Typically when investors consider purchasing an investment property, they inspect the property as part of their due diligence and also review the proforma income and expense reports provided by the seller. In addition, the investors review the rental income and expenses to make a decision according to their comfort level and ability to raise cash (i.e. obtain financing to close the transaction). In order to supply financing, financial institutions typically require certain debt coverage ratios as well as loan to value ratios. In addition to the income and expense information, they usually look for vacancy rates, management fees and reserves set aside.
Reserves set aside are often calculated at 2 – 3% of annualized income and covers items such as painting, new roofs, decks replacements, asphalt resurfacing, new carpeting, replacing appliances and new linoleum.
Strategies for dealing with capital expenses
There are many strategies used by investors for dealing with capital expenses. Some owners save money to address future capital expenses; others tend to forget and believe that the cash the property is producing should go directly to retained earnings (i.e. in their pocket).
- Conservative owners will establish a reserve account where they will save money over 5 to 10 years before starting any major roofing, painting and asphalt repairs.
- Other owners break the capital projects into small pieces. For example, they might do half a roof one year and the other half the next year. In a large property with many buildings, some owners paint a wall section every year and hope to have all of the walls painted over a period of 6 to 7 years. One view of this is that this is not a replacement but rather a repair and can be expensed in the year the repair is completed, rather than being capitalized and depreciated.
- Other owners will lend the property money and keep the property in first class condition using borrowed funds.
- Finally, some investors will wait to sell their property and have the buyer’s funds offset major repairs. For example, a 30 unit is being sold and needs a new parking lot. The Seller will have the work completed for closing and have the vendor place his invoice into the closing escrow. The vendor is then paid out of the proceeds of the Buyer’s down payment.
There is a cash flow difference between a well cared for property and a poorly cared for property:
About 10 years ago, we had the opportunity to make a special pitch to an owner of a 50 unit apartment property. The property was in a great location, but had become threadbare and worn out. The owner’s income could not keep up with the expenses and due to the condition of the property the rents were significantly below market. We met with the owner and suggested that he invest $50,000 in to the property, in paint, asphalt and roofing repairs. He did not have the money and had to borrow it to get the job done. Once the work was completed, we were able to increase the rents by $100 per unit and get rid of marginal tenants. As we improved the tenant profile, we were also able to improve the property’s cash flow.
More importantly, we generated enough cash flow to pay back the line and send the client $2000 a month. He did not had a client draw in years. In addition, there was enough cash flow for us to improve the interior of the units, one apartment at a time.
We were able to do this for this client because the property was in a great location, in the heart of the inner south east Portland. Even with the rent increases, the rents were affordable. This same result is not always possible in a location that does not have significant renter demand. Even more challenging is a property located in an area with significant crime issues and a financially weak tenant base.
Curb appeal is critical to all properties. To get a quality tenant, you need to have a quality property. It does not need to be new. But it needs to be clean and feel like new.
I toured a property this week with a client in a tough part of Portland. We knew that in advance, but the deal seemed good, and my client was considering taking a risk. So we went to look. The aerial pictures looked good and the building looked nice from a distance. As we got closer, we found out that the paint was peeling, the new windows installed wrong and the decks were rotting. We turned around and walked away.
Had the seller taken the time to make sure that the property was continually and correctly improved, he might have had a deal, or at least an offer (all cash offer at that).
In summary, the best strategy is to continue making improvements at your property. Do regular inspections and as items show up, do the work. It is easier to do the work while a property is full and there is cash flow coming in then do it at the time of vacancy and short cash.
In the long run all properties are judged by their looks, just as we judge people. The key to a successful long term investment is to have a property looking good, inside and out.