NN Leases - Reserves & Capital Expenditures
Reserves and Capital Expenditures (CapEx) are important issues for property owners with a so-called "NN lease". These lease agreements give the landlord responsibility for maintaining the condition of the roof and structure of their property. Expenses may consist of either repairs to existing property or replacement of property through capital improvements (CapEx), but both will involve an outlay of cash that is potentially large and unpredictable. How do you deal with this problem? Plan in advance to gradually build a reserve of funds that will be available when the bill comes due.
1. Reserving $.15 - .25/sf/year is an industry rule of thumb for landlords with roof and structure liability (and may be required by your lender). This amount may not cover all large-scale replacements, but should provide the owner with the cash on hand for most incidents.
2. View reserves as part of the operating expenses of your property -- if the roof has a useful life of 20 years then it makes sense that 1/20th of the future cash outlay should be accrued yearly. Investors also need to project the probable timing and size of future CapEx when they are underwriting an acquisition. Building this expense into your assumptions will provide a more accurate forecast of the cash that should be maintained and the investment's returns.
3. A proactive reserve and CapEx strategy limits risk and favors long term cash flows. A reactionary policy faces potential cash squeezes, depressed asset value, and tenants that may vacate a property that has diminished in quality.
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