How to Budget For Capital Expenditures
What are Capital Expenditures (CapEx)?
Money spent improving or adding to a property that goes beyond everyday maintenance and repairs is considered capital expenditure. Often referred to as CapEx, capital expenditures are used by investors for investment properties, business assets, and equipment. CapEx relates to expenses that are considered ‘big ticket’ items that need replacing less regularly such as appliances, roofs, plumbing systems, and roofs.
Effective CapEx planning and budgeting could save you time and hassle in the long run. Having a solid understanding of CapEx, how to estimate them, budget for them, and how they are taxed all affect your investment profits, so it is essential you know all you need to know about CapEx.
Estimating For CapEx
In the same way that estimating repairs and maintenance on a house can be challenging, it can also be difficult to estimate the CapEx. Various factors come into play when estimating CapEx including the condition of the property, its age, and the type and condition of it. The CapEx on a 1920s family house will be different from the CapEx on a single story family house built in 2010.
However, you can make an educated guess as to the level of CapEx if you have all the right information to hand. Details about the condition of the property, the roof, and the appliances will help you estimate the CapEx costs. If a new roof was installed 3 years ago then it is unlikely to need a full repair this year. CapEx costs can be substantial, so seasoned investors usually set aside some CapEx funds every month. These funds act as reserves if a major repair is required.
A good method of estimating and budgeting for CapEx is to make a comprehensive list of all the big-ticket items that may need to be repaired in the next 10 or 20 years. Once you have this list you can budget for expenditure which could be incurred. Big-ticket items usually include the following:
-Water heating system
-New major appliances
-Kitchen and bathroom remodels
Once you have a list, you should estimate the lifespan of the item, and then the cost of repair. This will help you break down the anticipated CapEx expenses and account for them yearly and monthly.
Replacement Costs and Time
While the above method is a simple way of getting started when estimating CapEx and budgeting for it accordingly, there are other considerations you will need to be mindful of.
It is impossible to predict the lifespan of the items listed above, they don’t break down as and when expected. Sometimes a new roof could spring a leak, and other times a 25-year old plumbing system keeps working fine. You need to ensure that you are realistic with your estimates and your budgets for repair. What you don’t want is to be faced with an expensive roof repair you had not anticipated for another 10 years.
Therefore, it is always best to save for any big-ticket item repairs and always have a contingency budget for emergencies. Please note, however, that any money you set aside for repairs are not operating expenses. These funds are reported on taxes when they have been spent on repairs, so having the reserves will impact your cash flow.
Normally, you would expect things such as the roof, driveway, structure, and plumbing to have a 15-25 year lifespan from when they were installed. Appliances tend to have a shorter lifespan of between 5-10 years.
Budgeting for CapEx
The best way to budget for CapEx is as mentioned above – make sure you set aside monthly reserves. You can either estimate the level of reserves you need by having a list of big-ticket items and their lifespan, or you can use the following to help you calculate CapEx reserves for budgeting:
-Percentage of the value of the property
-Percentage of the revenue generated
-Set amount per big-ticket item
-Set amount based on the age of item and replacement cost
Always remember that if you purchase a property that has a 20-year old roof that you think might need repairing in the next few years, then your monthly reserves will have to be built up quickly. Budgeting is difficult because you cannot predict exactly how much you might need so it is easy to overestimate, but at the same time, you don’t want to underestimate in case you don’t have the reserves needed in the event that a CapEx repair is needed.
CapEx is considered to be an investment into your real estate business, and your balance sheet will show any CapEx expenditure as an investment. Determining whether an improvement, overhaul, or repair is a CapEx is important, but can be confusing. The important question is whether you are returning the asset to its former condition or to a like-new condition.
There is a big difference between everyday maintenance and repair, and CapEx. If we take the example of a roof repair, if you replaced a few missing tiles this would not be considered a CapEx. However, if the entire roof was replaced then this would be deemed to be a CapEx as you will have effectively extended the life of your asset. Other examples of repairs (and NOT CapEx) would include:
-Replacing smoke alarms
-Replacing door handles
-Replacing a driveway
The Inland Revenue Service has information on their website that helps you to clarify whether the cost incurred is a CapEx or an expense. If you use a property management company they will keep you up to date with any maintenance issues that arise.
Not undertaking big-ticket repairs in a timely manner could result in more expensive and extensive repairs being required at a later date. Investors could also find that they are only able to recover lower rents on account of the state of the property. So, don’t delay carrying out the required CapEx works, as it could cost you more in the long run.
It is never a good idea to overlook CapEx for anyone who invests in real estate. Estimating and budgeting for CapEx will enable you to make smart decisions about your investment.
Rental properties can generate revenue and income, but they can also lead to losses and one of the most common reasons for losing money is not factoring in all the relevant costs and expenses. Large-scale repairs can be rare but they can quickly deplete your reserves and profits, so ensure you have enough money set aside for CapEx.