One thing that investors never like to do is spend money; however if you hold a property for a long enough period of time you will inevitably be left with the prospect of making capital improvements. Capital improvements can include anything from putting on a new roof, replacing a parking area, updating your landscaping, or painting the facade of the building. And while one hopes to get a return on that investment, it’s extremely important to prepare for those capital improvements so that you are not caught unaware and suddenly have to shell out a lot of money on a big ticket item.
When you purchase a building, it is very important to have a trusted contractor go through the building during the physical inspection phase. They will point out to you possible items that may need to be repaired on replaced now or in the future. If those costs have to be made now, then you have to determine if the cost of the improvement justifies the purchase price of the building. If those costs are to be made in the future, then it’s important to budget for those costs ahead of time using a sinking fund payment. A sinking fund payment is essentially an amount set aside periodically into a capital reserves fund that allows you to budget for items at a certain point in time.
For example, let’s say that your contractor comes to you and says that he predicts you will need a new roof in approximately 5 years and the total cost of the roof will be $100,000. You will put the sinking fund payment into an interest bearing account and use a financial calculator to determine the monthly amount each month we must set aside to prepare for those costs. This is another important figure to know, because it can change your annual net operating income and your desired yield on the property. It’s equally important to budget for these improvements so that you don’t suddenly have a big ticket item to pay for and limited funds. It’s better to receive interest on those funds now than have to borrow that money in the future and pay interest.