Reserve Fund Check-up
Four Ways to see if Your Study is on The Right Track
Director, Condominium/Strata Group
In Ontario, condominium corporations legally must have independent reserve fund studies conducted when first registered and have the reserve fund studies updated every three years thereafter. These regular, frequent, updates help to set the future course of positive cash flows for the following 30 years by accounting for actual spending, exact interest earnings, genuine major repair and replacement priorities, and in-line with similar market contributions. But, how do you check to see if the figures presented in a reserve fund study are meaningful? The following points can help to assure that the starting point on the map is where you are and that the proposed funding is the right route to success.
For the purposes of this article, let us keep in mind a hypothetical condominium that is now 20 years old and has 80 residential units.
The Condominium Act requires that cash flows be developed for a minimum of 30 years. Reserve fund studies develop funding plans based on both the longevity and cost of common element major repairs and replacements. Some building parts are likely to be very long-lived, well beyond 30 years. Think about footings, foundations, storm and sanitary sewers, metal studs, elevator rails, curtain wall assemblies and the like; they should last well beyond 30 years, probably beyond 60 in some cases. However, that longevity does not mean that the owners, in the first 30 to 60 years, should not contribute to the eventual major repair or replacement of them. In fact, the spirit and intent of the Condominium Act is quite the opposite, every owner should contribute.
So, run your finger down the “Remaining Life” column of the plan and find any components where the planner has estimated more than 30 years to go, if there are any, and ask what the impact of that expense will be on the balances past the 30 year mark and decide if a little bit more now will overcome that big amount later. Or, better yet, get a longer plan that considers the longest-lived items. You will appreciate it later when you are trying to explain to future owners that, after 15 years or so, you suddenly realized you had sanitary sewers.
Our hypothetical condo is now developing a cash flow plan that extends out to when the building will be 50 years old. Those long-lived items were probably missing from earlier reserve fund plans. In other words, 20 years of savings were squandered for that expensive thing that needs work in year 50 of the building’s life. Even $5/unit saved in those first 20 years would be $96,000 – that goes a long way toward fixing a collapsed maintenance hole and section of concrete sewer pipe or rusted cast iron water main. It also sounds so much better than a $1,200 special assessment for something known to exist.
This is fundamentally a real challenge and ranges widely from condo-to-condo and location-to-location. The reserve fund plan is based on the current major repair or replacement costs (the cost to do the work now even though it might be scheduled later). These costs are for major repair or replacement of everything but the units – so no tubs, sinks, toilets, fixtures, appliances, countertops, flooring or furnishings. Still, things like site work, structural components, building envelope, mechanical equipment, electrical systems, life safety, elevating devices and common amenities can all add up to significant costs. Typically, they are in the 30% to 60% range of construction costs depending on the condominium type (standard, common element, vacant land, phased or leasehold), construction style (town home, high rise or industrial commercial), and location (urban, suburban or rural).
Available data suggest that those construction costs are in the range of $115K/unit to $240K/unit. That means that if you add up the current cost column in the plan and divide by the number of units, it should be in the range of $35K/unit to $144K/unit. Our data leans very close the $65K/unit for standard urban residential condos. If your data are very different, then ask why – maybe there are no amenities, unusual unit boundaries, unique construction materials, difficult location issues or some other explanation. If not, well, the plan needs re-thinking.
Opening, Minimum and Maximum Balances
The opening balance should be one of the most confident numbers in the reserve fund plan. It is the same as the audited closing balance for the earlier period. If the corporation is small enough and all the owners have agreed, they may have waived an audit in favour of a less costly statement prepared by management or the board. In absence of the foregoing alternative, a copy of the bank statement for the reserve account will do.
The opening balance, or any balance for that matter, may be low due to completing a large spending program. Conversely, it may be high in anticipation of some immediate spending needs. Generally, corporations rarely have less than $500/unit in reserve at their lowest closing and often have managed to save (spend less than contributions) about $10 to $40 per unit per month. So, one would expect our hypothetical condo to have at least $4,000 ($500/unit x 80 units) in any closing balance of their plan. More likely, they will have saved in the range of $192K to $768K (20 years x 12 months/year x 80 units x $10 to $40/unit/month). Keep these numbers in mind (or on a separate note pad) for a later discussion about closing balance ratios.
“Is there ever too much saving?” you might ask. Well, in reserve fund planning, yes there is. These hard-earned after-tax owners’ dollars are solely for major repair and replacement of the common elements. Returning that money is not a possibility, except upon dissolution of the corporation. Saving too much is almost as irresponsible as not saving enough.
But how much is too much? The answer lies in the “Total Costs” discussion above. Since we know the total current costs that the plan is predicated on, there is no rational reason to save more than that amount, since the implication would be that ALL of your common elements need repair or replacing at the same time. That does not happen in occupied buildings. Our hypothetical condo is based on $65K/unit, so no closing balance should be more than the equivalent of $5.2M. Wait, the “equivalent”, what the heck kind of chicanery is that? None whatsoever! Because of the effects of inflation, $5.2M now is about $9.4M in 30 years at 2%. That is the Rule of 72 for you. Google it.
Now, about those closing balance ratios… you guessed it; simply plot each closing balance, adjust out inflation for that timeframe, divide by the number of units, divide that by the current cost per unit, multiply by 100 and you have a closing balance that should be – wait for it – in the 1% to 100% range.
Rates of Change
Finally, there are three rates of change that affect reserve fund plans, as follows:
- Construction Expenditure Inflation – affecting the assumed inflation adjusted expenditure column, usually more than CPI by about 1.0% to 4.0%.
- Guaranteed Investment Certificate – affecting the assumed interest earned on reserve fund deposits, usually in the 1.4% to 3.6% range, though the future is looking better for savers, and
- Consumer Price Index – affecting the annual contribution to reserve rate of change, usually in the 1% to 3% range as set by Bank of Canada’s policy.
Paying attention to these four criteria (duration, costs, balances and rates) will set a course for smooth sailing and help avoid turbulent future funding needs.