As a real estate investor in Austin, are you prepared to meet any large operating costs to properly maintain your investment for the long-term? Today’s blog post will examine the area of capital reserves for investment properties and how to proactively fund them. First, some basics: Capital reserves are used for capital expenditures. Capital expenditures or capital expenses are defined as funds spent to upgrade or materially improve a property. Typically, these are one-time major purchases. Capital expenditures are much different from routine operating expenses or routine maintenance and repairs.
For tax purposes, a capital expenditure must be depreciated over the useful life of the asset (talk to your CPA for specifics). A routine operating expense will be entirely deducted in the tax year it is incurred. Replacing an entire heating and air conditioning system or replacing a roof are examples of a capital expenditure. A plumbing service call, a minor AC call or touch up painting after a tenant moves out is examples of operating expenses. A single family real estate investor doesn’t need a complicated budget to figure out how much money to set aside for capital expenditures.
The best way to determine how much to hold in reserve for your property is to take a look at the remaining useful life of the “big ticket” items at your property.
Here is a partial list (from the National Association of Home Builders) and an estimate of useful life:
- Asphalt shingle “3-tab” roof: 15-20 years
- Asphalt shingle “Architectural” roof: 20-25 years
- Windows: 30 years
- AC condensing unit: 15-20 years
- Heating furnace: 20 years
- Wood siding: 20 years
- Countertops: 20 years
- Decks: 10 – 15 years (depending on upkeep)
- Vinyl siding: 25 years
- Carpet: 5 – 8 years (depending on grade)
- Exterior paint: 5-10 years
If you have a property that has a lot of big-ticket items that are nearing the end of their useful lives, you need to set aside more than if you have a new construction property.
While there is a debate about “how much” one should have in reserves, I find that on average, an investor should expect to budget 8-10% of gross annual rent toward capital expenditures. So, if you have a property that rents for $1000 a month, you should budget $960-$1200 a year for capital expenditures.
However, capital expenditures don’t typically happen every year, and when they do happen it’s typically a lot more than $1000. For example, the cost to replace an HVAC system (compressor and furnace) might range from $4,000 – $8,000 in a typical single-family property. A new roof can cost $8,000 - $15,000 or more.
By evaluating the age of the capital assets of your investment property, you should be able to arrive at a number you feel comfortable with to put aside for capital expenditures. The important idea here is to have an idea of what systems might need replacing soon and to be prepared to pay for the replacements when needed.
You don’t want to have $0 in capital reserves when the 20-year old HVAC system dies in the middle of the hot Texas summer, nor would you want to only have $1,500 on hand when your 25-year old roof finally gives is beyond cost-effective repairs.
We are perplexed when owners seem caught off guard by these types of expenditures. Think of the age of your investment, if it's in the age range of the end-of-life of some of these items you should be planning for this expense. We tell owners “it's not a matter of if but when” these items are going to fail beyond repair. Additionally, if you replace these items proactively instead of reactively, you will save money. For example, water heaters don't break down Monday morning at 8:00 am, they break down on Friday of the 4th of July weekend and the tenant has a house full of company. Or they start leaking over the long weekend that the tenants are out of town and the tenants discover their house has water on the floors on a Sunday evening. Remember, happy tenants, are more likely to renew their lease.
Keep your asset in tip-top condition for the long-term by maintaining proper capital reserves to make needed and necessary repairs and upgrades. Your tenant will thank you, your property manager will thank you and you’ll be thankful you did when it comes time to sell!