculation is never going to be 100% what is going to happen. You might have no repairs for 10 years or you could have a $5000 repair the very first year. Often times when we say this property will give x Cashflow or x% cash on cash return these are not true because these are just projections of what might happen. The real number isn't known until a couple years down the road when the actual expenses can be averaged out and you can see how you did.

My take on it is if you are going to have multiple properties then use the same formula to project all the expenses that includes vacancy and repairs+cap ex, you can choose the percentage you want to use. As you pointed out a percentage is not always the most accurate but it does make for easy quick analysis. Don't stress if it will be exact for that property because over your portfolio it will average out. Then when you have the property just make sure you have a reserve set up for every unit and just track your actual expenses, if you have an expense that can't be covered by the monthly cash flow then dip into your reserves. This works best when you have multiple properties because the risk is spread out so you can handle a larger expense without having to pay "out of pocket".

OP

Cleveland, OH · Member since 2017 · 161 posts · 38 votes

9y

Ok! You guys have me convinced. Thanks a lot! I guess i really didn't think about the small things.. Like the tenant losing their keys! Or a lender WANTING to see CapEx taken out. Thanks for th advise!

Andrew S.

Investor · Raleigh, NC · Member since 2013 · 1k+ posts · 708 votes

9y

Originally posted by @Joshua Hollandsworth:

I know the title is awesome. I would like to hear from all of you, the professionals! Though I am a newbie, please don't assume that I haven't done my due dilligence. I have been studying real estate for a few years. But you guys are in the field, and I ALWAYS want to learn. SO HERE WE GO!

I am about to sound like an amateur, prepare to laugh at me....

For the first time, I am thinking about not including CapEx in my Cash Flow Analysis. I do not think it makes sense to put away 30% (Vacancy, Repair, CapEx) For "What If" scenarios.

Here is what I got....

1. I do understand that it is a bad idea to invest in real estate without being aware of these expenses. A couple experienced investors have said that these expenses are so you don't "Get caught with your pants down" Right? Well... that makes sense! BUT, you are going to pay out of pocket regardless. Because it is deducted from your Cash Flow, so regardless of where the money is, or when it is there, it is being taken out of your pocket.

2. Vacancy and Repairs are a controllable factor. If you screen tenants correctly and find GREAT long term tenants, vacancy and repairs should be minimal. But let's put aside 10% to be safe! I am ok with that!

3. Isn't that what reserves are for? If i have say, 5k in reserves for a small SFR, (50-90k) then I shouldn't have to save half of my "would-be profit" for these repairs.

4. "BUT NEWBIE, IN 5 YEARS A NEW ROOF COULD COST YOU ALL OF THE CASH FLOW YOU HAVE MADE THUS FAR.." Think about that.... so will you? Say I have a duplex renting for $1000/mo. My PITI is $500. If i don't include CapEx, let's just say I take home $500, for the sake of simplicity. **I AM NOT SAYING IT IS OK TO SPEND ALL OF THIS, IT WILL ALL GO INTO THE BANK TO REINVEST/RESERVES** Say you also have a duplex for $1000/mo PITI $500. CapEx+Vacancy+Repairs leaves you with $200 cash flow, but you have $300 going in the bank for "What If's" ( I am making these numbers up. ) SO. 5 years later both of our roofs need replaced. I pay out of pocket. You fix the roof with your CapEx money! If you claim, I just lost all of my cash flow for the past 5 years, ($500/mo) Then you definately lost your $200. Even though you had $300/mo to fix this, it is stil $500/mo either way.

5. "Brandon Turner's book tells you to..." I believe that his CapEx chart was a little high.. great reference tool! But $5,000 for windows... what are the chances they break all at once? And a roof on a small home shouldn't cost $20,000..

6. $500/mo Profit vs. $200/mo Profit. Your cash flow is simply what YOU say it is. You could put $300/mo into an account... or you could consider that $300-Income.

I understand why people deduct it but do I really have to? I am not trying to sound smart... and I am not under-estimating anybody's intelligence. I just really want to learn! "Explain it Like I'm 5!" Right? Thanks, Guys! Please excuse my horrible grammar.

Looks to me like you are creating a problem where none exists! You are absolutely right:it doesn't matter what you "label" the money. At the end of the day, you have to fix your roof and spend that cash. Creating individual "buckets" for different expenses makes it easier for some people to keep track. Personally, I don't have different savings accounts for CapEx, maintenance, turnover, etc either. All comes out of one pot - but the important point is that the pot is large enough so you can withstand a series of unfortunate coincidences with roofs, pipes, appliances all breaking in one single month.

So what the experienced investors are really telling you is to MAINTAIN SUFFICIENT RESERVES. What you call them doesn't really matter

2 Reply

Account Closed

Investor · Denver, CO · Member since 2016 · 736 posts · 582 votes

9y

Capex is very important and you're right, it shouldn't depend on rents. Personally, my monthly depreciation expense is what I put into a reserve account. Up front, when things are new, I'm reserving about 30% on those individual items. As those items age, the depreciation decreases so my reserve amounts decrease as well. The reserve account is a liquid fund.

Let me give you a real world example of what can happen - say you have a vacant home available to rent. You or your property manager shows up to the house on a Monday morning and you find that all the copper was stripped out of it over the weekend including the air conditioner. All of a sudden, you've got to replace a $4k air conditioning unit, you've got about $5k in plumbing repairs to do, and another $3k in electrical repairs. We aren't counting the drywall that needs to be replaced for where the pipes and electric have been removed, the paint that goes on that drywall, or any water damage that may have happened when they pulled that copper pipe off your water heater. Your insurance company may pay for some of it (net of your deductible), but if you don't have code upgrade on your policy, you will have to upgrade your plumbing and electrical in order for it to pass inspection.

No, not all windows will be broken at once, but when it comes time to upgrade your windows (windows have a 12-15 year life), it's going to be expensive - I just had all windows replaced on a home and it was about $100 per window installed...or $7,000. You've got to save that cash - stuff happens aside from everyday wear and tear. It's less of a nightmare when you aren't stressing about how to pay for it to get back in business.

Sandy Sawyer

Realtor · Houston, TX · Member since 2017 · 177 posts · 68 votes

9y

Hi Joshua,

I'm not as experiences as these other clever people, but I know it's a lot funner to play with money that you have in the bank and speculate on how to leverage that money than to feel the dread and stress of being underwater in debt, stuck trying to climb up to the bottom. I tend to agree with the sentiments of speculating what the deal will net you over the next 5 years. Or even think of it as a slow flip, considering the return after you've gotten out. Will this investment feed you or will it EAT you? What will it do for your bottom line?

David Faulkner

Investor · Orange County, CA · Member since 2015 · 2k+ posts · 3k+ votes

9y

Originally posted by @Account Closed:

Capex is very important and you're right, it shouldn't depend on rents. Personally, my monthly depreciation expense is what I put into a reserve account. Up front, when things are new, I'm reserving about 30% on those individual items. As those items age, the depreciation decreases so my reserve amounts decrease as well. The reserve account is a liquid fund.

Let me give you a real world example of what can happen - say you have a vacant home available to rent. You or your property manager shows up to the house on a Monday morning and you find that all the copper was stripped out of it over the weekend including the air conditioner. All of a sudden, you've got to replace a $4k air conditioning unit, you've got about $5k in plumbing repairs to do, and another $3k in electrical repairs. We aren't counting the drywall that needs to be replaced for where the pipes and electric have been removed, the paint that goes on that drywall, or any water damage that may have happened when they pulled that copper pipe off your water heater. Your insurance company may pay for some of it (net of your deductible), but if you don't have code upgrade on your policy, you will have to upgrade your plumbing and electrical in order for it to pass inspection.

No, not all windows will be broken at once, but when it comes time to upgrade your windows (windows have a 12-15 year life), it's going to be expensive - I just had all windows replaced on a home and it was about $100 per window installed...or $7,000. You've got to save that cash - stuff happens aside from everyday wear and tear. It's less of a nightmare when you aren't stressing about how to pay for it to get back in business.

Setting CapEx expense at your monthly depreciation expense is a reasonable proxy, so long as you are invested in a desirable market where your total purchase price was at or above replacement cost. In some of the so called "cash flow" markets, properties regularly trade at retail prices well below replacement cost, and if you fund your CapEx expense around depreciation expenses derived from these below replacement costs prices, you will be woefully underfunded.

One other thing to mention is the newbie may think to themselves, great, why would I NOT want to buy in a market where I can get in at retail price for under replacement cost ... what a deal! Well, the issue is WHY things are selling at that cost ... it is a sign of a seriously depressed and declining market that is not keeping up with inflation on prices and likely not on rents either. What is your exit strategy in such a market? Abandon the house after something major breaks where the cost of it exceeds what the property is worth? ... Drive up and down the streets of one of these markets, all those boarded up windows are precisely the result of folks choosing this exact exit strategy. This is the extreme example of the "value trap" mentioned above, and there are many more less extreme but equally dangerous examples ... it can easily be spotted in the numbers, so long as you know how to look and read them.

Bernie NeyerPro Member

Investor · Chanute, KS · Member since 2016 · 155 posts · 60 votes

9y

First of all Joshua, please purchase the Bedford Handbook on English Composition and put some punctuation in your post so this old fart can read them. LOL

CapEx is just a way to calculate the real costs on ownership. If after you include all your costs, for CapEx they usually have a set number they throw in, and you are making a positive cash flow, then the property may not rise up and bite you unexpectedly. It is a way of doing due diligence on the property.

You are correct in one sense, I don't specifically save the CapEx, rather I use the income from my properties at that time to cover the repairs needed. You do however need to keep an adequate reserve of capital to cover unexpected expenses that arise. Problems are like wolves, they run in packs. LOL

OP

Cleveland, OH · Member since 2017 · 161 posts · 38 votes

9y

Thanks a lot guys! I know my grammar is terrible, I'm sorry. I am deducting CapEx. Either way It's coming out of the same place. Whether I label it CapEx or not. I still don't think the rent should have anything to do with it. However, I think in most scenarios, 30% for "future repairs" will do me good. Thanks, again.

Ralph R.

Investor · Bethel, AK · Member since 2013 · 1k+ posts · 852 votes

9y

Joshua Hollandsworth As your portfolio grows things change a bit. You won't fix all roofs in one year but here's an example After 3-4 years no major break downs or repairs I have since last March (13 months) had to replace 2 stoves $500 each, 3 hot water heaters,300 500 and $1000 respectively, and one garage door $1000. Since Jan I've had 2 renters turn south and eventually terminate tenancy. One unit cost 1500 plus his damage deposit. The other cost 500 plus her damage deposit. I replaced carpet in one unit for $900 dollars and just had another renter fail to pay rent. That unit needed rehab when I bought it. I'll need to put 3-5 k in it after eviction cost. These units have been rented some for 3 yrs tapering to one year. Last year I bought a SFR an put an additional 6k rehab in it. Notice I didn't mention vacancy costs on the 2 vacancys I've had already this year since January, plus 2 months vacancy on the re-Hab unit. I'll have another one in 15 days or so. Add those in. $4300 dollars vacancy plus in lost rent and all but the rehab vacant less than 1 month. Add also tenant lease up fees. I would have been S.O.L without reserves. Reserves serve many purposes. Banks like them when you are asking for loan #8 or 9. Reserves cover losses like those mentioned above. These were the worst losses I've had in 7 years all at once. Reserves requirement (in my opinion) change as your portfolio grows. I keep a set amount that covers ALL properties. Sometimes I'm over that amount (time to buy another property) and sometimes I dip a little below that amount (after I buy a property). My contribution to reserves changes every month according to needs. Reserves also pay taxes and insurance on some of my non escrowed commercial loan properties. When I'm below my amount I have lines of credit and 2 HUGE credit cards!! All 0 balance waiting. These are last resort things. Used only if there is no other way. First line of defense is reserves,second is incoming rent, third is income from w-2, (the amount I would normally save) lastly is the credit cards and lines of credit. I never dipped into my personal funds throughout all of these mishaps. For 2 months consecutively I had no income from one or more units. This happened twice last year if you count the re-hab. When I started with rentals paying out of my w-2 job was common. That's when you need the most reserves. Once it's rolling it is easier and you can manage them differently. When I started a broken swamp cooler would have been a huge challenge to get repaired. This year I was able to withstand these big outlays and still put savings away out of my w-2 earnings. The rents and reserves covered the whole ball of wax. RR

2 Reply

Brent Coombs

Investor · Cleveland, OH · Member since 2015 · 6k+ posts · 2k+ votes

9y

Originally posted by @Joshua Hollandsworth:

Thanks a lot guys! I know my grammar is terrible, I'm sorry. I am deducting CapEx. Either way It's coming out of the same place. Whether I label it CapEx or not. I still don't think the rent should have anything to do with it. However, I think in most scenarios, 30% for "future repairs" will do me good. Thanks, again.

By now, you should realize that no-one is arguing that the rent has anything to do with cap ex, as far as determining a pro forma one-percentage-suits-all-properties. BUT, you CAN work out the individual percentage (of rent) you could use for any SPECIFIC property!

In much the same way as you get told your interest rate as a percentage, I DO find it a useful analysis tool to have gross MONTHLY rent on one side of of the equation, and (all) gross MONTHLY (anticipated/actual) expenses on the other side of the equation, and therefore, work out the "percentage Rule" that applies to THAT property, (because over time, I don't believe that the ratio will change much). Rents DO tend to increase at a similar rate as expenses, right?

As a "rule of thumb", obviously the cap ex PERCENTAGE allowance will likely be lower for a $2k/m rent: property worth $500k, than for a $1k/m rent: property worth $70k.

(But then, some of the OTHER percentage ratios might be skewed the other way for those $500k properties eg. property tax? Not to mention: how about its mortgage as a percentage?)...