Understanding CapEx For Landlords – “It’s Not Rocket Surgery”

The Big Picture On CapEx For Landlords:

• • Capital expenditures are significant investments for maintaining and improving your rental property’s long-term value. 
  • Disregarding capex in your forecasting and budgeting can lead to some very ugly consequences, the chief of which is negative cash flow. 
  • Landlords can employ several tactics to ensure that capex and even operational expenses don’t disrupt their cash flow. 

I know, I know, you don’t like math.  We’ll keep it manageable.

Landlords lose money on their rental properties for many reasons. Still, the most common is failing to factor in all the costs of owning, managing, and maintaining the property before buying it.

Far too many landlords just subtract the monthly mortgage bill from the rent, and even those who factor in vacancies, maintenance, property management fees, accounting costs, and the likelihood of rent default still get it wrong.

So, to avoid this type of pitfall, let’s discuss capital expenditures or capex. 

What Is Capital Expenditure (CapEx)?

Capital Expenditure is any significant expense or investment you spend on your property to maintain and improve its value over time. 

For a shorter explanation, capex is large-scale property repairs and replacements. Capex are recurring since everything in a home eventually needs replacing or repairing, although they’re rare in most instances.

For example, maybe the roof only needs replacing every 20 years or so… but it costs a lot of money. And then there are furnaces, air conditioning condensers, flooring, framing, electrical systems, plumbing systems, HVAC and ductwork, kitchens, bathrooms, windows… every component in every home needs to be replaced or updated and on a largely predictable schedule.

Capex is different from operating expenses, which are the bills you pay to run your rental properties. Here’s a table to show you the differences: 

CapEx Deep Dive

If any of you think that might not be a problem, let me give you an all-too-common example. 

Let’s beat up on a landlord named Bill to illustrate this point. Bill bought a property that leases for $1,000/month, and his mortgage payment is $750/month. Bill thinks he’s a genius about to earn $250/month.

In reality, Bill is in big trouble. He has other expenses before we even get into CapEx:

• • Vacancy Rate: 10% = $100/month
  • Maintenance: $1,000/year = $83.33/month
  • Property Management: 8% = $80/month
  • Accounting, Bookkeeping, Administrative & Misc: $400/year = $33.33/month

(Psst: We have a free rental property calculator, that includes CapEx!)

Before CapEx, Bill’s property will cost him an average of $1,046.66/month. We’ll be generous and give Bill the benefit of the doubt that his property taxes and insurance are included in his mortgage payment of $750. But he’s still cash flow negative.

And the news gets worse from here.

Landlords are always taken by surprise when a furnace breaks, the roof needs replacing, or the AC condenser drops out. Last year, it was the roof, and after shelling out the $5,000 to replace it, Bill consoled himself by saying “Well, this was an off year because of that roof bill, but next year will be better.”

But this year, the furnace broke, and he’s howling in frustration after the $2,500 bill to replace it.

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Bill is worse off than we originally thought even a few paragraphs ago. Here are some invented numbers to illustrate the point:

Look at all the money he’s failed to account for each month! No wonder he’s losing money on his rental property.

And yes, I know the numbers above will vary wildly depending on the property. Don’t get cheeky on me.

Hard Truths Are Easier Than Hard Lessons

“But,” you ask, “didn’t I already budget for maintenance?”

Maintenance comprises costs you incur between each tenancy and mild repairs during it: new paint, new carpets, trimmed landscaping, patching a small roof leak. It doesn’t involve replacing the entire roof.

Capital expenditures and other unaccounted-for expenses are why so many landlords fail. Rental properties are a lot of work to maintain, manage, and financially care for, and most landlords don’t fully grasp all of the work and expenses involved.

Let’s break down an imaginary rental unit’s monthly budget:

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The Numbers May Be Ugly, But They Don’t Lie

When you think about the above, it’s actually pretty terrifying. Where is anyone supposed to find an investment property that rents for $1,500 but will only cost $500/month in mortgage payments?

There are a few answers to that question. One answer is that rents are not fixed in stone; they rise or fall depending on the condition of the property, the amenities offered, etc. Another is that there are additional ways to earn money from rentals beyond rents.

Also, remember that costs aren’t fixed, either. Perhaps aggressive tenant screening will cut down on your vacancy rate and turnovers. Maybe you can reduce your turnovers with a two- or three-year lease agreement to cut down on all the nasty maintenance, vacancy, labor, and other expenses that come with turnovers.

As you find ways to trim expenses and boost revenues, you may find you can afford to spend closer to $700 on the mortgage, even while your competitors can only spend $500 on it.

However, the important point is that this is why finding excellent investment properties is so hard. If it were easy, everyone would be doing it, right?

What You Can Do To Reduce CapEx And Improve Cash Flow

Extra expenses in real estate will come to you, no matter how you feel about them. The good thing is you don’t have to cower in fear of the next big bill that will hit you when you take prudent steps in reducing your capex and improving your cash flow, like:

• • Estimate the life cycle and replacement costs of major systems and components: There will come a time when keeping your property in its current state becomes more trouble than it is worth, and major overhauls are now required. You need to figure out when that is, at least roughly, so you don’t get blindsided.
  • Time investments to minimize operational disruptions and maximize spend: Timing your renovations and significant overhauls to low-occupancy seasons is the best way to maximize your time. Bonus points if you can do it when there are deals for equipment and labor.
  • Allocate funds from revenue for financial readiness: Emergency funds are important to landlords, too. On average, you must have at least 6 months’ worth of expected expenses in your pocket—and that’s just for operational expenses. You also need to set a little aside for major repairs and renovations so you don’t end up like Bill.
  • Prioritize projects with the best return on investment: Spending your money on a rental property more likely to give money back is just solid business advice. That doesn’t mean you don’t take care of the others, but you can use the proceeds from the successful property to fund the rest.
  • Consider potential tax benefits: Landlords have a lot of tax benefits, and taking advantage of them can save you hundreds of dollars down the line.

Become a Cash Flow Connoisseur

Before buying a rental investment, get as many details as you can about when each system, appliance, and component of the property was last replaced or updated. If you can, get copies of receipts and invoices. That will give you a better sense of when some chickens will come home to roost.

And, of course, if you’re renovating the property, you’ll know exactly when these systems will be replaced. However, you should still calculate the monthly cost of CapEx and include it in your ROI calculations.

The good news? It doesn’t take long to learn how to accurately forecast rental cash flow, so you can quickly dismiss losers and identify winners as you shop for your investment portfolio.♦

Have you made cash flow calculation mistakes, due to CapEx? Don’t be ashamed, I have too. Tell us about what you learned, and what you’re doing differently now!

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