394: Investors Biggest Mistakes #2 – Not Budgeting for Capital Expenses

SHOW NOTES FOR EPISODE 394: INVESTORS BIGGEST MISTAKES #2 – NOT BUDGETING FOR CAPITAL EXPENSES

Real estate investors make lots of mistakes.  But the ones that seem to hurt most are those that cost you big dollars.  In this episode, Bill explores the second biggest real estate investor mistake: not budgeting adequately for capital and other key expenses.

Owning a rental property can be a great way to bring in more income, but as a landlord, it’s your responsibility to keep the property in good condition for your tenants. That means you’ll need to learn how to effectively budget for repairs and improvements large and small – and larger repairs and improvements, like replacing a roof, can be harder to budget for than smaller ones.

Many of the repairs and improvements you’ll need to make to your rental property will be unexpected. You can’t plan for a broken window or frozen pipes. But, by budgeting properly, you can at least prevent getting stuck with a bill you can’t afford.  The key is to prepare yourself for unexpected repairs so that when they do come up you’ll be financially ready to respond quickly and be able to take on the bigger repairs and improvements when they occur.

Understand Your Market

Before you even buy a rental property, you should ideally understand the challenges of the market you’ll be operating in. By doing some market research, you can learn what expenses to expect in advance, and how much you can expect to lay out for them each month.

Is your area subject to severe weather – hail storms, heavy rain or snow, flooding or tornadoes? What kind of damage can potentially occur?  The roof on my 22-unit in Indy had to be completely replaced because of a serious hailstorm – fortunately that occurred BEFORE I bought the property.  But what if it happens again?  Would I be prepared

How you can find this information?  Start by talking to local property managers. Most will be happy to speak with you and give you information about how much expenses like utilities, repairs, and maintenance will cost in your area, because they’re hoping you might hire them to manage your properties for you.  You can also ask other landlords who own similar rental properties in the area, or even call utility companies or the tax assessor’s office to find out how much things like property taxes, heating or water cost for the property you’ve got your eye on.  Ask them also about seasonal variations in expenses.  When is electrical, gas or water usage likely to be highest?  I was not ready for the doubling of my sewer bill in Indiana.  I don’t even get charged for sewer in So Cal!

Planning for CapEx

When you are first considering a property to purchase, you need to factor into your analysis and your profit projections, how the age of the property will factor into your repairs and maintenance projects – as well as CapEx.  Everyone knows analyzing properties is important.  After all, if you don’t have the right math going into an investment, you’ll never get the right profit coming out of it.

And most of us can estimate expenses like repairs, vacancy, and property management fairly easily.  But the one area nearly every new investor struggles with is CapEx.

More formally known as capital expenditures, CapEx are those expensive “big ticket” items that need to be replaced every so often, but not every month or year. This could include roofs, appliances, driveways, plumbing or electrical systems, or any other large item you should budget for but that do not occur enough to be easily accounted for.

The older your property is, the more likely your expenses will be higher.  Galvanized pipes can corrode and can create ongoing and regular plumbing issues.  Older electrical systems that have not been upgraded can also have problems and can even be the cause of fires. The high costs of plumbers and electricians can seriously cut into your bottomline.  Not to mention water damaged wood and settlement/foundation issues.  That’s why inspections are so important as part of your due diligence for every property purchase you make.

Another way to think of CapEx:  If you were to earn $100 per month in cash flow for ten years ($12,000) and then needed to put on a new roof for $12,000, what did you really accomplish in those ten years? Hopefully, the value has increased during that time, but that’s an appreciation game I don’t really play.  I want to make sure the property is actually producing regular monthly cash flow.

Estimating CapEx

Like repairs, CapEx is difficult to estimate because it depends on a lot of different factors, such as the condition, the age, and the property type.  Your investment property might be a 3,000 square foot single family house built in 2005.  Mine might be a duplex built in 1900 that hasn’t been updated in thirty years. Is the CapEx going to be the same? Of course not!

While there is no single “CapEx” number you should stick to, you can sit down and estimate the lifespan or how many years a roof will last, how many years an appliance will last, what the condition of your plumbing is, what a new driveway will cost, and so on—and then divide these out by the number of years. To do this, start by listing every “big ticket” item that might need to be replaced in the next 20 years.  You’ll have five columns: CapEx Item, Total Replacement Cost, Lifespan, Cost per Year and Cost per Month.  When you take the total of the last column, that is how much you should set aside each month to save for replacement.

However, there are limitations to estimating capital expenditures this way.

This chart tends to assume that everything was brand new when the property was purchased, but as any landlord knows, things don’t break down evenly.

• What if the plumbing only has a few years left?
• What if the paint is peeling, so the property needs new paint next year?
• What if the appliances are thirty years old?

Although the average of monthly amount might be true, over the long run, what about immediate concerns?  If starting today you only saved that much each month, and then you were hit with a $5,000 bill for a roof replacement next year, you wouldn’t have enough cash set aside to cover it. Therefore, it’s also important to take an inventory of what will need to be replaced sooner rather than later and save extra just for those items. This is also a strong argument for why cash reserves are so important to have for real estate investors. Things don’t break down evenly.

Know Your Regular Operating Expenses

When it comes to rental properties, there are two kinds of expenses: fixed and variable.  Fixed expenses may not be fixed in the sense that they will be the same every month – things like water, sewer, trash pickup, and lawn care may vary in cost from one month to the next – but they are fixed in the sense that you can expect them to come around on a regular schedule, and you should be able to plan for them.

Fixed expenses for a rental property include any utilities you cover, rental property insurance, mortgage payments, and property taxes. They can also include HOA fees, special assessments, and property management fees. If you choose not to use a property management company, you should still include this expense in your budget, because you’re still paying with your time.

Variable expenses tend to be those expenses that you can’t plan for.  These include minor repairs, as well as your property’s vacancy rate, or the percentage of time it sits empty each year.  That can also include the expenses associated with the turn-over of a unit or rental property (paint, cleaning, carpets, etc.).  And, of course, variable expenses also include the big, expensive improvements that you’ll need to make to the property.  You won’t need to call in some local roofers to replace your rental property’s roof every year, but you will need to do it once in a while. Or, things like replacing the condenser or an air conditioner system or a furnace.  These are known as capital expenditures or CapEx expenses, and because of their high cost, they can be hard to budget for.  While you can deduct these expenses from your taxes, the IRS will require you to amortize them over many years.

I’m an out-of-state investor from Southern California.  When I first started investing in places like Atlanta, Memphis and Indianapolis, I didn’t even know what a boiler was, let alone how much one cost.  I also knew nothing about issues associated with basements – water leaks, mold, etc.  nor know much to budget for salt and snow shoveling during the winters. 

Set Your Repair and Maintenance Budget

There are a few rules of thumb you can use to budget for the regular ongoing repairs and maintenance to your rental property.  Many landlords use the 50 percent rule, which means that 50 percent of your rental income should go to covering fixed and variable expenses, other than the mortgage.  The other 50 percent should cover the monthly mortgage payments, property tax, insurance and whatever is left over is your profit.  Some landlords pocket the cash flow, or use it to pay off the mortgage on the property faster, or some use it to invest in additional properties.

Another strategy (mainly for those who are not dependent on the cash flow to cover living expenses) is to save all of the cash flow towards future repairs. If you’re just starting out, this may be a good strategy, at least until you’ve saved up enough of a cushion to protect yourself financially in case your rental property needs something big.

A third rule of thumb for budgeting for big repairs to your rental property is to set aside two or three percent of the property’s value each year toward the cost of future maintenance. So, if the home is worth $200,000, you might save $2,000 a year towards maintenance and repairs. This averages out to about $166 a month.

Many landlords combine one of these budgeting strategies with a home equity line of credit on the property.  It’s a valuable financial tool that can help you fit the expenses of keeping a property maintained into your monthly budget.  A line of credit can also give you some wiggle room when things get tough but be careful, racking up big debt can also cut big time into your bottomline.

Budgeting for big repairs to a rental property can be overwhelming, but if you want to succeed as a landlord, you have to do it.  With smart budgeting, a healthy reserve account, line of credit and an attention to detail, you should be able to cover the cost of any repairs or improvements your property needs, no matter how major.

DISCLAIMER:  Many of the above strategies take knowledge and have a higher degree of risk.  You need to do your research and/or work with someone who is experienced to reduce your risk.

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