Capital Expenditure, or Capex, is the term for money paid out for certain property improvements. It’s important to consider capex when underwriting (evaluating) an investment property. It’s really common to forget to factor in capex and run into a huge expense later on which sets the project back five years or more. Avoid this! And the only way to do it is before buying.
Capital Expenditures, Just One More Expense?
Definitely not. First, we have operating expenses – payments that are made routinely in the ownership of the property. These might include electricity, lawn care, property tax, and insurance premiums. There’s many more. As a rule of thumb, if the payment is recurring, though the amount might vary, it’s probably an operating expense.
What Expenses Aren’t Operating Expenses?
One big exception is the mortgage (also known as debt service). That’s recurring but not considered an ordinary expense, due to the fact that each mortgage is different and it’s not part of the day-to-day operations of the property. Another one is repairs. This might not seem like operating expenses, but there is likely a monthly cost of repairs for any property. These repairs, like a leaking toilet, have to be fixed to keep the property running and making money. Other non-operating expenses are legal expenses (except for evictions), depreciation, and capex.
Why Are These Separated?
When evaluating a purchase or sale, we want to look at the property’s potential to produce profit. Since income minus expenses is cash flow, we want to have only expenses listed that can impact the predicted cash flow routinely in our calculations of the value of the property. That’s why the Capitalization Rate uses the Net Operating Income, not the total income. It’s all in an effort to make an apples-to-apples comparison across multiple properties.
What is Capex?
Capital Expenditure is the expense that is outside of normal activity which is used to improve the property. These are funds used to buy or upgrade assets. If the furnace breaks down and you repair it, that’s an operating expense. If you have to buy a new one, that’s capital expenditure. Capex is usually a one-time investment into the property. Sometimes required, like the furnace, and sometime a choice, like adding an egress window to make a bedroom legal.
Why is this Important?
Capex is not used in the calculations of the operating expenses of the property. If a new furnace cost $10,000 on a property with an annual income of $12,000 and expenses of $6,000. You would only use the Net Operating Income to value the property. NOI on this one would be 12k-6k or 6k. At a 6% Capitalization Rate, that’s a value of $100,000. If you had factored in that furnace, you’d have a loss for the year (you did, in the end) but would have no way of valuing the property if selling. But you wouldn’t factor in the furnace, because you would not expect to buy another one for 10 to 15 years. If you just did a repair on that crunchy old thing, you can expect to do it much more frequently. Believe me, I know. Capex does not belong in ordinary expenses.
Bottom line: Look at what people are reporting in their expenses and determine if that’s operating expense or capex. If it’s capex, you might have more value in the property than the seller thinks! What a great deal! It’s extremely important you get this right next time you are negotiating that amazing deal.
