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Why go through the bother of putting Reserves for CapEx into escrow? Sometimes you don’t have a choice. Wharton Emeritus Professor Peter Linneman explains.
BRUCE KIRSCH: To look at one of the individual line items which is sometimes not clear to students, let’s just talk for a moment if we could about capital expenditures, which people abbreviate as CapEx. And what’s the difference between capital expenditures themselves and another line item, which looks similar, called CapEx Reserves?
DR. PETER LINNEMAN: Sure. Let’s take them in the order you do them. CapEx is, gee, I had to repair the roof. I had to replace the elevators. I had to put in new parking decks on my shopping center. I had to install new granite in the lobby to modernize my office building. That’s real capital expenditure.
Some of it is simply associated with wear and tear, and some of it is associated with keeping my building competitive with the taste and the technology of today. So it’s real outlays. Capital expenditures are true outlays that occur.
Reserves for CapEx are saying, analytically I know the building’s going to need a new parking deck. I know at some point I’m going to have to refit the lobby. I know at some point I will have to upgrade my lobby. I just don’t know when.
And so since I don’t know when but I don’t want to ignore the fact, I’ll take a normalized amount each year. So just take a simple example– I know sometime over the next 10 years I believe I’m going to have a million dollars for redoing parking decks. Sometime over the next 10 years.
Well, you might take a reserve where you’re saying, essentially I’m putting aside in an escrow account so that I have the money when the money is needed. I might put $100,000 aside each year. But if I don’t have to do the parking deck that year the money just sits in the escrow account.
And by the way if I want to take it out and use that money I can. But then I have to remember when that day comes I’ve got to reinsert the money. So the reserve is a notion that over 10 years I would take, say $100,000 a year not knowing exactly when the million’s going to occur.
Real capital expenditures are not going to occur generally $100,000 a year. They’re going to occur zero, zero, zero, $600,000, zero, zero, $400,000, zero, $100,000, and then zero over time. That is, they’re going to occur when they’re needed or when it’s the right time.
So all the reserve is doing is making you understand that there is a real cost associated with owning and operating this business that you cannot ignore. And that is maintaining your capital and keeping your capital competitive. And that will take money. And you don’t know the precise timing of it. Therefore, you’re going to deduct from each year an amount associated with that– normalized amount.
It’s a little like, if you think about it, it’s like in the insurance business. If I was in the life insurance business, I don’t know exactly when the person’s going to die. So what the life insurance companies do is, each year, take a reserve amount off of their income and escrow it for the moment when the insured actually dies. And in so doing, they don’t delude themselves that they made more money than they did in the year they got lucky and the person didn’t die.
BRUCE KIRSCH: Right. I think that– I know I did, and probably a lot of other students when they approach studying commercial real estate finance for the first time– they will often look at everything through the lens of the equity side or the principal.
As I have grown and learned more about the business I try to force myself to think about things from the lender side more. Because that’s obviously a major part of the equation. And so CapEx Reserves seems to me to be something that the lender would potentially require. Is this something that will show up in loan docs?
DR. PETER LINNEMAN: It can. It often does show up in loan docs. Especially if in the next year or two– the first year, or two, or three of the– loan then they will often require truly an escrowed reserve. Or they’ll require that money from the loan is withheld until the capital expenditures or tenant improvements are done. Especially in the early years.
Now they won’t generally say, OK, 10 years from now on a three year loan– 10 years from now you’re going to have some CapEx. You’ve got to reserve for that now. What they’ll normally then do is they want to look at it as a normalized. That’s their collateral.
If you go back to what I was saying is, they’re worried that if you can’t pay them the building is theirs. They’ve already made a contract, if you will, to buy the building at the value of their loan. So if the value of the building falls sufficiently to where the owner says, I don’t want to own it anymore. You can have it for the value of the loan and just let me off the loan. That’s their collateral.
They want to understand that the money is going in like any buyer. Like any buyer of a building, they want to make sure the money is going in to keep the building competitive and to maintain the building from wear and tear.
So of course they care. Because essentially a loan is a put contract that the borrower has that if the value falls below the loan I can put the property to you. Now there’s a lot of technicalities on that. We talked about it in the bankruptcy chapter ahead.
BRUCE KIRSCH: This next piece was a fine point but something that I think is worth addressing. Sometimes practitioners will carry the CapEx Reserve line below the NOI line, and others will carry it above NOI, meaning that it will in fact impact NOI. Is there a right way and a wrong way? And I guess really in light of what we just discussed how does the lender look at it?
DR. PETER LINNEMAN: I think the lenders– especially in normal times or when capital markets are tight– tend to look at it as it’s quote, “an above the line item.” You can put it wherever you want, but I’m treating it as a real cost as a lender. Whether you take it out of NOI or not I’m taking it out of the income that you have available to pay me with. Because before you can pay me I want you to keep my collateral competitive.
I’d say in good times when markets are hot and people get a little careless around the edges then people sort of ignore it a bit. They don’t completely ignore it. They kind of say, well, you know, it’s not such a big issue. And so people get sloppy.
If you said the right discipline– look, as long as you and I understand that we’re talking about NOI either after normalized reserves or before normalized reserves. If we know what we’re doing we know we’re talking the same thing.
When you get into trouble is when you’re talking to somebody and you say, I want to sell my building for an eight cap on NOI. And you realize that, well, they mean an eight cap on pre-reserves. And you go, uh-uh. I’m not going to give you an eight cap on pre-reserves. I’ll give you an eight cap on post-reserves because that’s a real expense. If I buy it it’s coming off. It’s not money in my pocket.
So it’s like a lot of things. It’s more that you’re very transparent and clear about which way it’s being done than mechanically how it’s being done.