Reserves for Capital Expenses in Rental Properties
What investors need to take into account when analyzing investment properties
A Reserve for replacement is a way of setting aside funds to cover a rental property's anticipated (though inevitable) future capital improvement expenses such as the replacement of a roof, carpets, air conditioning and heating equipment, appliances and other electrical or mechanical equipment, parking lot, exterior paint, etc. This is applicable for small and large properties and for residential or commercial properties. I see many times investors calculate the return on investment of real estate without accounting for these reserves which, in my view, is a mistake because sooner or later, depending on the age of the structure or equipment, the investor will have these Capital Expenses which will affect the return on the investment over the holding period.
When you are going to buy a property, either a house or an office building, you need to take into account these Capital Expenses. For commercial and large properties I suggest to invest some money after the purchase and perform a detailed Reserve Study but to have an idea and be able to incorporate these Capital Expenses in the Investment Analysis of the Property in question I suggest to use a fairly easy way. Seasoned Real Estate Brokers and Property Managers can also help in determining these values. The way to calculate them is as follows:
- Make a list of all equipment and items that will require Capital Expenses. Common items are, Roof, Air Conditioning Systems, Water Heaters and Appliances, Garage Doors Systems, Entry Systems, Elevator Systems, among others.
- Determine or estimate the approximate age of each item
- Look for the useful life of each item in manuals, equipment information or industry standards
- Determine the remaining useful life of each item to know the remaining estimated life and the possible date of replacement
- Check current market prices for each item. You can use the current price or adjust for inflation
- Determine the yearly allocation to reserves for each item by dividing the estimated cost by the remaining useful life.
- Incorporate these numbers in your analysis to calculate the real Return on Investment or Internal rate of Return over the expected holding period
When we put aside reserves every year it may make sense to actually have them in a separate bank account from the operating account. For Condominiums, Cooperatives and Homeowners Association the rules of the State of Florida must be followed. For rental properties it makes sense to put these funds into an interest bearing account, money market account or a securities account (low risk paper only is advised) as part of a good cash flow management policy.
By Gaston Reboredo CCIM CPM
Principal
Florida Property Management
Services LLC
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