Repairs & Maintenance: Past, Present and Future
Updated: Jun 10, 2019
Real estate is a depreciable asset. Things will break, wear-out or become obsolete over time. That’s to be expected. Knowing this will happen is important. Knowing how to account for it when underwriting is critical.
There are three types of repairs you need to be aware of when assessing a new investment property. There’s the past work that should have been done by the current owner. There’s the current work that needs to be done on an ongoing basis for any property. And there’s the future work that will eventually need to be done down the road. The better you understand how these impact you, the better you’ll be able to make an informed decision on whether to move forward with your offer.
Unless you’re buying a newly-build Class A complex, there’s most likely going to be deferred maintenance at the property. Hopefully, these are minor repairs and they can be handled by the seller prior to closing or easily worked into your budget. However, there are plenty of properties that are marketed for sale with MAJOR deferred maintenance needs. This is especially true in a “hot” seller’s market.
A seller may want to hit the market quickly or they may decide that there will be plenty of buyers that will overlook or accept meaningful issues to get their hands on the coveted asset. This isn’t necessarily untrue in today’s market but it doesn’t mean you don’t need to account for it in your offer.
If you’re buying a 15-unit property with $105,000 NOI at a 7.00%, your basis will be $1.50MM. If you later determine there’s $10,000/unit in deferred maintenance, your basis just went up to $1.65MM. As the NOI hasn’t changed, your yield just dropped to 6.36%. You would have been wise to offer $1.35MM and factor this into your basis if you had hoped to net a 7.00% return.
To protect yourself, you need to hire a credible property inspector during your diligence period. You may have submitted an “as is” contract, but that doesn’t mean you can’t walk away if the seller won’t acknowledge these issues. You’re better off losing a bad deal than going in blind and missing your targets day one.
The second form of repairs is what we all think about when we consider maintenance of our properties. This is the standard, everyday wear & tear you expect when owning any asset. Tenants will use the facilities, wear down the carpets and scuff the paint. Appliances will go bad. Trees will die. This is a regular cost of ownership and is always factored into a P&L.
A standard number you may see is around 5% of revenue or $500/unit (I would encourage a dollar estimate over percent of revenue, however, as the price of good and services doesn’t change with rent adjustments). These are fine starting spots for your initial review but be sure to dig in during diligence. The age, quality, location, target tenants, etc will all affect your ongoing repair budget. Having a solid property manager on your team is a great way to determine a realistic expense assumption. Take a look at the property’s past expenses. This should give you an idea.
Just be cautious of “reclassified” expenses.
It’s always interesting to see how some standard, recurring repair items seem to get called “capital expenses” and brought below the NOI when it comes time to value a property.
At this point, you’ve accounted for the work that was previously deferred and you’ve calculated your ongoing expenses for operating and repairing your property. But hold up. You’re not done quite yet. You may have figured out the cost of that light bulb and a can of paint or two but have you looked around your property? You’ve got bigger items to consider.
As we stated up front, your new multifamily property will depreciate over time. The biggest, most troublesome items aren’t funded annually but when they come up, they come up hard and fast. A roof may last 15-25 years, depending on the type, but they could cost +/-$10,000 per building when they’re ready to replace. Your parking lot may last a decade between substantial repaving but that will also be a big-ticket item. Exterior painting, major HVAC and other mechanical repairs, amenity replacement, etc will all take a lot of capital when the time comes.
Unless you’re flush with capital to burn, these major expenses need to be funded elsewhere.
NO ONE wants to issue a capital call to investors for a roof.
And when a roof is ready to be replaced, you’ll know it and you won’t have time to hold back distributions to fund it down the road. Therefore, you are best served by implementing an ongoing reserve to account for these items when they arise.
A standard reserve you may see is $250/unit/year. Unless some of these items are getting close to the end of their useful life, this is probably a decent reserve to assume. This reserve should be funded BELOW the NOI so it doesn’t affect your calculations and valuations. However, it’s important to factor it in during underwriting because it does affect your distributable cash flow to yourself and any investors you may have. If you’re proposing an 8% cash-on-cash return to investors and you end up passing along a 6% to hold back reserves, you’ll have some unhappy partners.
One more point on this reserve. You may see a reserve in an Offering Memorandum’s financials (sometimes) but, at least half the time, it’s classified as a “Turnover Reserve” for tenants moving out. Tenant’s moving out is a recurring part of business. There is no reserve for this. Approximately 50% of your tenants will leave each year. If you need a reserve for this, you’re not understanding what a reserve is. These vacancy, turnover, make-ready costs are simply standard repairs and maintenance. They should be in the R&M line item or listed separately in the expense portion of the P&L. If you see this, leave the number in your calculation but then add the ADDITIONAL $250/unit/year as well. Don’t let the reserve label trick you into missing cashflow and impacting your future returns.
You’re going to have to repair your property. It will protect your collateral, provide a better living situation to your tenants and help retain the asset’s value for an eventual sale. All repairs, past, present and future, are manageable if you just understand them and how to account for their inevitability in your underwriting. Get a good property inspector while diligencing the asset, a solid property manager while owning the asset and a fully-funded reserve while protecting the asset from future concerns. Do that, and you’ll be ready for anything and properly covering your ass.
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Next week: Putting it all today…How my adjusted NOI determines my value