Capital expenditure, or “CapEx,” refers to money used by businesses to buy, upgrade, and maintain long-term physical assets. Also called fixed assets, these are items that businesses expect will improve their future cash flow—such as a rental property or new roof, or even adding a new building to a large campus. Another term for long-term or fixed assets is capital assets.

CapEx differs from regular expenses, known as operating expenses, or “OpEx.” Operating expenses (or revenue expenditures) include the normal costs of running of a business. In real estate investing, mortgage payments or maintenance costs, such as paying to repair a leak in your investment property’s roof, count as OpEx.

The terms capital costs and capital expenditure are different ways to refer to the same thing. Both mean spending money to buy, update, or repair fixed assets.

There’s a large difference between capital expenses, which typically are expensive and irregular, and operating expenses, which occur on a consistent basis. Both should be worked into your budget, but operating expenses often have a direct, measurable impact on your cash flow—which is why they’re extra important to pre-calculate.

Operating expenses include:

These are subtracted from your net income to calculate your free cash flow for each month (or tax year, depending on what you’re using the money for). 

Since CapEx buys something expected to produce revenue, it’s added to a business’s asset account on its financial statements.

An asset account is a list of the assets a company owns. Examples of business asset accounts include cash, accounts receivable, and land or property. Financial statements include balance sheets, income statements, and cash flow statements. Business owners and accountants typically prepare these documents at the end of an accounting period, such as a fiscal year.

Here’s how this process works: You buy a rental property for $100,000, and that figure to the appropriate asset account—in this case, your property asset account. But you still need to account for the money you spent on the property. You do this by estimating the loss of your property’s value over time, or deprecation. This cost is what’s called a depreciation expense.

Let’s return to the $100,000 rental property you bought. When you bought the house, your home inspector said you’d need to replace the roof in 10 years—the remaining useful life of the roof, during which an asset is expected to remain functional.

You estimate that replacing the roof will cost $10,000. Divide that price over ten years to determine that the roof accounts for $1,000 of your property’s annual depreciation.

On your financial statements, you deduct $1,000 from your property asset account each year for the next ten years. Doing so counts the cost of replacing the roof over time while acknowledging your property as an asset.

This accounting method is more accurate than showing only the initial expense of buying fixed assets. It allows a business to account for both the value and cost of that purchase.

And knowing your depreciation is essential for figuring your capital expenditure.

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To calculate your capital expenditure, you need to know your depreciation expense and the value of what’s called your business’ PP&E (property, plant, and equipment). PP&E is how much, total, you estimate your long-term assets are worth. That’s because determining your CapEx requires subtracting your prior PP&E from your current PP&E and adding your depreciation expense.

Here’s the formula:

CapEx = current PP&E – prior PP&E + depreciation expense

For instance, you own one investment property worth $100,000. You have no other long-term assets. In this case, your PP&E in the first year of owning the house is $100,000.

But you estimate your annual amount of depreciation is $1,000. That means, in year two of owning the property, your PP&E drops to $99,000. Your capital expenditure, using these numbers, is $0.

What if, in year two, though, you buy a second investment property in for $150,000? You add the cost of that purchase to your first year PP&E of $100,000. That means that after buying another property, your PP&E is now $250,000. You estimate your annual depreciation at $2,750.

In this example, your CapEx is $152,750.

Capital expenditure gives an accurate financial analysis of your business. Underestimating a property’s CapEx can misrepresent the total cost of an investment property. And that can destroy your cash flow.

Let’s say you buy a $100,000 rental property. You estimate the property’s operating expenses to be $500 a month. You decide to rent the house for $600 a month. Based on this financial analysis, you’ll earn a $100 a month profit.

But that calculation undercounts the total cost of the rental property. The longer you own the property, the more likely you’ll have to make capital expenditures to ensure the house remains profitable. For example, you might have to replace the roof or buy new appliances.
Sticking with the example above, you make $100 a month for ten years, earning $12,000. Then you learn the property needs a new roof. That work costs $13,000. In this scenario, you don’t make any money. Instead, you lose $1,000.

But what if you had accounted for capital expenditure? You spent $100,000 on the property, so your PP&E is $100,000. At the time of your purchase, your home inspector said you’d need to replace the house’s roof in 10-15 years. So, you estimate your annual depreciation at $1,300.

Your property’s CapEx is $113,000. That means you need to charge $942 in monthly rent just to cover the cost of replacing the house’s roof in 10 years.

Of course, you don’t always know when you’ll need to replace a property’s roof, repaint its exterior, or buy a new appliance. That’s why it’s not easy to estimate your capital expenses.

The best approach is to identify all fixed-asset items you might need to replace in 10 or 20 years, like the HVAC and water heater. List the useful life of these items. Then deduct these items’ current ages from their useful life.

For example, a water heater’s useful life is eight to 12 years. You buy an investment property with a two-year-old water heater. It’s safest to use the low-end of an item’s useful life, so you figure you’ll need to replace the water heater in six years.

Doing so will help you set rent for the property equal to the cost of maintaining the house. And that’s the benefit of calculating capital expenditure in real estate investing. CapEx gives investors insight they need to run a cash flow positive business.