Capital

Capital is money that can be invested and consists of the total assets of a business. Capital is also any form of wealth used, or ready for use, in creating more wealth.

Making major improvements to a property involves the use of capital. Like any other kind of funds, capital should be budgeted. Earlier lessons discussed net operating income (NOI) and before-tax cash flow (BTCF) as important indicators of financial viability. NOI is used to determine whether the property produces enough income to pay debt service and to create a capital budget for major expenses.

Capital is often available for investment because investing money is usually the best way of increasing one’s wealth. Investors count on the value of their investment to grow over time. Similarly, property owners buy office buildings, shopping centers, and apartment complexes with the expectation that the value of the property will appreciate over the time that the owners hold the properties.

Starting with the basic definition of capital as money or property available for investment, we can look into several concepts that describe how capital is used. These basic ideas are handy for understanding capital and for thinking about capital budgeting. 

• Capital asset: a long-term asset, tangible or intangible, needed to generate income. In real estate, capital assets are often defined as land, buildings, and their improvements.
• Equity: the value of real property in excess of debt. It is the interest or value that an owner has in real estate over and above the mortgage and other financial liens against it. Sometimes the term equity investment is used.
• Liquidity: the ability to convert assets into cash. A savings account is liquid. Generally, real estate is not highly liquid because it can rarely immediately be sold for cash.
• Working capital: the amount of money a company has on hand to conduct business over the short term (30 to 90 days).

Working Capital
Working capital comes from various sources. NOI can become working capital, or other assets can be sold to build up working capital. Sometimes owners of real estate may sell off buildings to finance the renovation of other buildings, to pay debts, or to invest in another project. Corporations can increase their working capital by issuing long-term debt instruments, such as bonds, or by selling stock. REITs (real estate investment trusts) sell stock and invest the proceeds in real estate. In smaller businesses, cash is the main form of working capital. It often comes from cash reserves and the owner’s savings and investments.

Working capital is mainly used to purchase assets, to pay off debt, and to make up deficits from operations. These uses all tend to be short-term.

Uses of Capital
The purpose of capital expenditures is to add value to the property or to prolong its life appreciably.  

Capital has five major uses:

• Annual debt service (ADS)
• Reserves for replacement
• Capital improvements
• Tenant improvements
• Funds to owner

Annual Debt Service (ADS)
As described in the previous lesson, annual debt service is the payment of principal and interest on a loan each year.

• Interest is the cost of borrowing money, expressed as a percentage of the amount borrowed that is to be paid in one year.
• The principal is the original amount or the remaining balance of a loan.

Interest rates are often in the news, and if interest rates start rising (often a sign of an economic contraction), commentators write about the rising cost of borrowing and its effect on the national economy. Interest rates determine the amount of interest that must be paid for borrowing the principal. The higher the interest rate, the more interest is due.

In real estate, debt service has two sides: Debt service involves paying off the mortgage loan and the interest on that loan according to the terms of the promissory note. It is important to distinguish the two components.

Mortgages
A mortgage is a lien on a property. A lien can be described as a legal requirement that payment be made that a third party places against a property. Taxes are the only liens that have priority over a mortgage. Other liens sometimes are placed against properties, such as the mechanics’ liens placed against a property by contractors and subcontractors for disputed work.

A mortgage has two parts:

• The first part is the promissory note, the legal document that a person executes (signs), in which the person makes the promise to repay the lender (i.e., “paying the mortgage”). The promissory note details the payment terms, interest rate, and other conditions of the loan.
• The mortgage deed is the legal document that pledges the real estate as collateral for a loan. Collateral is property pledged for payment of a loan. All kinds of property can be used as collateral, but in real estate the property itself usually serves as collateral. Collateral is said to secure a loan. Unsecured loans are riskier, since no property backs them, and they have higher interest rates.

In some areas, particularly the western United States, a deed of trust is used instead of a mortgage. While the two documents are similar, a deed of trust involves three parties. The borrower (trustor) transfers title to the property to a third party (trustee) as security for the trustor’s loan. In this case, the lender is called a beneficiary. Real estate managers should be aware of local practices in lending.

Other important terms of the loan are the length of the loan and when payments must be made. Typically, the loan is repaid in monthly installments.

Amortization
Amortization is the gradual reduction of a debt by periodic payments that include interest and a portion of the principal over the term of the loan. Part of each payment goes first toward paying off the interest on the loan, and then a portion of the payment is applied to the principal. This means that the principal is not paid off uniformly. The interest to be paid is calculated on the outstanding loan balance. Therefore, as payments are made and the principal owed decreases, the interest portion of each payment decreases; at the same time, the payment portion that can be applied to reduce, or amortize, the loan principal grows.

Principal can be amortized over the term of a loan, repaid at the end of the loan term, or some combination of payment can be used. A lump-sum payment of principal at the end of the loan term, in addition to the final payment, is often called a balloon payment.

Reserves for Replacement
Replacement reserves are defined as money set aside for the replacement of a property’s short-life items and/or for capital improvements. (Note that this step can be included in a pro forma cash flow statement, however, this depends upon the owner’s requirements and the property’s tax situation.)

Capital Improvements
A capital improvement is a structural addition or betterment to real property that increases its useful life or productivity or extends the life of a building or its equipment. The improvement must have a life in excess of one year in order for the cost to be recovered for income tax purposes.

Tenant Improvements
Tenant improvements are fixed improvements made to a tenant’s space, usually based on specific building standards determined in advance by ownership. In apartments, tenant improvements consist of additions or alterations to the leased premises for the use of the tenant, made at the cost and expense of the tenant.