October 5, 2016
Joe Fairless

How to Never Go Into a Real Estate Deal Undercapitalized

Mark Walker is a single family and multifamily investor that built a multi-million dollar portfolio in less than four years. He had an amazing first year, acquiring 22 properties with an average cash-on-cash return of greater than 20%. In our recent conversation, he explained how he was able to achieve such high returns by being laser focused on his capital expenditures.

Mark says that can invest capital expenditures in two different things:

CapEx #1: Things that are going to increase rent or decrease expense (both expected and unexpected)

CapEx #2: Things that are required but don’t directly affect your bottom line (again, both expected and unexpected

CapEx #1 Example

Mark is in the process of completing renovations on a 64-unit apartment building in Denver, CO. His plan was to spend $5,000 per unit ($3500 on the interior and $1500 on the exterior) for a total of $320,000 on rehabs. As a result, he expected to increase the rent from $0.91 per sqft to $1.00 per sqft by the end of the first year. However, things went much better than expected! Prior to reaching the one-year mark, he was able to increase the rents to $1.03 per sqft.

His initial plan was to only renovate half the units, but after seeing the large jump in rent, he reevaluated. As a result, he decided to use the left over capex budget, as well as some personal capital, to rehab the remaining units. If everything goes smoothly, he will see the average rent increase to $1.12 per sqft.

The number one improvement that resulted in the ROI jump was upgrading the appliances. When he purchased the property, all the appliances were over 20 years old. After spending $1000 on upgrading to new stainless steel appliances for each unit, he was able to increase the rents by $50. That is an ROI of less than 2 years.

CapEx #2 Example

An example of this type of capex expense is deferred maintenance. When Mark planned for these issues, he went in with the understanding that he wasn’t going to see as strong of an ROI. However, it is something that he had to spend money on because if ignored, it will eat away at his rent increases that came from the CapEx #1 investment.

For unexpected capex repairs, it depends on the situation. Sometimes, everything goes according to plan. However, for Mark’s 64-unit apartment building, this wasn’t the case. When the city came in to perform their inspections, they told Mark that he needed to re-plaster the pool. It started out as an unexpected $6000 investment, but once he “peeled back the onion,” it turned into a $15,000 item.

The lesson that Mark learned from the unexpected pool expense was that you always have to worry about the city. When the city comes to do their inspections, they are almost always going to find something new. They can and will force you to spend the money to immediately correct the issue. Therefore, proper planning is a must in order to mitigate your risk!

It is really these unexpected CapEx #2 investments that you have to look out for. No matter how good your due diligence, you are going to discover something that you didn’t know about. Or something will break during the rehab process. You must be ready for those things. If not, you are taking a much greater risk, but more importantly, you are cutting off the properties maximum potential.

Never Go Into a Deal Undercapitalized

Mark’s best ever advice is to never go into a deal undercapitalized. The pool example is one of the reasons why. That $15,000 was paid out-of-pocket. Fortunately, he didn’t stress out about it because he budgeted for the unexpected. However, he has seen countless people go into deals undercapitalized. When they get hit with a big-ticket item, like a pool, it sets them back big time.

Two tips that Mark provided on how to ensure that you are going into a deal with the proper capex budget are the following:

  • When you are doing your due diligence, determine what the capex investment needs to look like in order to realize your return. You must do this for both types of capex investments, but especially for the unexpected items. As an example, Mark didn’t blindly decide to spend $1000 on appliances without determining the ROI he would see.
  • If you are able to find a loan that gives you loan to cost (i.e. capex are rolled into the loan), then you can plan for both of those, build them into your capex budget, and the bank will allow you to make those investments with your loan. Essentially, you are paying 20 cents on the dollar for repairs. In doing so, the extra 80 cents saved will mitigate the damage if you happen to be hit with a big ticket item.

Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.

Share this: