In the context of commercial real estate, capital reserves are funds designated for long term capital investment projects or future capital expenditures.
Capital reserve amounts are typically based on a per unit or per square foot basis and collected or accounted for annually.
For example, a lender may require a multifamily investor to set aside $250 per unit per year in capital reserves to account for any future capital improvements. Also known as Replacement Reserves.
Investors that don’t have a loan or lender constraints may structure their capital reserves differently. Capital reserves are there to cushion the blow from some (usually known) larger expense (i.e., capex or capital expense). Rather than waiting for the expense to incur and scramble to find money to fix it, reserves are built up over time with the expectation that the expense is coming.
For example, eventually, an AC unit and roof will need to be replaced. If the AC unit is $10,000 and the roof is $30,000 with life expectancies of 10 and 20 years, respectively, the investor will save approximately $2,500 per year ($10,000/10 + $30,000/20) in reserves.
Besides the per unit number mentioned above as a lender constraint, some investors will look at everything that can break, how much each will cost to fix, and their life expectancies. Then the investor will determine an average annual saving for these expenses.
Reserves are also used to cover vacancies. If there are four units on a property collecting $1,000/mo, that’s a total of ($1,000 x 4 x 12) $48,000 per year. With a 7% vacancy, the potential annual loss is $3,360. The investor will want to ensure that their reserves have enough to cover the $3,360 potential loss. Bumping that number to $4,000 worth of reserves dedicated to vacancies will provide an additional buffer.
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