It’s important to understand the issue of replacement reserves for commercial condominium real estate. Since our role and responsibility as Property Managers is to provide our clients with best practices in the area of property management, let’s talk about how property replacement reserves should work.
What are Replacement Reserves?
Real estate replacement reserves are funds that are set aside so that they are available to pay for “big ticket” items, such as those projects that fall into the category of capital expenditures. These include the replacement of building materials and components that wear out over time. Good examples include painting, the roof, and parking lots, which are three of the most common reserve items. However, the list of building components that should have funds reserved for them are building and site specific.
Replacement reserves are not set up to pay for ongoing repairs of those components that are having funds reserved for them. Items that must be maintained on a regular schedule and that fall under general maintenance, or are replaced frequently, such as light fixtures or locks, typically fall under the category of ongoing operating expenses.
Setting up a Replacement Reserve
There are a few steps to setting up a replacement reserve. The first is to have a professional review done of the physical building and grounds, and a report created to outline the current state of the facility and possible or probable future costs. For example, if a roof will need to be replaced within five years, the study will highlight this as a future expense.
Straight Line vs Pooled Reserves
Straight Line Reserves are the most common funding of building components. Straight Line creates a pool or bucket for each component. Funds are allocated to each bucket based on a calculation: the Replacement Cost minus the Current Reserve Balance divided by the Remaining Useful Life of the Reserve Component.
The funds in those individual buckets can only be used for that component. If you paint a building and there are not enough funds in the painting bucket, a special assessment will more than likely need to be issued; or hold a vote to move funds, in order to make up the shortfall of funds.
Pooled Reserves are similar, except all the funds reside in a single bucket. Pooled reserves calculation can be confusing, but all Professional Reserve Studies will show both methods. Pooled Reserves have inflows (Contributions), Outflows (Expenses), and beginning balance for each year. Pool Reserves Calculations can extend to 20+ years, depending on the useful life of the components, which are being collected. The Pooled Reserves should be calculated so that it will never have a negative balance during any year that contains outflows.
Each method, whether it is Straight Line or Pooled, has advantages and disadvantages. It is recommended to consult with the Association CPA or the Association Attorney prior to proceeding. If an Association wants to convert from one method to the other, a membership vote will be required.
After the physical review of the property, a financial analysis is required. This report outlines the expected costs to do the work detailed in the physical review. Typically, these reports plan out a specific timeline for the expected work. In the example of the roof, it might be a plan to save up or set aside funds to pay for the expected work.
The financial analysis considers many other factors, too, including any past or existing reserves, ongoing property expenses, and the rate at which the owner(s) will need to contribute to the replacement reserve fund.
Determining Future Costs
In the best of all possible worlds, these calculations should be done well in advance of the work so that the owner(s) have adequate time to plan for the work and, in some cases, save up for the expense. This allows for the basic concept of setting aside cash in advance of future needs.
One of the problems with property management is the timing of future costs. For example, work may be estimated to be certain price at a future date, and when that date arrives, the work is more expensive than anticipated. One of the most important responsibilities of property management is to schedule reviews of the replacement cost of the items on the reserve list to make sure that adequate funds are available at the time the replacement of one or more if the listing items in the reserve are to be replaced. Further, it is the responsibility of the management company and the property manager to maintain the property to assure that all building components achieve their full useful life, and to help anticipate future needs. This includes ongoing oversight and work, such as keeping the property properly maintained.
If property owners and members are pro-active and provide the funding for replacement reserves, future expenditures can be planned and executed. It’s not always easy or simple to do this, which is where a good property management company comes in.
If you have any questions about replacement reserves for a property in Palm Beach County, or Broward County, feel free to reach out to us. We’re happy to help you get started!