The four reasons to budget Capital Expenditures for Multifamily
Multifamily real estate investing is a business. You deploy capital into properties, and you reap income.

But not every apartment property is producing as much income as it could be.

For this reason, real estate investors budget **capital expenditure** (“CapEx”) dollars to improve the property, in the hopes of increased income.

&gt;You must spend money to make money — Plautus, 184 BC

I’m not really sure who Plautus is and if he’s the first person to utter the famous “spend money to make money” moniker, but it needs some qualification. It’s really not a surefire thing to spend money to make money in multifamily. Just spending dollars on a property doesn’t guarantee that you’ll be paid back in time via increased operating income. For instance, you can spend money on a new amenity that isn’t valuable to your tenant base, or redesign an apartment in a way that isn’t any more attractive than the old design.

Good investors know that spending money *wisely* helps make money. Knowing what types of upgrades you can deploy into a given property in order to increase the income and, therefore, the value of the property, is how you win on this real life monopoly board. The best CapEx projects have the highest Return on Investment (“ROI”) because they produce more income on less dollars invested.

You can think of a construction project as one large CapEx project. Building a building where one did not yet exist, and successfully producing income from it at a favorable return, is the ultimate CapEx project. At that point, you’ve earned more than the title of multifamily real estate *investor*… you’re now a real estate *developer.*

But you don’t need to become a full-blown real estate developer to understand CapEx. When you own a property that’s already built, there are four plausible reasons to budget capital expenditures:

1. Raise occupancy
2. Raise rents
3. Increase tenant retention
4. Change property use

## CapEx to Increase Occupancy

Vacancy is the very first killer of income that you’ll find on a property’s income statement. When you see vacancy on a property, your next question should be: Why?

After all, someone built that space with the idea that a tenant would pay to occupy it.

While there are many potential reasons for vacancy in a property, several of them hint that CapEx may be required to solve it. Those reasons include:

* Old property — if a property was built a long time ago, it might be time for renovation or rehab in order to attract new tenants.
* Deferred maintenance — a property falling into disrepair is one of the most common reasons for CapEx in order to catch up with necessary repairs.
* Weak amenity offerings — the types of amenities offered for a property’s tenants really varies based on asset type, class, and location. Studying available amenities for competing properties helps determine if something new should be built or offered.

## CapEx to Raise Rents

So you have tenants. Nice. Next question: Are they paying market rents?

Increasing the rent at a property is likely the most common reason a multifamily landlord deploys a capital plan for their property.

But be warned! Raising rents too rapidly can result in a trade-off of lower occupancy. The lower occupancy will be temporary if you are now appealing to a different set of tenants (higher income). The lower occupancy can be permanent (or until you drop rents back down) if there is no demand for your units at the higher rent level! Studying comparable properties and their vacancy rates to your new price point can help determine if there is demand for your units at the new rent level.

## CapEx to Retain Tenants

Let’s be honest, maybe you found a nugget or two above, but increasing occupancy and raising rents were the two reasons that already came to mind in conjunction with CapEx.

Sometimes, CapEx is necessary just to keep the tenants you have. If you have an older property that needs some TLC, or some competing properties are offering tenants better value, pulling out the checkbook to give your property a boost may be in order just to keep the status quo on income.

But did you know that tenant retention is also one of the most powerful ways to improve your property’s income?

An example: You own a 10-unit apartment complex. On average, 3 units turn over each year. You always rent up the vacant units, but it takes 4 weeks on average for a new tenant to move in. That means there are 12 total weeks vacant each year across all 10 units.

What if you could prevent just one of those 3 tenants from leaving your property?

**3 units turn**

Rents Available - $180,000

Vacancy - $4,141

Expenses - $72,000

Net Operating Income - $103,859

Value at 6% Cap - $1,730,976

**2 units turn**

Rents Available - $180,000

Vacancy - $2,761

Expenses - $72,000

Net Operating Income - $105,239

Value at 6% Cap - $1,753,989

***Increased Value: $23,014***

Every tenant “saved” in this scenario boosts the property’s value by roughly $23,000. Is listening to your tenants needs and making some small upgrades to the property worth this gain in retention for your property? It might be worth the peace of mind as well!

## CapEx to reposition the asset

A major rehab or repositioning project is usually going to be a large Capital Expenditure in comparison to the property’s current value. Here it’s important to really underwrite the full cost of the repositioning or renovation to determine if your cost numbers are accurate, especially in this day and age of [surging lumber prices](https://fortune.com/2021/05/19/lumber-shortage-price-spike-futures-decline/).

That said, the right repositioning of a multifamily property can pay major dividends to investors. While no two repositionings are the same, here are some common elements:

* Executing a large scale renovation to update an older property.
* Changing the physical appearance of the property substantially.
* Adding a number of unit upgrades and amenities at the same time.
* Potentially changing the name of an apartment complex to a new brand.

As with the warning above in the section on raising rents, this strategy is absolutely one that changes the tenant base you’re appealing to. Beyond appealing to new tenants, this type of CapEx project may also help appeal to a different class of *buyers* that are interested in investing in the asset where you’ve improved the quality.

The play here is trying to maximize the value of the asset not only by increasing the net operating income, but by improving the multiple at which the building is valued.

## Not mutually exclusive

When enacting a Capital Expenditure plan on a multifamily property, the reality is you are not simply picking one of the above outcomes to the exclusion of others. The same repair or upgrade to a multifamily property may very well lead to higher rents and higher occupancy. A repositioned asset may achieve higher rents, lower vacancy, and higher retention. You can and should model various scenarios for how a CapEx plan will affect the income and value of your property at completion.

None of us have a crystal ball. All of us have a brain. Use your instincts to think creatively about how you can best position your multifamily asset in its given market, model it out, and make the decision that will lead to the highest projected return.
[{"id": "gyu2haq", "text": "Great info, thank you for sharing.", "replies": [], "depth": 1}, {"id": "gyudbr2", "text": "Great post. Thank you.", "replies": [], "depth": 1}, {"id": "gyuhaju", "text": "Agreed. I'd go a bit further and recommend modeling after us in CMBS-land by using NCF instead of NOI for DSCR/DY/income capitalization.", "replies": [{"id": "gywkfi8", "text": "Isn't the point of a DSCR to show how many times over the asset can pay for the debt load based on NOI?  Wouldn't using NCF defeat the point of a DSCR?  I'm just learning about DSCR as a metric as opposed to cap rate, so I'm curious if I'm missing something.", "replies": [{"id": "gywmaa7", "text": "CapEx is still an expense, it's just not an operating expense. People like to keep it separate because it's potentially value-accretive so it's not just operational overhead. Also, to maintain an element of objectivity in comparing different properties since operational expenses are not as affected by operator decisions, they are often just what they are. But as OP pointed out sometimes CapEx is needed just to stay relevant/competitive and you don't usually get back 1-to-1 with your invested CapEx.\n\nLet's talk in practical matters. You are still spending X in real dollars per year in CapEx. You cannot avoid it. While things can be reserves and the actual expenditure is lumpy, long-term that will be actual cash flow leaving your pocket and no longer available to service your debt. So you want to be absolutely sure that your NCF is still sufficient, with a buffer, to cover the debt service, as that will be what drives your take-home.\n\nAs a specific example, for hotels it is very common to base all your metrics off of NCF as that will take into account FF&amp;E (furniture, fixtures, and equipment) which are essentially mandatory capital items that depreciate. But for whatever reason, people in other property types seem to think CapEx is more optional. This is why I love OP's post, these things are not optional.", "replies": [{"id": "gz0787v", "text": "This is awesome - I have a much better understanding now.  Thank you!", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "gyuhdhw", "text": "Fantastic post u/tmilazzo. Thanks for sharing", "replies": [], "depth": 1}, {"id": "gyv67ep", "text": "Thanks for the write-up! \n\nThe section on CapEx to retain tenants is an excellent explanation for why we see so many projects ramp up CapEx the year or two prior to selling the property. It increase the retention, thus the NOI, thus the price.", "replies": [], "depth": 1}, {"id": "gyvh4i4", "text": "Saved, beautiful, thanks.", "replies": [], "depth": 1}, {"id": "gyvpsck", "text": "How do you compare adding debt for CapEx to using retained earnings?", "replies": [{"id": "gyyo2f1", "text": "It's common for lenders to offer funds like this in a Reserve account. Basically, the borrower does the work on their own dime, and the lender refunds them based upon successful completion of key steps. Protects the lender, and also boosts the borrower's returns.", "replies": [{"id": "gyyxdcy", "text": "I know... my read was you were suggesting bootstrapping all capex and just wanted to see what equity vs. debt % you think is optimal.", "replies": [{"id": "gyz056k", "text": "Mathematically, if the CapEx project has a positive ROI, max debt is almost always \"optimal\", though obviously more risky for both borrower and lender. So maybe what is optimal dependent on risk tolerance and credit constraints.", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "gyw7zr9", "text": "fucken saved.\n\nthanks!", "replies": [], "depth": 1}, {"id": "gywcdgz", "text": "Great post. We are buying a 100+ unit now that has a lot of deferred maintenance because they didn\u2019t budget capex correctly.  The sellers are going to lose money on this deal.  It\u2019s really important that your project is well capitalized and the sponsors have a good business plan to use that capx.", "replies": [{"id": "gywl5ck", "text": "Are you me? Absolutely though, we have a $1.5m capex budget funded by the lender and I know we'll be using all of it.", "replies": [], "depth": 2}], "depth": 1}, {"id": "gywcl9s", "text": "(Claps) Extremely well written, not even in the MF space but appreciate the approach and rigor. Thanks!", "replies": [], "depth": 1}, {"id": "gz6um0j", "text": "Great post thanks. The mentions on vacancy are so important not to be overlooked especially in large multifamily. Lots of \"value-add\" deals are currently stabilized value add, meaning stabilized or near stabilized occupancy, above 85%, but where there might be room to increase rents via a CapEx plan to renovate the interiors and some curb appeal items. The renovations typically happen on lease expirations, but it's possible to \"force\" the situation, by making large rent increase offers or even cash for keys to get people to move out and free up units to renovate.\n\nIt's crucial though, to carefully plan the unit turns and timing in order to make sure occupancy doesn't dip drastically. Pushing too hard to get unit turns done and increasing rents can force the older tenants to vacate because they are worried rents will be rising too high for them under new management. If you have an agency loan or perm debt from a diligent bank, they will have issues if they see your occupancy fall below 80% -- perhaps even try to trigger a lockbox on the property income which can be devastating in terms of maneuverability. It's easy to get into a lockbox situation, but difficult to get out. \n\nWe had a property where we started chunking away at 8-10 units per month because we wanted to exit within 3-5 years. Our occupancy dipped from 92% at purchase to 76% within 6 months -- truly terrifying. Luckily Fannie Mae did not pull the trigger on the DACA agreement -- but we received a few concerned messages before we adjusted and changed the plan to a more moderate 5-6 units a month. Occupancy is now at 95-98% avg.\n\nIn these stabilized value add deals first look to use Agency variable debt with rate caps as a \"synthetic\" type of bridge loan, since Freddie and Fannie allow a 1% exit fee after a 1-year lockout. This affords some flexibility but also forces us to raise renovation capital from investors, which costs on the face 7-8% annually in preferred return. So finding CapEx dollars with a cheaper cost is helpful. Soft pref equity might help and is typically 5-7% current pay against a 10-12% coupon. That is if you can get pref equity since many of the single-check-writer capital providers require a meaningful track record and market experience.\n\nAbove $5m you can find bridge programs in the 450-650+LIBOR range. Many with no min DSCR requirements and the ability to get some interest reserves to cover your a\\*\\* when the occupancy dips below acceptable perm loan thresholds. LTVs are typically a % of the purchase price plus 100% of the renovations or a % of the total costs excluding things like acquisition fees. \n\nWhat I want to mention is that although this can be a great alternative, critical planning is also necessary to make sure your renovations that generate rent premiums are able to roll in faster than you are spending capital on the renovation loan. That means if you spend money from the renovation loan on non-income generating or amenity items like roofs, plumbing or painting or even a refresh on the fitness room, the debt service will rise and may outpace the rising income. \n\nSo again I think it's wise to strategize very carefully on the timing of the CapEx spend when using a bridge loan with a renovation line. You may even think twice on chasing cheaper capital and decide to raise it from investors, paying a bit more to have those dollars available to allocate without risking the property itself.", "replies": [], "depth": 1}]