Understanding capital expenditures in your real estate investment is critical to effective asset management. Explore the importance of CapEx in your real estate investment so you are better equipped to make the financial decisions that maximize your return on investment.
What Is CapEx?
Capital expenditures refer to the budgetary expenses related to the acquisition, improvement, or maintenance of real property assets or fixed assets. CapEx is a fundamental metric used across finance, especially in real estate contexts.
As opposed to operating expenses, capital expenses have less to do with the actual operational function of the company and more with the necessary fixed assets it needs to carry those functions out.
For example, the wheat General Mills uses to make cereal is an operating expense; the building and improvement of the factory where the cereal is made falls under the capital expense budget. Companies will naturally need to utilize any number of real property assets: land, property, equipment, etc.
As physical structures, fixed assets degrade over time and need to be improved or replaced outright. Capital expenditures may appear on a budget balance sheet for several reasons, such as undertaking the acquisition of new assets or projects, starting new investments in development, improving existing fixed assets, and beyond.
All payments made on goods and services for the purpose of maintaining or improving fixed assets qualify as capital expenditures.
What’s the Difference Between Capital Expenditures and Operating Expenditures?
The clearest difference between CapEx and OpEx is the period of time in which they are incurred.
OpEx
Operating expenses are shorter-term, day-to-day expenses related to standard business or asset operations. They are directly tied to the actual operating function of the business or asset.
OpEx occurs more frequently and over a shorter period. This may refer to labor costs, logistical costs, payroll, and other day-to-day expenses incurred within a shorter period.
Additionally, operating expenses are generally tax-deductible and can be clearly found on an income statement.
CapEx
CapEx is a longer-term, foundational expense. Payments will not qualify as CapEx if they are made on fixed assets with a useful life below one year. Capital expenditures refer to transformational investments that have profound, lasting impacts on a company or asset.
CapEx is typically associated with the growth of an asset or company; they happen infrequently and generally have high costs.
Capital expenditures are not found immediately on an income statement, and while they are not tax deductible outright, depreciation can provide tax breaks on them.
What Does CapEx Tell You?
Capital expenditures on a company’s balance sheet indicate where the money is being spent on fixed assets that maintain or grow the function of the business.
Capital invested in a new factory, the acquisition of heavy machinery to perform key operational functions, and so on are technically non-operational expenses that provide the ability to carry out operations that earn profit in the first place.
CapEx does not necessarily provide insight into profitability; profitability is calculated through the collection of data related to operational functions like net sales, gross profit, and costs of goods sold.
Rather, capital expenditure provides information about a larger functional context that allows a business or asset to operate and expand. Measuring the fluctuations of capital expenditure can indicate the growth of a company’s functionality; increasing capital expenses may indicate a company is expanding.
In a sense, capital expenditures are the costs of running a business: necessary baseline expenses that are virtually guaranteed to appear on the balance sheet. The scale to which capital expenditures appear on the balance sheet is the true indicator of whether a business is growing or not.
What Is CapEx in Real Estate?
For real estate investment purposes, capital expenditures and maintenance of the asset are effectively the same. Property owners of an investment property gain a profit through the income earned through the investment property. Capital expenditures on the maintenance of the property are part and parcel of the real estate investment process.
For larger real estate investment companies, the scope of capital expenditures may expand beyond the maintenance of the assets. Property related to the real estate investment companies’ operations, like office space, would qualify as capital expenditures; they are integral expenses to the actual function of the company.
However, for individual investors, capital expenditures can generally be regarded as expenses made on the maintenance of the real estate asset to sustain its useful life and necessary standard for function.
Examples of CapEx in Real Estate
To understand how capital expenditure works in a real estate investment context, let’s examine an example of the types of payments investors can expect to see under a capital expenditures heading:
- Installing a new septic tank for a property.
- Building an additional wing on a property to increase the number of available rooms.
- Repairing significant structural damage to the property’s roof.
- Integrating a security system into a property.
- Investments in development from scratch.
CapEx in real estate pertains to larger projects. Standard maintenance and repairs are not typically considered capital expenses; repainting a property for a new lease, carpet cleaning, and other such maintenance do not count. CapEx refers to repairs and renovations that noticeably alter the value of the property.
How Do You Calculate CapEx?
To calculate capital expenditures on a property, investors must first find two data points: PP&E—the changes to fixed assets on the property—and the current depreciation for the property.
PP&E
PP&E stands for property, plant, and equipment. It is a generalized term meant to refer to any number of fixed assets that could appear as capital expenses on a balance sheet or income statement.
The change from the balance on the previous PP&E period to the new one is the first step to finding capital expenditure; this change amounts to the difference in payments for fixed assets between those two periods.
Depreciation
Depreciation is a tax break opportunity that can be used on most real property assets. Because real property degrades over time, asset holders have the opportunity to account for the expected degrading value of their assets in the form of tax breaks.
Asset holders can file for a year stipend proportionate to the property’s basis—the value of the physical structures of the asset—and its useful life—the reasonable span of time in which a physical asset can be used; commercial properties have a useful life of 30 years; residential property has a useful life of 27.5 years.
What Is the Formula for CapEx?
The final formula for CapEx is as follows: CapEx = PP&E + current depreciation expenses.
In effect, the formula establishes the change in fixed asset investments spanning between periods and the depreciation expenses that may offset those costs. Tax break opportunities like depreciation and amortization can reduce those payments of property, machinery, and so on.
The number indicates the final, total expenses investors should expect to pay on their fixed assets—their capital expenditures.
The Bottom Line: Capital Expenditure Is an Indicator of an Asset’s Financial Health
Capital expenditure is a key metric for long-term, growth-focused projects. CapEx has many applications in a real estate context: property renovations, structural repairs, and the development of new real estate assets.
Whether they are necessary projects to maintain the integrity of the property or improvements to add additional value, keeping a close eye on an asset’s CapEx lets property owners know what they can expect from their property.
CapEx is a guaranteed expense of real estate ownership. Finding favorable loans ensures you have the means to cover these critical expenses.
