What’s the best way to understand the profitability of a particular asset? An important place to start is calculating the cash-on-cash return from a property based on its operating statement. However, one must examine each line below Net Operating Income (NOI) to determine the source of the funding of each expenditure before making the calculation. If funded by a source other than the rental revenues of the property, it should be deducted to arrive at the final periodic cash flow from operations. Specifically, while planned capital improvements reduce monthly cash flow, rehab improvements are paid with equity reserves set aside at the time of acquisition or refinance. Therefore, the monthly amount of rehab improvements should be added back to the bottom line on the asset’s operating statement to get an accurate picture of the current profitability. This article will explain the reason for the distinction between these two types of expenses.
Investing in real estate can require periodic cash investments to maintain the asset’s condition and/or a large investment to renovate and reposition a property within its market. These are commonly referred to as capital improvements and rehab Improvements, respectively. In the real estate investment business, the difference between these two expenses is significant, as it relates to how distributions from these investments are accounted for when calculating returns.
In a multi-family real estate investment, capital improvements can include routine and ongoing replacement of appliances, flooring, equipment, and many other items used in the normal operations of an asset. We budget for these types of improvements on an annual basis, therefore, they can be somewhat predictable in nature. Replacement reserves are normally set aside on a monthly basis to offset these costs and therefore cash flows from the asset can be budgeted more accurately on a monthly and annual basis.
Rehab improvements, on the other hand, are generally made immediately after an acquisition or following a refinance of an asset. Here, non-operating cash is used to renovate or reposition a property. Rehab improvements to a multi-family asset tend to be more complex and costly than typical recurring capital improvements. Therefore, plans for rehab improvements are generally part of the investment and business plan of the asset. Cash equity or loan proceeds are typically set aside during the initial capitalization of the asset or following a refinance, and those funds are only used for those specific improvements included in the business plan. These rehab improvements are typically major improvements to the property. Examples include roofs, siding, exterior paint, unit renovations, and construction of new amenities. Since rehab improvements are financed with cash equity or loan proceeds, these expenses do not reduce distributable cash flow.
In summary, ongoing capital improvements are taken into consideration while determining distributable cash flow from an asset and calculating cash on cash returns. Recurring expenses for the upkeep of a property tend to be classified as capital improvements, and these expenses reduce monthly cash flow from operations. Rehab improvements, while shown as an expense below NOI, should be added back to cash flow from operations, as these expenses are paid with equity proceeds at acquisition or refinance and not out of monthly operating proceeds.