By Fred Matera, CIO, Redwood Trust A lack of affordability will lead to near-term weakness,…
Residential real estate investors don’t often like to talk about maintenance or CapEx. Why would they? It’s not glamorous, and it’s sure not fun to think about ongoing expenditures when looking at investment properties. But if you are serious about analyzing a deal and building a cash-flowing portfolio of rental properties, this is one of the most important and most commonly overlooked aspects of being a landlord. It’s true – nothing lasts forever, and that definitely applies to real estate structures. Make sure to plan and budget for repairs now, maintenance later and be prepared for the unexpected!
As with anything, there is no right or wrong way to budget. My hope is that after reading this, you can have a better sense of why you need to budget, what you need to budget for, and a starting point for researching and determining what makes sense for your specific situation. It could be the difference between making or losing money (and time) on your investment!
How To Budget for Maintenance
To most landlords and investors, maintenance (or OpEx) is pretty self-explanatory – it is the routine upkeep that is part of any rental property, and something essential to keeping your tenants happy. Things like painting, inspections, property damage, pest control, or any other miscellaneous expenses for the property typically falls into this bucket. But, what investors typically struggle with is not what it entails. Rather, they often have a hard time budgeting and managing expectations for maintenance. Luckily, there are some general rules of thumb that many investors use when budgeting for these expenses.
The good folks over at Real Property Management have compiled a few for investors:
50% Rule: Total operating costs (repairs, maintenance, taxes, insurance) could equal half of your rental property income. So, if your property rents for $1,200/mo., you may expect to spend up to $600 on keeping the property up and running.
1% Rule: Maintenance should cost at least one percent of the property value per year. So a property valued at $190,000 might cost $1,900 a year to maintain (or $160 a month).
Square Footage Formula: Plan on spending a minimum of $1 per square foot for yearly maintenance costs. So, a 2,200-sq.ft. rental could cost roughly $2,200 a year to maintain.
5X Rule: Annual maintenance costs will average 1.5 times the monthly rental rate. So, if your home rents for $1,200, then you should anticipate spending approximately $1,800 a year in repairs.
As with any general rule, it’s important to understand that these are all estimates; no two properties are the same. The most important take-away from this is that maintenance costs are real, inevitable and could be a sizable piece of the pie. Develop a budget, stick to it, and don’t dip into the funds. Maintenance costs fluctuate drastically from month to month and can be affected by seasonality so it is important to keep a reserve account for these funds. Sooner or later, something will go wrong and you’ll be glad you were prepared.
What is CapEx?
CapEx is the funds used to upgrade or repair the property. When we think of CapEx, we usually think about the “big-ticket” items that will eventually be needed to be repaired or replaced.
Common CapEx items include the following (among others):
- Water Heater
How to Budget for CapEx
While budgeting for CapEx typically requires a little more work upfront, it is actually easier to prepare for because it does not typically involve fluctuating or unexpected expenses.
Managing CapEx can much more focused and precise for these reasons:
- We know that each of these items will need to be replaced at one point or another
- We know the average lifespan of each of these items
- We know the costs to replacing these items
Once we consider these factors, the budgeting process becomes quite simple. It first starts with homework. Research the average life of roofing in your area and figure out how much it will cost to replace it. Estimate how long your appliances will last for and consider how much you plan to spend to replace them.
Talk to neighbors and investors in your neighborhood and see how much things have cost them in the past. Take notes, sit down, and create a budget. Divide the total costs by the estimated life of each of these CapEx items, and add to these reserves the set amount monthly. Don’t be afraid to be generous with your estimates; things often seem to cost a little more than anticipated.
Research and Follow Through
In summary, no matter how you budget for maintenance and CapEx, the important part is that you do your research and make sure to follow through. While there are countless ideas on what is best, and helpful rules of thumb, no two properties are the same and few things ever happen exactly as you have planned. If you already own similar properties in an area, it might be easier to estimate what you should be budgeting by looking at the history of your existing properties. However, if you are new to the area or new to investing, it is important to take your time and do your diligence.
Factors such as the existing condition of the property, the value of the property, age, type of property, neighborhood, and weather conditions all contribute to how each investment will incur varying amount of expenses over the course of its use. Still, there is no right or wrong way to budget. The only incorrect way to budget is to NOT budget at all or to not consider items fully and seriously under budget.
CoreVest is a leading provider of financing solutions to residential real estate investors. We provide attractive long-term debt products for stabilized rental portfolios as well as credit lines for new acquisitions.