The Smart Apartment Investor’s Guide To Capital Plans

67 Pages·2004·0.42 MB·English

by  Mike Scott

The Smart Apartment Investor’s Guide To Capital Plans

The Smart Apartment
Investor’s Guide To
Capital Plans
Avoid Common Apartment Investment
Mistakes With A Replacement Reserve
Plan Tailored To Your Investment Strategy.
The Smart Apartment Investor’s Guide To Capital Plans

© Copyright 2004 by Dupre + Scott Apartment Advisors, Inc.

All rights reserved.

No part of this book or associated spreadsheet model may be reproduced, in any form or by any means,
without permission in writing from the publisher.

Published by Dupre + Scott Apartment Advisors, Inc.
4300 SW Holly Street, Seattle, WA 98136-1711

Phone [phone]; fax [phone]; email [email protected]; web www.dsaa.com

Other publications by Dupre+Scott:

• The Apartment Advisor newsletter
• The Apartment Investment Report
• The Apartment Expense Report
• The Apartment Development Report
• The Apartment Vacancy Report
• The 1-19 Unit Apartment Report
• The Apartment Salary Report
• Controlling Apartment Expenses

This publication is sold with the understanding that the publisher is not engaged in rendering legal, tax, investment, accounting, property
management, insurance, or any other professional advice of any type through this publication. No statement in this publication is to be
construed as a recommendation or as investment or other advice.
The Smart Apartment Investor’s Guide To Capital Plans i
ACKNOWLEDGMENTS

We would like to thank everyone who helped us directly and indirectly with this book. Over the years, John
Reed, editor of Real Estate Investor’s Monthly and other real estate publications and books, has helped us
develop a questioning attitude about real estate. He also helped with our writing style and encouraged us to
share our views through writing.
Others have offered important encouragement along the way as well, including Alvin Arnold, editor of The
Mortgage and Real Estate Executives Report; Dr. Anthony Downs, Senior Fellow at the Brookings Institution;
Dr. George Sternlieb, Director of the Center for Urban Policy Research at Rutgers University; and in memory of
Dr. James Graascamp and Dr. Richard Ratcliff, two pioneers in real estate research who gave us tremendous
support and counsel when we began researching the apartment investment market 25 years ago.
ii The Smart Apartment Investor’s Guide To Capital Plans

TABLE OF CONTENTS

ACKNOWLEDGMENTS..............................................................................................................................i

TABLE OF CONTENTS..............................................................................................................................ii

ABOUT THE AUTHOR...............................................................................................................................v

WHY WE WROTE THIS BOOK................................................................................................................vi
Our response.............................................................................................................................................vi

MYTH VERSUS REALITY.........................................................................................................................7
It’s not enough...........................................................................................................................................7
Reality.......................................................................................................................................................7
Says who?..................................................................................................................................................7
Real numbers.............................................................................................................................................7
Chart of accounts.......................................................................................................................................8
So what if it’s Seattle................................................................................................................................8
It’s not just us............................................................................................................................................8

WHY SO LOW?.........................................................................................................................................10
Passing the buck......................................................................................................................................10
Buyers pick up the tab.............................................................................................................................10
Rational or rationalizing?........................................................................................................................10

MODELING STRATEGY..........................................................................................................................11
Your strategy matters..............................................................................................................................11
Spreadsheet model..................................................................................................................................11
It’s more than a life-cycle.......................................................................................................................11
Modeling strategy and scenarios.............................................................................................................11
I already have a replacement reserve model...........................................................................................11

ACTUAL CAPITAL EXPENSE TRENDS................................................................................................13
Actual capital expenses...........................................................................................................................13

PROPERTY FACTORS IMPACT CAPITAL COSTS..............................................................................14
Property size............................................................................................................................................14
Unit size..................................................................................................................................................14
Property age............................................................................................................................................15
Slowly sliding downhill..........................................................................................................................16
Buyers step in..........................................................................................................................................16
Neighborhood..........................................................................................................................................16
More is more...........................................................................................................................................16

INDIVIDUAL PROPERTY PERFORMANCE.........................................................................................18
Case studies from our files......................................................................................................................18
Reflecting real-world variety..................................................................................................................19
Case study property list...........................................................................................................................19
The Smart Apartment Investor’s Guide To Capital Plans iii
THE PERILS OF THINKING IN NOMINAL DOLLARS........................................................................20
Inflation...................................................................................................................................................20
Rents look different adjusted for inflation..............................................................................................20
Market trends distort property trends......................................................................................................21
Rents today lower than in 1969...............................................................................................................21
Inflation adjustment table........................................................................................................................21
Customize for your market area..............................................................................................................21

COMPETING STRATEGIES....................................................................................................................22
More than apartments..............................................................................................................................22
Impact on yield........................................................................................................................................22
Real numbers...........................................................................................................................................23
Skinny & skinnier...................................................................................................................................23
Is it sample error?....................................................................................................................................24
Overestimating returns............................................................................................................................24
Do you really set aside a reserve fund?...................................................................................................24
Set yourself free......................................................................................................................................24

CUSTOMIZE YOUR OWN RESERVE....................................................................................................25
Reserve Estimator model........................................................................................................................25
Sale loaded..............................................................................................................................................25
Everything that goes around…................................................................................................................25
Timing troubles.......................................................................................................................................25
Calculating replacement reserves............................................................................................................26
What counts?...........................................................................................................................................26
Replacement reserve components...........................................................................................................26
Is this list complete?................................................................................................................................27
Prioritize..................................................................................................................................................27
Take a hard look......................................................................................................................................27
Long range planning versus annual budget.............................................................................................27
Inspect.....................................................................................................................................................27
What’s your plan.....................................................................................................................................28
Put it in the bank?....................................................................................................................................28
Sensitivity analysis..................................................................................................................................28
Bottom line..............................................................................................................................................28
The investment market versus reality......................................................................................................28
Go with the flow – sort of.......................................................................................................................29
Market prices versus value to you...........................................................................................................29
This is not a static analysis......................................................................................................................29

LENDERS AND RESERVES....................................................................................................................30
A lender’s example.................................................................................................................................30
How did they do?....................................................................................................................................30
Oops – we ran of out cash.......................................................................................................................31
One year at a time...................................................................................................................................31
Another lender’s analysis........................................................................................................................32
Why the difference?................................................................................................................................32

CASE STUDIES.........................................................................................................................................33
Some lives more predictable than others.................................................................................................34
Case study #1..........................................................................................................................................35
Capital costs for newer construction.......................................................................................................36
Keep inflation in perspective...................................................................................................................37
iv The Smart Apartment Investor’s Guide To Capital Plans

Case study #2..........................................................................................................................................38
Case study #3:.........................................................................................................................................39
Case study #4..........................................................................................................................................40
Case study #5..........................................................................................................................................41

USING THE RESERVE ESTIMATOR WORKBOOK.............................................................................42
Workbook contents.................................................................................................................................42
Make a template......................................................................................................................................43
Getting started.........................................................................................................................................43
Components.............................................................................................................................................44
Changing components.............................................................................................................................45
Changing lives.........................................................................................................................................45
Adjust for condition................................................................................................................................45
Test the model.........................................................................................................................................46
Design scenarios to fit your strategy.......................................................................................................46

RESERVE MODEL FIELD DESCRIPTIONS..........................................................................................48

PRINTED REPORTS.................................................................................................................................50

CONTROLLING CAPITAL EXPENSES..................................................................................................52
Participant comments..............................................................................................................................52
Additional participant comments............................................................................................................55

APPENDIX A: RESOURCES....................................................................................................................58

APPENDIX B: PANEL OF EXPERTS......................................................................................................59

APPENDIX C: CHART OF ACCOUNTS.................................................................................................60
INCOME.................................................................................................................................................60
EXPENSES.............................................................................................................................................60

FEEDBACK................................................................................................................................................62

PARTICIPATE...........................................................................................................................................63

INDEX........................................................................................................................................................64
The Smart Apartment Investor’s Guide To Capital Plans v
ABOUT THE AUTHOR

Patty Dupré and Mike Scott have worked together for 25 years. They spend most of their time on apartment
research in the Seattle market. They publish the results of their work in a number of reports for clients. Patty and
Mike also write a newsletter to help clients interpret trends; they advise clients on investment and market issues;
and they are apartment investors.
vi The Smart Apartment Investor’s Guide To Capital Plans

WHY WE WROTE THIS BOOK

Our years in real estate have taught us some things. This book is about one of them: Investors don’t pay
attention to replacement reserves. When they do, they don’t develop the right plan. Investment goals should
drive the plan. Yet goals seem to get lost in the shuffle most of the time. That results in mistaken analyses.
Those mistakes lead to erroneous assumptions about returns. In other words, bad plans lead to bad decisions.
Our response
First, we talked to clients about reserves. Then we wrote articles. Then we made a simple Reserve Estimator
model. It became part of our Apartment Expense Report. This book brings all that work together. It gives us the
room we need to tell the whole story. It gives you the tools you need to walk away with a solid plan: a plan
based on your investment goals.

Sincerely,
Patty Dupré + Mike Scott
The Smart Apartment Investor’s Guide To Capital Plans 7
MYTH VERSUS REALITY

It’s not enough
Buildings wear out. Investors know that’s true. So they budget for it, setting up a reserve to take care of
future capital costs. For most, this replacement reserve is fiction. They don’t really set aside dollars. That’s okay
some of the time, but not all of the time. The problem is investors usually don’t budget enough. That may feel
good in the pocketbook now, but it hurts later, and ultimately costs money at the time of sale.
Most budgets we see are less than $350 a unit a year. Investors who budget that much think they are being
careful. Well, here’s a shocker: you need twice that to cover capital costs over the long term. That’s if you start
with a new property and increase reserves every year as costs rise. If you buy an older property, your reserve
budget may need to be higher.
Reality
Investors spent an average of $647 a unit on capital expenses last year. That’s in the Seattle area. But I bet
hot water tanks or carpet prices are about the same here as anywhere else. Granted, that’s just the average cost.
Some spent more and some spent less. In fact, half spent less than $400 a unit. One out of four spent more than
$800 a unit. Apartments will have some lower-cost years and some higher-cost years, so the average cost is a
good measure to watch.
Says who?
You need to be a skeptic when it comes to expenses. Most of the information floating around out there
is, well, wrong. Sellers tend to report lower expenses to get the best sale price. Brokers work with what they are
given. Most also have a duty to the sellers. Appraisers and lenders set up expense budgets based on their own
goals. Good property managers know what it costs to run a property. But if they’re trying to get your business,
they may not tell you. On top of that, many people in this industry just don’t know what it really costs to run a
building properly.
Real numbers
Don’t give up. You can get good information. The examples in this book are real. We did not fudge them,
massage them, or rationalize them. So where do we get our information? We get year-end expenses from
owners. Then we study them. We’ve been doing this since 1986. Over the years, we have built up a strong level
of trust with investors. They know we won’t write about the income or expenses for their property, at least not
by name. So they don’t mind sharing the facts about their business with us.

This work adds up over time. Since 1986, we studied costs for 7,455 properties.
That means we looked at most of the same buildings, year after year. They are all
in the Seattle area; we’ll talk more about that later. That works out to expenses
for 810,730 units. At this rate, we’ll reach one million units in three years.

We look at both operating and capital costs every year. And we look back at prior years’ results too. This
history helps a lot. We can see trends for each property over many years. That leads to some valuable insights,
especially about capital expenses. We used this history for the case studies in this book.
We now collect expenses for 600 to 700 properties a year. That’s more than just a sample. It’s one-third of
the total market. Such a large survey makes this research more useful. For one thing, we can see what really
happens to expenses over time. The properties we collect expenses for range from ten units to more than 400
8 The Smart Apartment Investor’s Guide To Capital Plans

units. We publish the results in The Apartment Expense Report every March. The next table is one of more than
one hundred from the report.
Chart of accounts
Everyone has their own way of listing expenses. Some owners list 200 or more “line item” costs. Others list
only ten items. We group the costs owners give us into 16 categories. This is our “chart of accounts.”
That lets us make apples-to-apples comparisons. We call owners when we have questions about how to
group their costs. We list the participants in this research, as our Panel of Experts, in the Appendix. We also list
our complete chart of accounts in the Appendix.
Here is an explanation of three of our line-item costs: capital expenses; decorating and turnover; and repairs
and maintenance. We listed all three so you can see which items we treat as capital costs.

• Capital expenses. These are expenses that do not fall under the regular maintenance category.
Examples include: roof replacement; building exterior painting; appliance replacement; resurfacing of
the parking lot; and other major expenses for the upkeep of the property. Capital expenses are similar to
replacement reserves; however, this line-item reports the money actually spent, not the budgeted
reserve. Some properties, particularly smaller buildings that are owner-managed, include costs we
consider capital expenses in with general repair costs.

• Decorating & turnover. This includes cleaning and painting of unit interiors when they become vacant.
It also includes all contracted labor, cleaning of the unit, carpet cleaning, painting, materials, supplies,
wages, payroll taxes and benefits. Unit repairs are in “Repairs & Maintenance.”

• Repairs & maintenance. This category accounts for all items of general repairs and maintenance. It
includes wages, payroll taxes and benefits. Capital expenses, such as carpet or appliance replacements,
exterior painting of the building, etc., are excluded from this category. Please note for some statements,
particularly smaller properties that don’t detail costs, decorating and/or capital items are sometimes
included in this category, although we make every effort to reclassify such items.
So what if it’s Seattle
Although our research is regional, focusing on apartments in and around the Seattle metropolitan area, the
results are meaningful anywhere. There will be some differences in the cost of material and labor from city to
city, but the overall behavior of investors, consumers, and the market will be similar.
It’s not just us
We’re not alone. Others think the industry’s way of setting reserves is wrong. When we talk about this
problem, we admittedly get a lot of blank stares. But we also get some agreement, at least in private.
Here are just two comments clients shared with us recently. We could fill a book with similar quotes.
Hopefully this is enough to show you that others think more focus on reserves is a good thing.

• We talked to a lender who finances large apartment properties. She told us, “Owners do not budget
enough for reserves. In fact, I have never seen a provision for adequate reserves in any budget.”
• An investor who has bought and sold apartments for many years told us, “It has long been my view that
investors budget reserves based only on one thing: what lenders need. Their logic: capital expenses in
the acquisition budget are enough to take care of problems with the property. Buyers spend something
up front. That makes it like new, so little is needed for future reserves.”