You bought a rental property in Marion County, Florida. Congratulations! You know it will rent for $1,200 per month and the expenses will be $750. You just earned yourself $450 a month in cash flow, right?
Let’s look at the following breakdown:
- Property Taxes: $125
- Insurance: $125
- Vacancy: $75
- Repairs/Maintenance: $75
- Mortgage: $350
Total expenses: $750
Rental income less total expense ($1200-750) is your cash flow, right? Not exactly. In the example above, we are not setting aside reserves for capital expenditures (also referred to as capex).
What is a capital expenditure? A capital expenditure is something, usually an item like an appliance or roof, that someday needs to be replaced. These items are expected to last over a long period of time. Adversely, replacing the broken hinge on the front door would be a repair, and hiring a technician to check the HVAC system every six months would be maintenance.
The idea is to set aside enough reserves each month in preparation to purchase a new refrigerator in a few years or replace the roof in 10-15 years (or whenever the lifespan of the roof is estimated).
So how is a true Capex value determined?
If you’ve ever visited the forums or watched the training videos on https://www.biggerpockets.com, the largest membership site for investors in the nation, you likely know that most investors estimate a percentage for repairs, vacancy, and capex. Typically, on a property in good condition, investors use 5% vacancy, 5% capex, and 5% for repairs/maintenance. Property management fees need to be factored in as well if you are not self-managing your property. The final number would be your true cash flow.
Of course, these percentages are just standard rates used by many investors. Other factors that may increase or decrease your repairs, maintenance, vacancy, or capex can be whether your tenant is a single person or quiet couple vs. a large family with children and pets. Pets can ruin flooring, requiring replacement sooner than anticipated. Properties located in C or D areas may have tenants with less stable lives or fluctuating employment who move more often, therefore increasing vacancy expense. For more information, you can visit https://www.biggerpockets.com/buy-and-hold-calculator or read the book “What Every Real Estate Investor Needs to Know About Cash Flow.” by Frank Gallinelli, available at Amazon, Barnes and Noble, eBay and many other places.
If you do not want to use a percentage for capex, you can estimate actual dollars required. Let’s assume the roof is somewhat new. Although the property you own has a 20-year roof on it, the remaining lifespan of the roof at the time you purchased the property is realistically 15 years. In 15 years, you will likely need to replace the roof.
If fifteen years from now it will likely cost around $7,500 to replace the roof, you divide this number by the years/months remaining. Therefore, to calculate how much to set aside, divide the cost of $7,500 over fifteen years, or 180 months, to arrive at $42 per month in capex to set aside as reserves. For the next fifteen years, $42 (at a minimum, since inflation is not factored in) should be set aside monthly as capex specifically for the new roof you will need someday.
Repeat this process for the appliances, HVAC system, flooring, water heater, and any other big-ticket items that will need replaced eventually. Add all those items together and that will determine the capex reserves each month. Now you are ready to roll with lower risk.
If you have questions about determining capex reserves on a property you own or a property you are thinking about buying, email Clay@ResoluteRentals.com.