The most successful real estate investors today understand that spending money is often necessary to attract the best tenants and achieve higher rents. This includes capital expenditures, crucial for running and improving any real estate asset. While it may seem counterintuitive, expenses are necessary for running a profitable property, and capital expenditures are no exception. These expenses are integral to the long-term success of your real estate investment. By properly budgeting for capital expenditures, you can set yourself up for success and increase your chances of hitting your business plan.
What are Capital Expenditures in Commercial Real Estate?
Capital expenditures are typically the larger expenses required to keep a property in good condition over time. These improvements all involve construction. Depending on the property type and condition, these expenses can be significant. For instance, if you’re looking to purchase an older property, you may need to invest a considerable amount upgrading building systems or modernizing other components.
Some common examples of capital expenditures include roof overlays or replacements, HVAC upgrades or replacements, plumbing or electrical work, elevator modernizations, facade repairs, lighting upgrades, and other major improvements. These expenses are typically one-time costs incurred over the hold period, as opposed to operating expenses, which are recurring costs required to keep the property running on a day-to-day basis.
- Pavement Replacements/ Repairs
- Irrigation Upgrades
- Major Landscape/ Hardscape Improvements
- Facade Repairs, Sealant Joints, and Masonry Repairs
- Roof Overlays, Roof Replacements
- HVAC Equipment Upgrades – Cooling Towers, Chillers, AHUs, VRF, VAVs, FPBs
- BAS (Building Automation System) Replacements
- Lighting Controls
- LED Replacements
- Electrical Switchgear, Busduct, Main Distribution Panel upgrades
- Plumbing line replacements, fixture upgrades
- Elevator Modernizations
- Lobby Renovations
- Restroom Upgrades
- Spec Suites
- Fitness Centers
While capital expenditures can be expensive, they are necessary to maintain the value and functionality of the property over time. Neglecting these expenses can lead to more significant problems down the road, such as leaks, system failures, or other issues that can impact the safety and functionality of the property.
Deferred maintenance only gets worse with time. Additionally, not investing in capital improvements can reduce the property’s value over time, making it less attractive to potential buyers or tenants.
“An investment in knowledge pays the best interest.”
– Benjamin Franklin
When investing in commercial real estate, it’s important to have a clear understanding of the capital expenditures that will be required to maintain the property over time. It’s critical to prioritize capital expenditures based on their impact to prevent minor issues from becoming more risks down the road. While most CapEx can be planned over time, occasionally, an urgent need will arise, like swapping out a bad fire alarm control panel (FACP).
Capital improvements are a necessary part of investing in commercial real estate. Understanding how to program, prioritize, budget, and manage these expenses is crucial to the long-term success of your investment. By taking the time to conduct a thorough property tour and inspections with vendors, you can develop a property improvement plan by working with qualified contractors to get estimates for the cost of each improvement.
Why Capital Expenditures are Important
Capital expenditures are a critical component of any commercial real estate investment, and understanding them is essential for several reasons. The first reason is simple – lower expenses equals higher returns. CapEx can significantly impact an investment’s overall profitability. If you underestimate the cost of capital improvements, you may find yourself facing unexpected expenses that eat into your profits. Capital improvements that cost more and take longer not only affect your asset’s expenses but also your income. Tenants will be less likely to renew or sign new leases if your property feels like a never-ending construction site. The sooner you can complete the projects, the sooner you can charge for the added value.
Capital expenditures are crucial for keeping an asset operational and laying the foundation for future success. However, it is imperative that real estate owners understand the importance of CapEx and how it can affect their business plans. For example:
- Poorly allocated CapEx can lead to disastrous consequences, while wise investments can significantly increase an asset’s potential. Priority and precision matter.
- Having a brand new $2MM lobby is worthless if your restrooms look like they are from 1987.
- Owners need to be aware of the long-term implications of their CapEx decisions and view them as choices that will impact the future property performance.
- Why would you replace lighting when your maintenance staff are dealing with increased hot/ cold calls from tenants on a floor with an Air Handling Unit (AHU) from 1972?
- Allocating CapEx can be cost-intensive, but it is essential to ensure that capital is spent wisely. “Measure twice, cut once” is an appropriate proverb here.
- Do you have the right team of people in place? What is their experience in overcoming challenges and doing work quickly?
Another reason why gaining knowledge about capital expenditures is important is for budgeting purposes. By estimating the cost of capital expenditures up front, you can develop a more accurate budget for the required improvements. This information can help you avoid unexpected expenses and prevent you from running out of funds before the necessary improvements are completed.
“The most urgent decisions are rarely the most important ones.”
– Dwight Eisenhower
Learning about capital expenditures can help you prioritize improvements based on their importance and urgency. For example, if the roof needs to be replaced, it’s important to prioritize that improvement over other less urgent improvements, such as cosmetic upgrades. Maybe you can defer the replacement of the entire roof with more aggressive repairs and maintenance. Maybe your cosmetic upgrades need to be phased to attract new tenants.
The plan is part art, part science. If you are unable to deviate from your plan or adapt to changing conditions, you probably should question your plan and your planners.
Capital expenditures are important for long-term value, requiring long-term thinking and planning. By anticipating the cost of future improvements, you can develop a plan to manage those expenses over time and ensure that the property remains in great condition. This strategy, with a long-term perspective, can help you improve the property’s value over time and ensure that it remains an attractive investment for potential buyers or tenants. It is simple, not easy. Thinking strategically is a long-term view of the world while acting tactically requires actions in the short term.
Capital expenditure knowledge is essential for any commercial real estate investor. By estimating many costs within a CNA (capital needs assessment) up front, you can understand the overall scope of potential improvements. Prioritizing improvements based on their importance and urgency is a key skill that is learned from practice, not theory. Most importantly developing and executing a plan to manage those expenses over time, you can ensure that your investment is profitable and successful in the long run. Actions matter.
How to Budget Capital Expenditures (CapEx)
Estimating capital expenditures is a critical step in any commercial real estate investment, as it allows you to develop a more accurate budget. Controlling expenses help to maximize returns for your asset. However, accurately estimating capital expenditures can be a challenge, as there are many factors to consider, such as the age and condition of the property, the type of improvements needed, changes in the market, and the cost of materials and labor.
“We must consult our means rather than our wishes.”
– George Washington
We believe that accurate budgets are part art and part science. They require skill and continuous efforts to improve your process. If you do not have a process for budgeting CapEx, you will need to start there.
A number of factors can impact the overall costs of your Capital Budget. However, you can take a few key steps to develop more accurate estimates:
- Have a target. What is your business plan? In a year, in two years, where do you want your asset to be from a performance and aesthetic perspective? Do not wait until 6 months after you close on the property. Do not wait until construction in your market reaches its peak season. You cannot hit a target that you are not aiming at.
- Conduct a Property Tour: When estimating capital expenditures, you need to know what you are working with. Conducting a thorough property inspection requires you and your team to get out of the office and into the field. Knowing what to look for is a key skill you will develop over time. These site assessments will give you a better sense of the overall condition, areas of deferred maintenance, and immediate or near-term repairs that may be necessary.
- Research: Do you have the right scope, the right team, the right budget, and the right schedule? Remember, “right” is relative. Do some research to determine industry standards, market data, and asset performance for the cost of various types of improvements. This information can help you develop better budgets and ensure you are not over- or underestimating the cost. What are your limitations? What are your constraints? What are the challenges you understand today?
- Develop a Plan: Based on the results of your plan, your field observations, your property tour, and your research, develop a property improvement plan that outlines the improvements that will be necessary over the hold period. This plan should include a timeline or schedule for completing each scope of work. Project estimates are key. But remember, everything always takes longer than anticipated. So plan accordingly.
- Build a team: You will be working with a team of teams. The technical skill of your architects, engineers, and contractors is crucial. But what is often missed is how well does your team work together, how well do they adapt to unforeseen issues, how well do they respond to criticism, and how do they handle setbacks?
Following these guidelines will help you ensure your CapEx budget is accurate and realistic. By following a simple and thorough process to estimate capital expenditures, you can develop a more accurate plan that takes into account all necessary improvements. You will gain a greater understanding of the potential risks, issues, and challenges.
Tips for Managing Capital Expenditures
Managing capital expenditures is a critical part of any commercial real estate investment. It’s essential to have a clear plan in place to ensure that your property remains in good condition over time. From conducting a thorough property tour and site inspections to prioritizing improvements and developing a practical budget, there are many things you can do to manage capital expenditures effectively.
Once you have developed an estimate for the costs of capital expenditures, you can follow a few tips to manage these expenses and improve your NOI:
- Develop a Reserve Fund: Develop a reserve fund to cover unexpected capital expenditures. Many rules of thumb exist that budget a certain dollar per square foot (sf) annually or a 4% reserve of NOI. In reality, these measures are usually not enough depending on the type of asset you are managing. A Class B highrise office will have a different reserve than a suburban Class A multifamily asset, which will differ from an industrial bomber of 1 million SF. The rule here should be to save as much as you can for the potential improvements you expect.
- Prioritize Improvements: Most humans nowadays suck at priorities. We can barely prioritize our calendar, so prioritizing potential improvements can be tough. Again this skill is part art and part science. Prioritize improvements based on both their importance and their urgency. Many investors and asset managers think they know where to spend their money. Sequencing improvements is key to freeing up your management team’s time, focus, and energy. Plus, if done properly, you will more than likely attract better tenants and reduce the number of issues raised by your current tenants. Really challenge yourself to focus your resources on the most critical improvements first.
- Plan for the Long-Term: When making improvements, think about the long-term impact of each improvement. Is there a need for a 50-year fix when planning to sell in the next 5 to 10 years? If you want to sell in 18 months, good luck. You will need to be very precise and know what your future buyer will want in terms of a credit on the sale price. There is an opportunity cost when deciding what type of high-quality materials and systems to use. While it may cost more upfront, you can save money in the long run by reducing the need for frequent repairs and replacements. Bandwidth and focus are important for managing any real estate asset.
- Preventative Maintenance: Stay up-to-date and current on maintenance to prevent minor issues from becoming larger, more expensive problems. If you never change your oil in your car or rotate your tires, everything will wear out faster. Your driving habits also affect the performance of your vehicle. The same is true for your buildings. Regular inspections and maintenance can help you catch potential issues early and address them before they become more significant.
Managing capital expenditures is an ongoing process that requires careful planning, budgeting, and execution. By following these tips, you can ensure that your property remains in good condition over time while maximizing your return on investment (ROI).
Remember to stay vigilant, prioritize improvements based on their importance and urgency, and always be prepared for the unexpected. With a little bit of foresight and proactive planning, you can set your investment up for success for years to come.
Planning and Management
Understanding capital expenditures is crucial for any investor looking to invest in commercial real estate. Capital expenditures can significantly impact the overall profitability of any commercial real estate asset. Suppose you underestimate the cost of capital expenditures. In that case, you may end up facing unexpected expenses that eat into your NOI, while overestimating the cost may result in you unnecessarily deferring the work to a later date.
It’s essential to estimate the cost of these expenses upfront and develop a plan to manage them. While estimating capital expenditures can be a bit tricky, remember these key details:
- Conducting a thorough property inspection can help you identify necessary improvements and repairs. Once you have identified necessary improvements, it’s essential to prioritize them based on their importance and urgency. Try to separate the signal from the noise. Urgent needs do not always need to precede important needs.
- Having a plan is a fundamental starting point. A property improvement plan outlines the necessary improvements and their associated costs. From researching industry standards to speaking with contractors, you can develop a more accurate estimate of the costs related to materials, labor, and the various scopes of work.
- Preparing for the unexpected helps you prevent small obstacles from turning into bigger challenges. Plans change. Life happens. The world around us evolves. Therefore, it’s essential to set aside a reasonable contingency fund to cover unexpected expenses that may arise.
Overall, managing capital improvements requires careful planning, management, and oversight. With the right process and the right people, your plan can be successful no matter the challenges. Capital expenditures can be managed effectively, allowing you to improve asset values over your hold period. Again it is simple, but definitely not easy.