Every building owner, residential and commercial, needs to create a financial budget for capital repairs and replacements. The various components of every building have an estimated useful life, and at the end of that useful life the component will require an expenditure for major repair or replacement if the building is to remain in good condition. Preparing a financial budget and reserving adequate funds for these future costs can prevent unanticipated financial hardship.
Who Pays for Capital Repairs and Improvements in a Real Estate Transaction?
It is always in a buyer’s and a tenant’s best interest to have a thorough inspection of the premises performed before being bound to close under a purchase agreement or lease. This enables the parties to identify and budget for necessary repair work. In a real estate purchase agreement, it has become customary for buyers to engage in an inspection period allowing them to negotiate repair costs and price, and/or to cancel based on the result of the buyer’s inspections.
In a commercial lease transaction, the terms regarding responsibility for payment for maintenance and repairs is negotiable. Before signing a lease, landlords and tenants should be aware of and carefully review the lease provisions regarding maintenance and repairs, and the terms regarding the pass-through to tenant of any costs for capital improvements or repairs to a building. In a residential lease transaction, generally the landlord bears the costs for building repair and maintenance, apart from damages caused by the tenant.
The Remaining Useful Life of Building Components Affects Value
The need for immediate and prospective capital repairs to a building is an element of calculating the building’s current value. A conservative commercial property valuation or appraisal may include a figure for ‘reserves’ (for future capital repairs) that is applied as a reduction to the calculated net operating income of the property, which results in a reduced appraised value. This same valuation methodology can be used by lenders when underwriting the property for loan financing, and/or for future loan default or cash management triggers.
Commercial lenders often require an escrowed reserve fund from the borrower’s cash flow to cover the estimated cost of immediate and future capital repairs and replacements. The lender’s reserve amount would likely be based on a Property Condition Assessment obtained by the lender during its underwriting process.
How to Budget for Major Repairs and Replacements
The elements of a capital repair budget are: (1) the estimated dates for the needed repair, and (2) the estimated price for each repair. The estimated repair dates can be determined using the estimated remaining useful life of each building component. The International Association of Certified Home Inspectors has published an estimated useful life chart for the typical components of a home that can be found at this link https://www.nachi.org/life-expectancy.htm
The useful life of the components of commercial buildings depends on the materials, products and equipment installed. For new construction, the architect, engineer, contractor and materials suppliers can likely provide the estimated useful life of the newly installed building components and systems, and a replacement cost estimate for each component. For an older building, a ‘Property Condition Assessment’ can be obtained from a qualified inspector. This report will include inspection results, an estimated schedule of the remaining useful life of the building components and systems, and the estimated cost for replacement or repair.
Practice Routine Maintenance
Good versus poor maintenance and extreme weather or usage, can affect the useful life of the building components. In order to extend the life of the building components, the owner’s operating budget should include routine maintenance and periodic inspections of the building components and systems.
What Difference Does it Make?
The need for a substantial and expensive repair or replacement to keep a building in good operating condition will inevitably arise. Being prepared and budgeting for the necessity allows property owners to avoid unexpected cash shortages, potential defaults under loan agreements or leases, potential liability for injury or business interruption damages, and undue anxiety. Budgeting for immediate and future capital repair and replacement costs when evaluating an investment in real estate is an important element in determining a fair price and value for the property.
Contact MBM’s Real Estate Team today to help you develop a proactive capital repair and replacement budget evaluate your existing agreements.