All About Cap Ex
In this post, we are going to take a deeper look into capital expenditures. What it is and how we account for it in cre underwriting.
Capital expenditures, commonly referred to as Cap Ex, are expenses that occur outside of normal operating expenses. They are items that ownership either needs to or decides to pay for that are not a part of the normal annual budget. Items such as a major renovation or major repairs that will usually improve the quality of the asset and may occur once every few years or less. Some examples of capital improvements are as follows:
- Tenant Improvements
- Roof Repair
- Lobby Renovation
- HVAC upgrade
- Lighting upgrade
- Parking lot repaving
- Elevator renovations
- FF&E Upgrades
- Leasing Commissions
Roof Repair: a common capital expenditure
How to Model For Cap Ex
Since these are uncommon and nonrecurring expenses, the normal convention is to model them separately from the annual operating expenses and below the Net Operating Income (“NOI”) line. In a typical proforma you will see the cap ex appear in the following order:
- Revenue
- Less: Operating Expenses
- Equals: Net Operating Income
- Less: Cap Ex
- Equals: Cash Flow From Operations
As a result of modeling this way, cap ex is not considered when deriving a purchase price based on a cap rate (NOI/Cap Rate = Value). Does this pose a problem for potential investors if they are excluding potentially significant expenses from their formula to derive a purchase price?
Not really. As long as the investor is taking a holistic approach to the valuation and is including the capital expenditures when looking at return metrics such as the IRR and Equity Multiple, then the investor should be clear eyed about the opportunity. If there is a significant amount of cap ex needed that reduces returns, then an investor can adjust their going in cap rate up (higher cap rate equals lower purchase price) accordingly in order to meet their return objectives.
Capital Reserves
One nuance to underwriting cap ex is capital reserves. It is common practice to include an annual capital reserve allocation that will be funds set aside from the operating cash flow for future capital improvements. Does a known and reoccurring capital reserve amount that is budgeted for and being deducted from the asset’s cash flow become a part of the op ex?
It depends on the asset. When underwriting multifamily and hotel opportunities, the common convention is to model for capital reserves above NOI due to short term leases and smaller spaces that potentially result in more frequent, unit specific, capital improvements such as new flooring or a stove for example. Also, for this same reason, leasing commissions and tenant improvements, two common capital expenditures in every other asset class, are considered operating expenses.
For office, retail, and industrial, capital reserves are usually modeled below the NOI.
Tax Treatment
As a result of any capital improvement project having a life cycle of longer than a year, capital expenses usually cannot be expensed entirely in one year and will have to be depreciated over time. Depending on the capital improvement, the depreciable life will vary. For more on how capital improvements are depreciated, please check out my post on Depreciation.
Frequently Asked Questions about Capital Expenditures (Cap Ex) in Commercial Real Estate
What is Cap Ex in commercial real estate?
Cap Ex (capital expenditures) are expenses that occur outside of normal operating expenses. These include major repairs or improvements that enhance the quality or value of the asset, such as roof repairs, HVAC upgrades, lobby renovations, or tenant improvements.
How is Cap Ex treated in a real estate pro forma?
Cap Ex is typically modeled below the Net Operating Income (NOI) line in a real estate pro forma. The standard flow is:
Revenue → Less Operating Expenses → Equals NOI → Less Cap Ex → Equals Cash Flow from Operations.
Does Cap Ex affect the valuation when using a cap rate?
No. Since Cap Ex is modeled below NOI, it is not directly considered in cap rate-based valuations (NOI / Cap Rate = Value). However, investors typically account for Cap Ex in IRR and Equity Multiple calculations to ensure they meet return objectives.
What are capital reserves and how are they treated?
Capital reserves are funds set aside annually from operating cash flow for future capital improvements. Treatment varies by asset class: in multifamily and hotels, reserves are often modeled above NOI, while in office, retail, and industrial, they are usually modeled below NOI.
Are leasing commissions and tenant improvements considered Cap Ex or Op Ex?
It depends on the asset class. For multifamily and hotels, they are typically treated as operating expenses. For office, retail, and industrial assets, they are considered capital expenditures.
How is Cap Ex treated for tax purposes?
Cap Ex generally cannot be expensed in a single year since these projects have a multi-year lifecycle. Instead, they must be depreciated over time based on their asset type and applicable IRS guidelines.
Why is it important to account for Cap Ex when underwriting deals?
Ignoring Cap Ex can distort cash flow and return projections. By including Cap Ex in IRR and equity multiple calculations, investors get a more accurate picture of the investment’s performance and can adjust pricing accordingly.
Can Cap Ex significantly affect investor returns?
Yes. Significant capital expenditures can reduce cash flow and lower investment returns. Investors often adjust the acquisition cap rate to reflect anticipated Cap Ex and maintain target returns.
