Repairs and maintenance expenses are part and parcel of the routine operation of the property and involve amounts that are significantly smaller than those typically funded through reserves. Landscaping, painting, patching pavement, etc. are examples of repair and maintenance items. Replacing a roof or HVAC unit would be classified as a capital expense. Another good rule of thumb is, that items funded out of a capital account can be depreciated and are included when calculating the owners’ basis.
Capital Reserve accounts are typically funded monthly and are calculated as a percentage of gross income. A capital reserve balance is normally shown “below the line”, or after the NOI has been established. As such, these amounts do not negatively impact the value of the asset when appraising using the Income Method.
Funding a capital reserve account serves three important functions:
- Helps prevent major disruptions to the property’s income stream. Failure to make improvements frequently results in reductions to rental income due to increased vacancies, and/or tenants withholding payment due to interruption of their operations.
- Making replacements and improvements proactively can prevent other collateral damage that may be caused due to deferred maintenance. For example, replacing a roof is expensive, however, a large roof leak may result in the need to replace the roof and repair drywall and mold remediation.
- Well-maintained properties sell more quickly and at higher prices than ones that reflect significant deferred maintenance.
Murphy’s law says “Anything that can go wrong will go wrong, and at the worst possible time”. During heavy rains roofers are busy, during heatwaves HVAC contractors are swamped, and during cold snaps, plumbers are busy fixing burst pipes. If a property owner has an issue during these types of events, finding a qualified responder may be extremely difficult and expensive. Having a capital reserve means landlords will have a substantial portion, or all of the funds necessary to keep their property in good condition and make repairs at the most convenient and economical time, thereby optimizing their return on investment.
Funds allocated to a reserve account qualify as Common Area Improvements. Amounts reserved can be included in the CAM charges. By reserving these funds landlords are doing themselves and their tenants a favor. Large increases in CAM charges can be a shock for tenants, and in some cases, may result in a good tenant having to vacate in order to stay viable.
Rent receipts are not profit, they are revenue. Savvy property owners understand the costs associated with holding and operating their portfolios and plan for these eventualities. Establishing a realistic budget that includes reserves for capital improvements helps landlords live “within their means” and helps them avoid capital calls and/or the need to originate additional debt in order to properly maintain their real property investments. Some lenders require capital reserve accounts as well. Virtually all real estate funds and trusts reserve monies for capital improvements
We at illi encourage you to consider reserving a portion of your properties’ income to fund inevitable large capital improvement needs. Please consult your CPA or legal advisor. Should you determine it is time to establish a reserve account, our property management and accounting staff will be happy to review your portfolio’s historical income and expenses. Together we can design and implement a program that optimizes the performance and value of your holdings while helping to reduce ownership stress and provide reliable and predictable monthly distributions.
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