The OpEx vs. CapEx debate tends to overwhelm new real estate investors. The difference between the two terms may seem relatively small at first glance; however, both expenditures play an integral role in a company’s bottom line. These indicators are important to the growth and maturation of a company, which begs two important questions: What is a capital expense in real estate? What is an operating expense in real estate? The sooner real estate entrepreneurs know these answers, the better.
CapEx is short for capital expenditures which refers to any funds used by a respective company to remain in business. Therefore, money spent on maintaining or growing a company’s scope of operations qualifies as a capital expenditure.
Capital expenditures are typically used to secure, upgrade and maintain a business’s physical assets. Real estate investors, for example, would include fixing the roof of a rental property in their capital expenditures. However, on a larger scale, capital expenditure may describe the funds used to buy anything from a new office building to replacing a piece of equipment.
Keep in mind, there are limitations to what may be called a capital expense. As Investopedia is quick to point out, “an expense is considered to be a capital expenditure when the asset is a newly purchased capital asset or an investment that improves the useful life of an existing capital asset.” Perhaps even more importantly, the respective expense needs to be capitalized, which will witness a business amortize (reduce the value every year through depreciation) the cost of the entire expenditure over the useful life of the asset. Capital expenditures are unusual in that they can’t be deducted from income for tax purposes. Instead, the value gained from capital expenditures is added to the company’s assets. As a result, CapEx plays an integral role in a company’s cash flow.
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CapEx is an important business indicator, which begs the question: What is a capital expense in real estate? Capital expenses are broad and sweeping, and are best described as the costs associated with acquiring, upgrading or repairing a property. Here are a few CapEx real estate examples to clarify the concept even more:
The money used to fix or replace a roof is a capital expenditure
The money used to fix or replace an HVAC unit is a capital expenditure
The money used to paint the home is a capital expenditure
The money used to improve the plumbing is a capital expenditure
The money used to rewire a home is a capital expenditure
Again, capital expenditures are the funds spent on growing or maintaining a company’s operations. As a real estate investor, capital expenditures can range from replacing a roof or building a new home altogether. That said, you’ll never come across a universal formula to account for every company’s CapEx simply because there are too many variables to account for. Therefore, real estate investors will need to do a bit of forecasting instead of using a formula.
To estimate CapEx accurately, investors need to create a budget. Compile a list of “big ticket” items each of the properties will need and how long they are reasonably expected to last. Additionally, investors will need to predict the lifespans of their current amenities. In other words, ask questions like how many more years does that roof have left? Is the HVAC unit nearing the end of its term?
As stated above, while there is no exact formula for calculating CapEX, you can estimate this number through the following method. Once you have identified each expenditure, divide its total replacement cost by the number of years it’s reasonably expected to last.
As an example, let’s say a new roof typically sets homeowners back around $5,000 and lasts about 25 years. To calculate the capital expenditure, divide $5,000 by 25 (the roof’s expected lifespan). On average, you would expect to pay $200 per year in capital expenditures on the roof alone.
There is no such thing as a capital expenditures formula. Investing in real estate is convoluted by far too many variables, at least too many to formulate a single equation that accounts for everything that deserves your attention. The property’s condition, how old it is, and the type of property it is are just the beginning. For all intents and purposes, the capital expenditure budget for each home will be different, and rightfully so: no two homes are identical, and neither are their owners.
As I already alluded to, capital expenses are reserved for those costs dedicated to scaling a company. Capital expenditures are long-term costs specifically designed to scale a company, or at least maintain its current trajectory. On the other hand, repairs suggest a much shorter timeline and are reserved for routine maintenance costs used to maintain an asset’s condition. It is important to note that repairs do not improve the asset or extend its lifespan; they simply return it to its original state.
Otherwise known as revenue expenditures, repairs are charged directly to the company in the same year they are incurred. More importantly, revenue expenses are entirely tax-deductible in the year they occurred. Unlike revenue expenses, capital expenditures can’t be deducted from income for tax purposes. Instead, they are added to the value of the asset and depreciated over time.
OpEx, or operating expenses, are routine expenses a business incurs over the course of normal business operations. Not to be confused with CapEx, operational expenses are not reserved for investing in the company’s future growth but rather maintaining day-to-day operations. For example, some of the most common OpEx a company will face include rent, equipment, inventory costs, marketing, payroll, insurance, and funds allocated for research and development. In other words, operational expenses are necessary but generally unavoidable.
Operational expenses are also viewed differently in the eyes of the Internal Revenue Service (IRS), or at least compared to CapEx. Namely, the IRS allows businesses to deduct operating expenses in the event they are profitable.
Again, operating expenses are the costs necessary for running the business. Instead of buying physical assets, like capital expenses, operating expenses include, but are not limited to:
The money used to pay rent or a mortgage is an operating expense
The money used to pay wages and salaries of employees is an operating expense
The money used to pay accounting and legal fees is an operating expense
The money used to pay property taxes is an operating expense
The money used to pay interest on a loan is an operating expense
There is one OpEx formula passive income investors need to concern themselves with, perhaps more than any other: the operating expense ratio. As its name suggests, the operating expense ratio measures how much it costs to run a rental property compared to the income it is bringing in. To determine a property’s operational expense ratio, simply divide its operating expense by its gross operating income. Proceed to add up all of the necessary expenses to stay in business (rent, equipment, inventory costs, marketing, payroll, insurance, and more) and divide the number by the amount of profit realized by the business.
In differentiating between CapEx vs. OpEx, the first thing many people will realize is the accounting methods used for each metric on income statements. CapEx expenses, for example, must be deducted over the course of several years (not a single year). If for nothing else, capital expenditures account for assets with a useful life beyond the current tax year. As such, capital expenditures are to be amortized over the course of the depreciated asset. Operating expenses, on the other hand, can be fully deducted in a single year.
What is a capital expense in real estate? What are operating expenses in real estate? These are two fundamental questions investors need to answer before they even break into the investing community. That said, don’t let the industry jargon confuse you. The CapEx vs. OpEx debate can be quite confusing, and for good reason: the two metrics share many similarities. If for nothing else, both are necessary expenses incurred to continue running a company. What’s more, both CapEx and OpEx factor into a company’s cash flow and can significantly impact its bottom line. While several differences need to be considered, the companies that can do so successfully stand a better chance at exercising a more sound financial strategy.