Asset Management: Managing Capital Improvements - Part 3

In the third part of the asset management series, we’ll cover the implementation of capital improvements (or Capex). Though this is not a glamorous subject and rarely talked about, it is a particularly important aspect of value-add multifamily investing as the improvements should directly impact the net operating income of a property and improve its valuation.

Like many of the variables that are used to underwrite a deal, Capex is budgeted upfront with the help of contractors and other experienced professionals. Every buyer will view the Capex needs of a property differently, depending on their vision for the property. As we have stated in previous articles, we believe that properly capitalizing deals is crucial to success especially for older vintage assets that will have heavier capital needs. 

Estimating the Capex accurately with the appropriate contingencies is very important as it can impact the projected returns (good or bad) significantly. Even with a good estimate upfront, the managing of the Capex throughout the deal lifecycle is critical to ensuring success and this is where the asset manager plays an important role. The following keys areas of Capex that require good asset management:

Scoping & Managing the Capex:

Some sponsors may have their own construction arms or hire a G/C to oversee the entire capex implementation. Sponsors that are newer in the space may try to “G/C” the construction themselves, especially if they are newer and are local to the asset. Either way, the asset manager must solicit, evaluate and award bids for the various Capex projects and then must ensure that they are being executed on time and within budget. There are usually multiple projects, some interdependent, and phases occurring simultaneously, that a mastery in project management execution is critical for success. 

Managing Interior Capex Spend

More often than not, interior unit rehabs are done in conjunction with the property management company as it’s usually more efficient and cost effective. The asset manager will provide the on-site manager the scope of the unit rehabs and the number of units to rehab per month with the expected rents to achieve. The asset manager will need to track the progress (units turned, units ready, unit premium, capex spent, etc.) very closely and make adjustments as needed. If rehabbed units are not getting rent the proforma rent premiums, adjustments (e.g. reducing scope, stopping upgrades, focusing on certain floor plans, etc.) need to be made quickly to avoid missing the proforma altogether. 

Handling Lender Draws / Inspections

Lender draws is one of the most archaic and time consuming processes in this industry. Lenders provide the 75-80% of Capex funds on many loans but escrow them at closing. As such, deals need to front the costs upfront (working capital needed) and then request draws (submitting invoices, payment proof, inspections, etc.) to release the escrows. These draws can become very large if they are not requested consistently and can result in cash flow issues as lenders are not quick to release funds. The best asset managers have a regular cadence (monthly, quarterly, etc.) and process to efficiently request draws and ensure cash flows are not impacted.

Financial Analysis / Re-forecasting

Even if there is flawless execution on the Capex, there are often several reclasses needed on the financials to properly account for Capex. This requires that asset managers review capital accounts and related opex accounts (like R&M) for capital spend to ensure they are in the correct buckets for accounting purposes. This has a direct impact on successfully making draw requests as well.

Furthermore, the budgets on all projects are never exactly right and as the project evolves, things change with the property and this requires re-forecasting capabilities. Asset managers need to be able to identify where capex is over budget and properly reduce the scope of future planned projects, otherwise, they will begin eating at operational cash flow to pay for the capex overspend, which results in reduced investor returns. Strong asset managers have a good pulse on capex spend in relation to operating cash flows on a monthly basis to ensure cash flows and distributions are analyzed properly. 

Summary:

Managing the Capex properly requires attention to detail, timelines and significant project management skills. Asset managers who effectively manage the Capex can really help the property’s cash flows. Losing sight of Capex spend, even for a month or two, can result in some ugly surprises so even though this isn’t the most glamorous part of the job, it is a very important part of the asset manager’s role. 

About the Author:

Shane Thomas is co-founder of Catalyst Equity Partners, a Texas-based private equity firm focused on helping busy professionals earn double digit returns through investing in apartments. To learn more, visit www.catequity.com and connect with Shane on LinkedIn and Facebook.