Several years ago, an acquaintance purchased an apartment complex near the downtown area. It was built 20 years earlier at a time when it was the place to be for renters who worked downtown. He was a successful medical professional, and the apartment complex was his first investment. He remarked that he got a good deal, which was important to him because a wise investor had told him that, “You make money when you buy real estate, not when you sell it.” Five years later he told his wise investor that he would be, “happy to get back what I paid for it.” What happened?
In his case, the numbers looked good. Net operating income was positive, the property was in a good location because people were beginning to move back downtown, and the occupancy rate was almost 100 percent. What he did not take into consideration was replacement reserves.
Income-producing real estate can be a great investment for many people. Successful investors research the market and the property. One of the property items that doesn’t get enough respect is replacement reserves. Perhaps it’s because it’s viewed as an expense that doesn’t get paid until a future date. In this column, we will discuss replacement reserves and some non-real estate expenses that get put off, sometimes with disastrous results.
Replacement reserves are funds set aside to pay for large future maintenance items, such roof replacement, air-conditioning systems, parking lot repaving, etc. Replacement reserves are sometimes, even often, not shown on Net Operating Income (NOI) statements because they are viewed as not being operating expenses. They are shown on Cash Flow Statements. The point is that a prospective real estate investor should not rely solely on the NOI statement to estimate the cash expenses of the property over a long period of time.
There are two common ways to estimate the amount for replacement reserves. The first is to estimate the remaining useful life of the item, and then estimate the cost to replace the item. For example, if an air-conditioning unit would probably last seven more years, and cost $9,000 to replace, then the number would be $1,285. Setting aside $1,285 per year means that there would be cash available to pay for a new air-conditioner, assuming no inflation cost. Likewise, a roof that has a remaining useful life of 20 years would meaning setting aside appropriate cash each year to pay for a new roof. The second way to estimate future amounts is to simply come up with a percentage of revenue as the expense. Ten percent is an example.
Back to my investor acquaintance, he failed to take into consideration that because of the age of the property, many expenses for large items such as those mentioned above were about to become due. Those items required real money, not accounting entries.
Speaking of setting aside funds, it seems that it is uncommon for most businesses, government agencies and even individuals to do so. The latest headlines offer some prime examples.
The California wildfires have exposed Pacific Gas & Electric’s failure to maintain its system properly and to fail to set aside funds for replacing power lines and equipment. According to The Wall Street Journal, the utility company’s equipment led to more than 1,500 fires from June 2014 to December 2017. Well-run utility companies have transmission line replacement programs. They replace a portion of their lines each year as they age.
Government agencies at all levels have issues with failing to set aside money to replace large items when they wear out or are no longer useful. The capital city’s infrastructure woes are blamed on previous city administrations’ failure to maintain systems and set aside funds for replacement. Take a look at any municipality budget and examine what is found in a Capital Improvement Plan or capital improvements. Of course, the ultimate set-aside fund is the Social Security Trust Fund. Let’s save that for a future column.
Many businesses also fail to take replacement reserves into consideration. Today’s profits and expenses are more important than tomorrow’s roof replacement.
Replacements reserves is a term most often applied to real estate, but it really applies to everyone, every organization and every business. It’s a necessary expense that doesn’t have to be paid at the current time. It’s sneaky. Consequently, it gets little respect as a real expense. But as the old Fram oil filter commercials pointed out, “You can pay me now, or pay me later.”
» PHIL HARDWICK is a regular Mississippi Business Journal columnist. His email address is email@example.com.
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