CapEx Expenses and Going Over Budget: Operational Risks to Your Business #2

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In the second installment of this series about the threats and risks to your business, I’ll be sharing six tips that will help keep your CapEx expenses in line and your value-add projects on schedule and, most importantly, within budget.

These are the things that you need to have dialed in so that your property is performing the way that it should, that it continues to generate cash flow so that you can increase your operating income and your bottom line.

With a looming recession and interest rates continuing to climb, it will likely be tougher to refi or sell your properties because of the cost of taking on debt and ongoing supply chain issues. Managing how you order and store materials are just one of the keys to success, and with these processes in place (and boots on the ground), these tips will surely help you stay on time and within budget.

Key Takeaways with Josh Cantwell

  • The challenges of completing value-add projects outside of your area during a recession with inflation and supply chain issues.
  • The cost savings from ordering the materials yourself.
  • How to properly store those materials on the work-site and how to create a process for checking out the material.
  • Ways that you can save on costs when hiring contractors and why you should hire construction managers internally.
  • The importance of secret shopping the units once per week and having boots on the ground to verify the work that is done.

Josh Cantwell Tweetables

“This is where operations will be unbelievably important because on the back side of this, after rates go up and then come back down, there’s going to be a big demand for multifamily housing.”

“I can guarantee you that your contractor is not going to show you some of the quality of the work, the things that are done wrong that are behind schedule or over budget.”

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Josh Cantwell: So, hey there, welcome back to Accelerated Investor. This is Josh, your host, and today, we are on to Operations Threat Number 2. We’ve been talking about in this series about threats to your deal, threats to foreclosure, threats to receivership, threats to losing your deal in the looming and upcoming recession. So, whether you’re general partner, operator, or limited partner, there are things that you have to be really dialed in on and tied up on in order to make sure that your property performs, that it continues to spit off cash flow, continue to raise the net operating income, and continue to raise the gross rents.

 

In the first part of this series, we talked about lack of a business plan and the three different types of business plans with multifamily, either one, the quick flip play; two, the refi and roll play; or three, the cash flow out the door play; and lack of a business plan and a lack of kind of strategic objectives, strategic execution, that is one of the major threats to operations in this looming recession market.

 

The second is CapEx values. So, got a lot of guys who’ve bought properties over the last three to five years who’ve said we’re going to do value-add improvements. It’s the biggest overused term in multifamily real estate. We’re going to add value. Actually, people say it’s so much, it’s like so annoying to me at this point. But anyway, doing value-add improvements includes capital improvements.

 

Now, number 2 operations threat is CapEx failures. And obviously, you think of the simple things like going over budget, being understaffed, not having people show up on the job, having the project take too long, being over schedule, and of course, going over budget with change orders. So, those are easily the four that I think of – going over budget, understaffed, overschedule, and change orders.

 

The challenge is, is that I’ve had a lot of people on this podcast who live in Canada and invest in Arizona, people who live in California and invest in the Southwest or Southeast, people who live in Florida and invest in the Midwest. All great people. I hope their operations are dialed in. But I can tell you that as the market gets a little bit more volatile, the 10-year Treasury goes up and down, the cost of materials goes up and down. We’re going to have some increasing unemployment over the next year or so. I’m not sure if you saw it, but many different outlets, including the Federal Reserve, raised their benchmark projection for unemployment. Right now, we’re sitting at about 4%. They think it’s going to go to 5.7%, which is almost a 50% increase by the end of 2023.

 

And so, some of the challenges with CapEx that we’ve had is some of the supply chain problems that we’ve had. And so, when you are operating a building in a normal environment, meaning interest rates are normal, purchase price is normal. There’s a normal amount of buyers, a normal amount of sellers. I would say that would look more like the 2014 to 2019 markets. In 2021 and early part of 2022, we had an overabundance of cash from all the stimulus. People were buying and overpaying for apartments.

 

And now, what you’re going to find is those people maybe had a quick flip play. They were going to turn the building in 24 months and they wanted to do a bunch of capital improvements. Well, if they’re not local to the property, they’re not on-site, let’s say at least once a week, if they’re not seeing the property often, the chances of that deal going over budget on CapEx or the subcontractors being understaffed or going over schedule and running long or having change orders, all can then go into, well, do we have the cash to go make a draw request from the lender assuming the lender had rehab draw dollars?

 

And so, I think it’s critically important now over the next 24 months, as interest rates continue to get up, we go into a recession, and then interest rates will come back down. It will be a little tougher to sell or refi because the cost of debt, the debt-service coverage ratio, all the things we talked about in the first solocast of the series, lack of a business plan. But the capital improvements is the way that we make a better product, a better unit, a more nicer unit so that we can charge more in rent. So, that capital improvement making sure that we’re on time, we’re on schedule becomes even more critical when you’re walking into a recession.

 

So, what are ways to make sure that we stay on track with our capital improvements? Number one is order the materials yourself. Set up a pro account at Lowe’s and/or Home Depot. We have our accounts with Lowe’s. I’m able to buy materials for probably, in some cases, 90% off. I literally made a paint order earlier this year that in a normal circumstance would have been $30 to $40 a gallon of paint. We were able to get those for $3 to $4 a gallon of paint.

 

And so, when you have relationships with major supply boxes like Home Depot, Lowe’s, etc., don’t leave it up to your contractor to order the materials. We always stay about 5 to 10 units ahead of schedule, so we buy and rent Conex boxes. They sit out in the parking lots. They’re under lock and key and we order material from Lowe’s anytime we get down to about five units of cabinets or countertops or appliances or flooring. We order another 10 units worth. They could sit into the Conex box, and so, the contractors can use those materials. So, order the materials yourself or have your, let’s say, vice president of construction order the materials yourself.

 

Number two, store those materials in a Conex box. Conex box is one of those giant steel, movable, flexible dumpsters, but they have doors in the front, doors in the back. So, we have at one of our properties at Stewart House, I think we have four Conex boxes sitting out in the parking lot side by side by side by side. One is full of flooring, one is full of cabinets, one is full of lighting and shoe mold and countertops and sinks. And we buy all that. We stored it in the Conex box.

 

Then, number three, we have a checkout process. So, whenever the contractor then wants to use the material, they have to check it out using a basically checkout sheet that says that this is the material that they took out of the Conex box to use for a unit turn. So, that allows us, number four, to pay for labor only. We’re basically hiring the contractor for their labor only. They do not buy any materials, supply any materials. They can’t just run to Home Depot and get what they need. They can’t just use our debit card or credit card. We buy all the materials, we order ourselves. It gets shipped.

 

Sometimes, if we need stuff and rush order, I’ll send one of my internal guys. Actually, I won’t, but Dave, my VP of construction, will send one of our guys to Lowe’s or Home Depot to buy everything and bring it back and then put it in the Conex box. And then they again check it out. They check it out. They fill out the sheet. They give it to Stephanie. Stephanie’s our director of finance for CapEx. Then we know that that material has been taken out of the Conex box, and she keeps a running total of the inventory that we have. So, that allows us, again, number four, to pay for labor only. Labor only. You’re just showing up. You’re the contractor, the subcontractor, the carpenter. You’re showing up. We pay you for labor only, and you use the material that we bought.

 

Not only that, but we have what’s called a Lowe’s pro account where we actually get rebates. We get special deals, we get rebates. So, not only are we paying the absolute lowest price, but then we get money back at the end of the year.

 

And then number five is if you’re doing any kind of significant CapEx is to hire a construction manager on the inside, meaning you have a construction manager or an asset manager who can go and see the units. They can secret shop the units, which is number six. We’re going to secret shop the units at least once a week because part of my portfolio is in my backyard. I actually every Monday show up at a different property, sometimes also on Thursdays, could be Fridays, but definitely on Mondays, I go to the gym and I immediately get in my car and go to one of the properties. And I secret shop the property. I walk in, I tell the property manager, I’m here, bring me all the keys for all the vacant units, bring me all the keys for the units under CapEx. I want to walk it and see it myself.

 

And so, now, let’s take the opposite of all the things I just recommended. I suggested order the materials yourself. So, one of the threats to your deal is that you don’t order the materials yourself, your contractor ordered the materials. The materials are more expensive. And they’re not being done and they’re not on-site in a timely way.

 

Number two, I suggested store your materials in a Conex box under lock and key. Well, let’s say you just, again, let your contractor do that. Maybe you live in California. You bought a deal in Texas. You tell your contractor, yeah, go ahead. You do it. And now, some of your materials walking off the job site. It gets stolen.

 

Number three, let’s say, again, I suggested have a checkout process to check out your material out of the Conex box when it makes its way into a unit. So, again, let’s suggest you don’t have a checkout process. And again, stuff is being wasted, materials are being lost, materials are being stolen, leads to cash flow problems.

 

Number four, I suggested hire for labor only. Well, in a lot of cases, some people would be like, well, I’m just going to hire a contractor. They’re going to do the labor and the materials. Well, now, you have two jobs for that contractor, which is they have to buy the materials, they have to source it ahead of time, they have to find it and buy it early, they have to keep it in inventory and use it. So, by hiring contractors for labor only, it eliminates half the job. So, they could just be really good at the carpentry, setting the cabinets, setting the appliances, setting the countertops, the shoe mold, the sinks, the plumbing, making sure it all works.

 

Number five, let’s say that you instead of having a construction manager or an asset manager that walks the units, that secret shops, which is number six, you don’t have them and you’re actually just using video, you’re using pictures to verify that units are done and completed. Well, guess what? I can guarantee you that your contractor is not going to show you some of the quality of the work that’s not done well. They’re not going to show you the things that are done wrong. They’re not going to show you the things that are behind schedule or over budget.

 

I’m baffled still when I walk into units, even with all of our process and even though I secret shop when I walk in and I see backsplash that’s been laid with subway tile and it absolutely looks like garbage, and I’m like, you got to replace this, and we make the contractor replace it, rip it out, redo it. I walk in to see a paint job, and there’s paint all over the outlets or there’s paint dripping, redo it.

 

And so, as this recession starts to come on and you start to look at capital improvements for a property that you’re about to buy or properties that you just did buy last couple of years, those are some of the things, those six – order the materials yourself, store them in a Conex box, have a checkout process, hire for labor only, hire a construction manager or an asset manager, and then secret shop your properties, this is where operations is going to be unbelievably important because on the back side of this, after rates go up and then come back down, there’s going to be a big demand for multifamily housing. The demand might taper down a little bit in 2023, 2024 because rates are so high. But in 2025, 2026 when rates come back down. Guess what? Yup, there’s going to be massive demand. So, if you’re going to operate your way through the recession, you have a huge chance to win and a huge value-add in your property and a huge amount of equity in cash flow that will be sitting at your fingertips.

 

Now, as we wrap up this episode and move on to the next, don’t forget to join me for our last recording. You should check that out, Lack of a Business Plan, and also make sure you check out the next recording that’s going to be coming out shortly, which is Property Management Failures. We’ll talk about that as an operations threat in our next episode. We’ll talk to you then. Take care.

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