How much to set aside for Maintenance and Cap Ex?

[Garrett Christensen]

Hi All,

I've been investing for a few years now and when I'm running numbers I always set aside a percentage of the rent for maintenance and cap ex. I adjust this number slightly based on the condition of the property, but I don't really have a set system for this and I'd like to. It just seems too arbitrary at this point.

I'd love to hear from others on how they determine the amount of the rent to set aside. Ideally, we'd have years of data and just go off that, but when purchasing a property we don't have that. Also, costs of materials vary by location so I'd be totally lost if I were to invest out of state. 

Excited to hear what ya'll are doing.

Garrett

[Eric Fernwood]

Hello @Garrett Christensen,

There is a standard method of calculating a maintenance provision, used in the commercial world for many years. I will show how to calculate a property-specific maintenance provision for our target properties in Las Vegas. You can adapt this method to any property.

Maintenance Cost Is Not Related to Rent

Before I continue, rent has nothing to do with maintenance costs. I can demonstrate this with a couple of examples.

Below are two properties. Due to location and demand, both rent for $1,000/Mo. According to the rent multiplier method (rent x arbitrary constant), they will have the same maintenance cost. This is not true. Climate, construction materials, vegetation, and roof, are all very different. It is obvious that the property on the left will require far more maintenance than the property on the right.

Another example. Below are two properties. According to the rent multiplier method, the older property on the left has a lower maintenance cost than the newer one on the right because the rent is higher. This is not true.

Below is a rental property I own. According to the rent multiplier method, the maintenance cost increases every time I raise the rent.

The initial rent was $1,500/Mo. So maintenance cost is $900/Yr ($1,500 x 5% × 12). The rent increased to $2,000/Mo. so the maintenance cost increased to $1,200/Yr ($2,000 x 5% × 12)? Not true. First, the actual maintenance cost is closer to $200/Yr (newer property), so the method failed because rent has nothing to do with maintenance costs. Second, if I raise the rent, the maintenance cost also goes up? Why? Same property and probably the same tenant.

The rent multiplier method is invalid because low-rent properties tend to be older and in poorer condition and require more maintenance than newer properties with higher rents.

I understand the desire to add “something” for maintenance. As an engineer, I assure you that the rent multiplier method always produces false results, decreasing the accuracy of return calculations. The rent multiplier method falsely makes properties with low rents appear to have lower maintenance costs than newer properties with higher rents.

How to Estimate Maintenance Costs the Right Way

The method below is how maintenance cost has been estimated for over 100 years in the commercial world; this is nothing I dreamed up.

Maintenance cost is a function of the following:

• Property condition
• Property age
• Climate
• Construction materials
• Tenant pool
• The skill of the property manager in selecting good tenants

Maintenance costs have two components:

• Base maintenance - Base maintenance is all the little stuff like dripping faucets, running toilets, etc. Base maintenance does not include expensive items like water heaters, A/C compressors, or the HVAC system.
• Major cost items include water heaters, A/C compressors, roof repairs, or replacing an HVAC system.

You would think asking property managers for their opinion on annual maintenance costs would be a logical starting point. That has not always proven to be the case. For example, I asked a few property managers about what to estimate for annual maintenance costs, and received a wide range of answers. My two favorite responses are below.

• “Assume your annual maintenance will be two rent payments.” In this specific situation, the property was rented for a little over $2,000. So, the property manager suggested a maintenance provision of $4,000. The owner said his annual maintenance averaged about $250/Yr.
• “Assume 10% of annual rent for maintenance.” Using the 10% of the annual rent: $2,000/Mo x 12 Mo x 10% = $2,400. Still no relationship to the $250/Yr actual average maintenance cost.

None of the answers I received had any factual basis; they were (wild) opinions. As an engineer, this was unacceptable. So, I did a little research. Wading through a few property managers’ filing cabinets for maintenance information on my clients’ properties, I accumulated two years of maintenance data on over 60 properties. (Yes, I know this is too small of a sample, and two years is not enough time, but it was the best I could do.)

Below is a chart showing annual maintenance costs versus the number of properties at that cost.

I was surprised that there were two peaks. Most properties had an annual maintenance cost of between $0 and $500, but a small number of properties had much higher maintenance costs, ranging from $1,500 to $2,500. When I looked at the properties in the second cluster, I discovered that all had a single expensive repair. Usually, a water heater or an air compressor. Once I subtracted the single large repair, the annual maintenance cost was about $350.

Based on this research, I concluded that the base maintenance for the properties we target is about $350/Yr. Over the years, I've had multiple questions about why our maintenance costs are so low. It is a combination of two things. First, we have specific criteria for the properties we select. In general, properties built after 1990, with tile roofs, stucco siding, etc. Properties that do not meet our strict criteria are eliminated. The other has to do with Las Vegas being in the Mojave Desert. Because of the climate, only certain kinds of materials survive. Below is a typical property we target.

As you can see, due to the construction, climate, landscaping, and property age, little maintenance is needed.

Maintenance costs will differ for every location, building type, age, construction materials, condition, climate, and landscaping. I assure you that $350/Yr annual base maintenance will not work for all properties; your base maintenance cost will differ.

Determining a Property-Specific Maintenance Provision

Annual maintenance provisions for expensive items are based on statistical averages of component useful life. Useful life is the average years a component is expected to operate between repair or replacement. Typically, you will get a curve similar to the one below. The curve shows that some units failed earlier than expected, and others worked longer than expected. The vertical line on the chart is the average time all units operate. Said another way, 50% of the units fail before the predicted useful life, and 50% operate longer than the useful life.

To put the above in context, water heaters have a useful life of 12 to 14 years in Las Vegas. Have I seen water heaters fail after six years? Yes. Have I seen water heaters last 18 years? Yes. So useful life is only a statistical tool used to predict failures. While not accurate for any specific component, useful life statistical averages are the best we have to work with.

Below are useful life estimates for the three major Las Vegas rental property cost items.

• Water heater - 12 to 14 years
• A/C Compressor - 20 to 25 years
• HVAC Replacement - When parts are no longer available or about 35 years.

Instead of trying to explain how to use useful life, an example will be more understandable. Suppose you bought a property with a water heater. Checking the manufacturing date code on the unit, you determine that it was manufactured five years ago. If the useful life of a water heater in Las Vegas is 12 years, how much useful life remains?

• The remaining useful life is 12 – 5 = 7 Yrs.

The typical cost to replace a standard 40-gallon gas water heater in Las Vegas is about $900. So, by the end of the remaining useful life (7 years), you want to accumulate enough money to pay for the replacement. The formula for calculating the annual maintenance provision for a component is below.

• Annual Maintenance Provision = Replacement Cost / Remaining Useful Life

Or

• Annual maintenance provision = $900 / 7 Yrs = $129/Yr. or $11/Mo.

You can do a similar calculation for all the major components of your property. Remember that a house is just a wooden structure with standard components (HVAC, plumbing, electrical, etc.).

For example, below are the three major repair items in a Las Vegas rental property. I also included the component's useful life, replacement cost, and the years the components have already been in service.

Next, I will calculate the monthly maintenance provisions for each component:

• Water heater: $900 / (12 – 6) = $150/Yr. => $150 / 12 = $13/Mo.
• A/C Compressor: $2500 / (20 – 10) = $250/Yr. => $250 / 12 = $21/Mo.
• HVAC: $7000 / (35 – 10) = $280/Yr. => $280 / 12 = $23/Mo.

The total for all three components is $57/Mo. Remember that the average annual base maintenance provision is $350 or $29/Mo. So, the total monthly maintenance provision is $57 + $29 = $86/Mo.

Some considerations:

• If you replace the entire HVAC, you will not need to replace the compressor. You do not need to provide for both, so provision for the more expensive. So the monthly provision would be $23/Mo. + $13/Mo. = $36/Mo.
• What is the probability of all components failing during the same year? Statistically, very low. Remember from earlier; the useful life is the average of all components. So, while all components may fail in the same year, it is unlikely. I would only provision for the HVAC because the accumulated cash flow will cover all other components likely to fail in a single year when you include the $350/Mo. cash flow. So, $23/Mo.
• Once you reach an acceptable maintenance reserve, stop accumulating funds.

More considerations:

• The only way to keep maintenance costs low is not to buy properties requiring a large amount of maintenance.
• During the property inspection, have the inspector get the age of key components. The HVAC is more difficult, multiple components may have been replaced, so the manufacturing data is less relevant.

Provisioning for Multiple Properties

How you budget for maintenance is different if you have multiple properties. This example is based on the following assumptions:

• You have ten properties
• The average cash flow from each property is $350/Mo.
• The cash flow total from all properties is $3,500/Mo.

Some considerations:

• With $3,500/Mo. You can replace one water heater and one compressor monthly without out-of-pocket funds.
• Monthly cash flow will certainly cover base maintenance.
• The more properties you have, the lower the total provision you need due to combined cash flow.

Garrett, I hope this helps.