Today’s greatest real estate investors know it, and it’s about time you did, too: you need to spend money to make money. While it may sound counterintuitive, expenses are necessary for running a successful business, and capital expenditures are no exception. These expenses are nothing if not integral to running and scaling one’s own real estate company. It is safe to assume that those who can budget their costs accordingly stand a better chance of realizing success.
What Are Capital Expenditures?
Capital expenditure is a fancy way of describing the money spent to maintain one’s real estate business. Or, as Investopedia so eloquently put it, capital expenditures represent the “funds used by a company to acquire, upgrade, and maintain physical assets such as property, industrial buildings, or equipment.” More specifically, CapEx is generally used to simultaneously maintain and scale business operations through fixed assets.
An expense is usually only considered a capital expenditure if it is used to improve an existing capital asset or business operations for at least a year. As a result, CapEx is often spread out throughout the asset’s lifespan. Capital expenditures are those “big ticket” items that are sure to need replacement now and then. Roofs, driveways, and appliances are great examples.
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Why Are Capital Expenditures Important?
Capital expenditures are used to keep business operational. The money is often the foundation of future growth and can be directly correlated with future success. However, there are multiple reasons business owners need to familiarize themselves with CapEx, not the least of which include:
Future Implications: Some costs can serve as the foundation of future business operations. The money spent to keep a company in business has long-lasting implications and can determine future success. In other words, capital invested poorly can ruin the prospects of a company, but CapEx spent wisely can increase its potential. Therefore, any CapEx spent without thinking about the long-term ramifications is dangerous. At the very least, shortsightedness can come back to haunt owners.
Finite Decisions: It is important to note that capital expenditures should be viewed as finite decisions. Since capital expenditures are intended to keep the business operating and functional, there’s no reason not to look at them as permanent. The future of a business will depend on capital expenses, so make sure the decisions to spend the money are thought through with the future in mind.
Cost Intensive: Allocating CapEx can cost a lot of money. More often than not, the costs are certainly worthwhile. However, poorly allocated CapEx can be a lot more costly. Reversing a capital expenditure can be devastating, so take the time to make sure you are putting money in the right spot.
Tax Shelter: Many costs may be written off at tax time, using depreciation. The tax money saved by making capital expenditures can often lead to huge savings every year, not the least of which business owners may reinvest in their companies.
What Can Capital Expenditures Tell You?
CapEx represents the money spent on existing and fixed assets to maintain business operations. Perhaps even more importantly, CapEx doesn’t need to be used to simply maintain a business; it can also be used to grow a business. Therefore, CapEx can identify the trajectory of an existing company. A business with a lot of capital expenditures could indicate a lot of growth (provided the CapEx is a wise investment). On the other hand, low business costs may suggest stagnation, or perhaps even limited liquidity.
How To Calculate Capital Expenditures
Knowing how to calculate capital expenditures has less to do with predicting the future, and more to do with making an educated guess. As an investor, it’s your job to know roughly when things will eventually run their course and need replacing. The best way to come up with a capital expenditure budget is to compile a list of each “big ticket” item and its reasonable lifespan. Not only that, but you’ll need to identify where each item is currently at in its usable lifespan. Once you have identified each expenditure, divide its total replacement cost by the number of years it’s reasonable to expect it to last.
A new roof, for example, typically sets homeowners back around $5,000 and lasts about 25 years. To calculate the CapEx, simply divide $5,000 by 25 (the expected lifespan of a roof). That means, on average, you can expect to pay $200 a year in capital expenditures on the roof alone. Now, take the same approach and apply it to every major maintenance item you expect to encounter. What you’ll end up with is the average amount you can expect to spend each year. If you so choose, you may also break them down into months, which most people are more comfortable doing.
Differentiating Between Capital Expenditures & Regular Maintenance
CapEx is reserved for fixed assets, not the least of which is expected to be productive for the duration of their usable life. Capital expenditures are long-term expenses specifically designed to help scale a company in one way or another. Regular maintenance, on the other hand, represents more of a short-term cost. Otherwise known as revenue costs, regular maintenance refers to costs related to revenue transactions or operating periods. More specifically, the differences between the two can be broken down by the following:
Timing: Capital expenditures are usually accounted for gradually via depreciation over extended periods of time. Regular maintenance, however, is usually deducted immediately, or at least shortly after the cost is incurred.
Consumption The cost of a capital expenditure is usually realized over the useful life of the cost in question, whereas regular maintenance will see the cost consumed in a shorter window.
Size: Capital expenditures tend to represent larger sums of money than their maintenance counterparts. For a cost to be considered a capital expenditure, it needs to exceed a certain number.
Capital expenditures represent some of the largest expenses associated with an investment property. Having said that, they are nothing, if not necessary. It is true what they say: you need to spend money to make money, and capital expenditures are no exception. There’s no way around them, so you may as well budget for them. Those that cannot only account for said expenses but also budget for them accordingly, will find running a successful real estate business to be easier
CapEx is usually accounted for gradually via depreciation over extended periods of time.
What are capital expenditures, if not for the necessary cost of running a successful real estate business?
Understanding how to find the CapEx will come with time and experience.
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