Cap Ex Vs Cap Reserves

[Anonymous]

Hi Spencer,

I seem to be little confused about the two terms: Cap Ex and Capital Reserves, they seem very similar to me. To make things more tricky, when modelling multi-family, we place cap reserves above NOI and Cap Ex below.

If I understand correctly, capital reserves is the cash funding (typically modelled as $___ per square foot) we set aside for a “rainy day” when we need to make major renovations, for example?

And from there, we would only fill values in cap ex when we expense those funds towards upgrades like Tenant Improvements? And I also see in the hold/sell analysis that Cap Ex = Tenant Improvements + Lease Commissions?

Thanks in advance for clarifying!

Josh

[Spencer Burton]

Hi Josh,

Thanks for the great question. Let me see if I can answer it for you.

First, I think your definition of Capital Reserve (i.e. cash funding set aside for a rainy day) is spot on. The complication enters when you ask, what constitutes a “rainy day”. Some real estate professionals will reserve for leasing costs, usually because a lender requires it, while others will only reserve for property upkeep.

Personally, I prefer to limit my use of Capital Reserve to the cash necessary to maintain the market condition of the property. So a Capital Reserve would be reserving cash for major capital improvements such as replacing the roof, mechanicals, fixing the structure, etc. Such that at sale, there are no deferred maintenance items dragging on the value.

The reason you’ll sometimes see Capital Reserve above the line (i.e. factored into the Direct Cap value), as that many real estate professionals view Capital Reserve as necessary to maintaining the property’s value, and thus should be factored into the valuation calculation.

Now the Capital Expenditures vs. Capital Reserve question is a good one. First off, Capital Reserves are Capital Expenditures, where a Capital Expenditure refers to an amount spent on a tangible asset (e.g. new elevator) that will be used for more than one year in the operation of the property. From a modeling point of view, however, I put all of the unknown Capital Expenditures into the Capital Reserve line item while I place all of the known Capital Expenditures (e.g. leasing costs, known CapEx such as roof repair, capital improvement plan as part of value-add strategy, etc) into separate line items under the Capital Expenditure section.

Hope that helped! Happy to answer any follow up questions you may have.

Spencer

[Anonymous]

Hey Spencer, great job on distinguishing between them.

I especially agree with your allocation method of putting all the known costs separated under the capital expense line, and having cap reserves as an estimate of any unforeseen costs down the road.

But say we allocated $50,000 a year towards capital reserves, I am imagining that goes directly in to a savings bank account, and that reserved cash is not really an expense until it is needed for the new elevator replacement?

Let me see if an example would elaborate my confusion: Say we we’ve been allocating $50k a year for 4 years as capital reserve, and in year 5 we need a new elevator. Wouldn’t the cost of the new elevator come directly out of the capital reserve funds, instead of coming out of the Op Cash Flow for year 5 when it’s recorded as a Cap Ex item?

Thanks again Spencer, accounting can be a whirlwind sometimes!

Josh

[Spencer Burton]

Hi Josh,

Before elaborating further, I think it’s important to first distinguish between accounting (i.e. look back) and finance (look forward), and how capital reserves are thought of distinctly in each.

So from a backward looking accounting point of view, all Capital Expenditures are known and itemized; because they actually occurred. The Capital Reserve is not an expenditure in the P&L, because really it’s just a transfer of funds from one account to another. So in your example, from an accounting perspective the $50k per year that was reserved was not a Capital Expenditure in each year but a way to save for the $250k new elevator expenditure that actually occurred in year five. And by the way, the lender probably required that amount to be placed in savings (i.e. lender reserves).

In forward looking analysis like we’re doing here, we don’t necessarily know when capital expenditures will occur. But we need to account for the likelihood that there will be capital expenditures over the hold period. So early in our analysis we’ll hit our income statement with a Capital Reserve amount, either above or below NOI, that will impact returns. Or in other words, we assume some total amount will be spent over the entire hold period but because we don’t know when, we just make a straight-line estimate and we’re done.

Then, as a deal becomes more real, what many firms will do is hire a consultant (i.e. property condition consultant) who will actually forecast what capital expenditures will be needed over the hold period. So for instance, the consultant may predict that the elevator only has five years of life left, the roof has seven years of life, and the building will need to be painted twice over the ten year hold. And maybe the consultant estimates the cost of those capital expenditures will be $1,000,000.

With that information, some firms will adjust the Capital Reserve in their forward looking analysis to reflect the consultants estimate: $1,000,000 ÷ 10 or $100,000 per year. Other firms will then delete the Capital Reserve line all together and manually model the elevator, roof, and paint expenditures in the years that the consultant expects those expenditure to occur. Irrespective of how the timing of the expenditures are modeled, both firms will assume $1,000,000 in capital expenditures over the hold period.

Hope that helps.

Spencer

[Anonymous]

That was a perfect explanation Spencer, cleared the confusion up right away, thanks again for always committing a detailed explanation to all our questions!

Josh

[Spencer Burton]

It was a great question – thanks for it!

Spencer

[Anonymous]

With that said, how have you typically dealt with revenue generated from amortized capital expenditures in an acquisition? Do you keep this income below or above the NOI line?

[Spencer Burton]

Hi Wisdom,

Not sure I fully understand the question. Are you asking, from the perspective of the firm making an acquisition, how to account for in-place rents that are above market due to amortized tenant improvements embedded in their rents?

Spencer

[Anonymous]

Hi Spencer,

What I’m referring to is that there are instances where a property may have just undergone a major capital expenditure program (i.e. to replace a roof, cladding, paving etc.). However, the leases permit the landlord to pass on that cost to the tenants by amortizing it over a 10-20 year period and including that within the tenant’s additional rent. From an acquisitions perspective, given that it is not perpetual income and there is a specified end-date on when that income will no longer be coming in, how would you treat that within your analysis?

[Spencer Burton]

Wisdom,

This is a great question. From a modeling and valuation perspective, there are a couple of ways to handle situations where one or more tenants are in-place at above market rents. Now I should mentioned, why the rent is above market is somewhat unimportant, but you provide a good example of when it might be the case.

How you handle this depends on whether you’re valuing the property using a direct cap or DCF.

Direct Cap.

In the case of a direct cap valuation. What I do is first, in my direct cap pro forma, I mark the tenant’s rent to market. This ensures that I’m not capping the above market rent into perpetuity. Using this adjusted pro forma, I arrive at a direct cap value before accounting for the value of the above market rents.

Next, I calculate the present value of the portion of rent that is above market. This entails modeling how much rent is above market in each period out into the future, and then discounting those cash flows back to the present at some discount rate (e.g. a percent equal to the cap rate). That present value is then added to the direct cap valuation to arrive at an adjusted value.

DCF.

In the case of a 10-year DCF valuation. I would model the rents in-place (i.e. as-is), but then mark the rents to market in the residual pro forma to ensure that I’m not capping the above market rents into perpetuity in the residual value.

If necessary, I may also do a similar present value calculation of any remaining above market rents after the end of the analysis period, and add that amount to the residual value to properly give credit for the additional cash flow.

Thanks again for contributing to this discussion!

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