What are Capital Replacement Reserves?
Part of the calculation lenders use in analyzing expenses are termed Capital Replacement Reserves or just CapX (the term commonly used in the industry). These are expenses not typically seen on an annual or even longer basis. These are typically the larger ticket expenses such as roof replacement, siding replacement, complete exterior painting, resurfacing of parking lots, etc. Think of CapX items as longer term and higher cost projects. These sometimes get lost in the mix as buyers review property financial statements. However, they are a critical piece of the expense puzzle.
For any property, the items mentioned above and many more will need to be dealt with over time. To that end, owners should always maintain some allowance for them by retaining some of the annual profits to cover these costs when they arise. Many homeowners associations – as an example – do annual reports in which they look very specifically at those replacement reserves and when they will be needed as they determine how much of the monthly dues need to be allocated to these items.
While many owners purchase properties without giving it much thought, lenders and appraisers do give it considerable weight. While the amounts used are typically fairly low and depend greatly on the overall age and condition of the property, accounting for those costs can make the difference in being able to meet the financing needs of the client or not. These costs are typically in the $200-300/unit per year range. As a buyer, if you don’t see this as a line item, beware! The lender and appraiser will insert that as a line item cost.
On the flip side, if you review a property’s financial statements as a buyer and see high CapX expenses, do not worry about the lender and/or appraiser seeing that as a negative! First, it demonstrates a seller’s commitment to properly maintaining the property. Second, lenders and appraisers typically just use market standards (in the range mentioned above) and do not let potentially high historical costs negatively impact the expenses – and by extension the cash flow needed for the financing.
All of that said, it’s a good habit for buyers and owners to look for these expenses and even more importantly not to avoid them when they come up. Normal capital repairs done when needed tend to prevent those replacements from become exorbitant expenses down the line.
