In an earlier post we discussed how leases describe and allocate operating expenses between the landlord and the tenant. Today, we would like to dive deeper into the topic of expenses, focusing on how expenses should be properly captured in your model. This capex vs. opex distinction is important both for your job and when preparing for a real estate modeling test during an interview. In addition to this post, you can also gain more knowledge through Leveraged Breakdowns’ real estate private equity online courses (here and here).
It is important to understand the difference between capital expenses (capex) and operating expenses (opex), because they are addressed in separate sections of your real estate LBO model. Operating expenses will be included in EBITDA or Net Operating Income (rents minus property-level expenses), while capex is dealt with close to the bottom of the model, just before distributions back to investors. The reason for handling differently is twofold: (1) capex is not usually an annual occurrence, and therefore is not considered part of the core profitability or cash flow of the property (whereas opex clearly is); and (2) capex will be depreciated, which is excluded from EBITDA or Net Operating Income.
By definition, a capital expense is an expense that acquires a new physical asset, upgrades an asset, or is a significant one-time expense that extends the useful life of the asset. Some obvious examples are:
- Replacement of the heating and cooling (HVAC) system, or major components (rooftop package units, chillers, etc.)
- New roof
- Parking lot replacement or overlay
- New lighting throughout a suite (not just replacing a single ballast or fixture), or in an entire building
- Upgrading an electrical panel for the building
A less obvious example of capex is tenant improvement allowance (TIA), which was briefly discussed in an earlier post. Tenant improvement allowance is a lump-sum payment, or allowance, that the landlord gives to the tenant in order to customize the leased space to the tenant’s desires. This is a material cash outlay directly related to the building and to the lease. Since it is a cash payment to the tenant and not a direct investment into the building, this expense will actually be amortized (instead of depreciated), but the cash flow and EBITDA/NOI effect is the same.
Operating expenses are the costs of owning and maintaining the property. These are charged against the income of the property in order to arrive at EBITDA or Net Operating Income in your real estate LBO model. The most common examples are:
- Property Taxes
- Insurance (casualty, liability, named storm, loss of rents, etc.)
- Garbage Collection
- Common area maintenance
- Parking lot sweeping, striping
- Lawn and landscape maintenance
- Snow removal
- Repairs and maintenance
- Homeowner’s Association (HOA) dues
Where Things Get Dicey
Repairs and Maintenance is always the category where making the distinction between capex and opex is tricky. A couple of rules of thumb are helpful: (1) If the expense is too small to ask your accounting team to set up a depreciation schedule (ask them what that number is!) then you can probably include it as opex; or (2) If the expense replaces a component within a larger unit (for example, replacing a coil in a rooftop cooling unit, or patching a pothole in the parking lot) then it would be an operating expense.
Another bit of nuance is that in some industries (multifamily, for example), an annual capital replacement reserve is included as an operating expense. To be specific, project underwriting may include a reserve of $300 per bed per year as a part of NOI. This provides a cash reserve to fund capex as it arises. This annual reserve funding helps smooth out the NOI and cash flow.
Start Practicing Today
Building your real estate private equity model correctly requires that you know the difference between opex and capex. This could even be a topic that is discussed in a REPE interview, or you will have to demonstrate during a real estate modeling test. Take advantage of opportunities to practice modeling, and sharpen your REPE skills with real estate private equity online courses from Leveraged Breakdowns.