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What do Strata Council Members Learn when they Attend a Seminar On Depreciation Reports?

What do Strata Council Members Learn when they Attend a Seminar On Depreciation Reports?

1.    Background on Reserve Fund Planning and Depreciation Reports

Since I am a strata lot owner and strata corporation treasurer, I was invited to a seminar on depreciation report (DR)s. The seminar was to focus on the role of DRs in budgeting.

I must disclose that I am involved in the Real Estate Institute of Canada (REIC)’s Certified Reserve-fund Planner (CRP) Task Force, and that I am reviewing Reserve Fund Study (RFS) and DR standards. I also chair the REIC CRP Task Force’s Education and Experience Committee, and am reviewing the minimum competencies required for conducting reserve fund planning and RFS | DR report writing.

I have also been trained by the Institute of Real Estate Management (IREM) to be an instructor for the REIC. I will thus be teaching new professionals wanting to work with strata councils on their reserve fund planning, and instructing professionals wanting to write standardised reports that can be used to compare two lots in two developments.

Since the seminar, we learned that the speaker has a CRP designation, and that the company he works for is in a co-broker concession agreement with the property management firm that sponsored the seminar. The comments below partly explain why the speaker did not mention his CRP designation, but nowhere was the co-dependence of the two companies disclosed before or during the seminar.

We strongly suggest that working with certified reserve fund planners and that acquiring DRs that meet standards are more important than saving money.  Strata councils that acquire three DR provider quotes, and actually meet with their reserve fund planner, are better equipped to manage their risks.

What follows is a review of the seminar based on a selection of statements made by the speaker.

2.    What Was said and How Close Does it Come to the Cross-Canada REIC CRP Standards?

Provided below are paraphrases of comments expressed by the speaker; explanations as to why each statement is misleading; and direct attention to some consequences of each statement. The commentary also provides relevant information on reserve fund planning and on the role of DRs in budgeting.

1.   “Engineer DRs are very expensive… They come with destructive testing and can cost up to $50,000”

It is not true that all engineer DRs come with destructive testing. Most do not conduct destructive testing, and many break with BC’s Strata Property Act (SPA) guideline, by outsourcing some of the component analysis to third parties.

A standard interpretation of how to conduct reserve fund planning, and a standard way to compare the position of a reserve fund across developments is important for all stakeholders, and already exists across Canada.

In BC, the REIC CRP functional approach is recognised by engineers and architects as written in the guidelines of the Association of Professional Geoscientists and Engineers of BC (APEGBC).

The APEGBC guideline is clear that writers are to follow the REIC CRP technical bulletins, which refer to functional budgeting and visual-assessment of common assets, and not to destructive testing. Destructive testing is actually at the centre of another type of engineer report: Building Envelope Condition Assessment (BECA)s. There is little reason for a strata council to acquire an engineered DR at twice the cost if it does not follow the REIC CRP functional approach.

Confusing processes and products, and putting down a professional group, rather than focusing on what a profession is supposed to contribute is unwise.

2.   “We want you to purchase functional reports that are not intended to have you replace engineering judgment”

Without defining what a functional report is, the speaker states that DRs involve a list of big ticket components, an interpretation of their effective age, cost estimates to replace them, and that inflation is important, without saying if the latter is to be construction inflation or the inapplicable consumer price index.

Putting down engineers only to have you buy a product that does not replace their judgement or meet REIC CRP standards is confusing. The REIC CRP approach is clear that as part of their reserve fund planning, strata councils are to acquire trade, specialist, and engineer reports, and that their findings are to be incorporated into DR writers reports.

3.   “The pace of stratas getting DRs is increasing”

Putting focus on acquiring a product, rather than on the process of reserve fund planning and actual role of DRs is misleading.

Reserve fund planning is about actual, approved, and planned major repairs and replacement expenditures, reserve fund monies management, and setting reserve fund contribution levels.

DRs are about a strata corporation’s reserve fund position and future outlook, in relation to other developments.

4.   “According to our client base, the yearly contributions to the reserve fund per unit in BC are $420 and have increased by 20% over the last few years. Ontario owners are sending $1,000 per unit per year to their reserve fund”

While Ontario started first and BC last with RFS | DRs, reserve fund planning and DRs are not about how much units are paying, but about current reserve fund requirements and optimised contributions.

Comparing the two provinces detracts from the needed focus on reserve fund planning for each individual development.

While owners want to know how much they will be contributing to a reserve fund, strata councils are responsible for ensuring that their non-profit organisation is well managed. Reserve fund planning allows for both.

Reserve fund planning is about each strata lot’s fair share of the common assets’ depreciation on a fiscal-year basis, regardless of an owner’s occupancy profile, or how long an owner owns.

DRs are about the position of a reserve fund so that it can be compared to other developments.

Stating that North American averages are between a certain spread is about the impact on owners, not about the strata corporation’s needs.

While instructive, this comparable is as valid as saying that common asset needs can be related to an operating budget, or that a reserve fund closing balance is to be equivalent to a portion of the market value of a development. These calculations relate loosely to the needs of common assets.

5.   “BC is different and calls the report a depreciation report instead of a reserve fund study or capital asset plan”

Factually incorrect and incomplete, and confuses the listener as to the distinction between the types of reports.

A capital asset plan is about present needs based on current costs, not the fiscal-year to fiscal-year position of a reserve fund based on current requirements.

As BC waited the longest, we actually have the strongest legislation when it comes to protecting owners buyers, and lenders.

By calling them depreciation reports we are making it clear that the depreciation of common assets is at the core of the analysis, not the operating budget, not the value of a development, not the projection of expenditures.

6.   “We set the threshold for inclusion of expenditures and components at $2,500”

This is an arbitrary cut-off, and the rationale for it is not provided.

The speaker states that anything under this cut-off can be dealt with through the operating budget. This is misleading.

The SPA and the REIC make it clear that all common assets must be disclosed in a DR, and that the common assets that make their way into reserve fund planning are to be part of the component inventory, while those that don’t are to be disclosed.

This does not mean that below $2,500 a common asset component becomes an operating budget item. A strata council can decide to have its cut-off at $0 if they choose.

More importantly, the rationale for the cut-off is if an expenditure occurs less than once a year. Anything more than once a year is an operating item. Something that happens each year is an operating item.

Operating expenses require monthly revenue to offset them. Reserve fund contributions offset common asset liabilities as determined by their depreciation.

7.   “We want to change the course of the industry and have you focus on 5 to 10 years capital asset plans”

The speaker degrades the importance of errors and omissions insurance by stating that anyone can get it for $95, and insinuates that standards don’t exist, and that many DRs are hard to read.

A DR is a legal document, it must meet REIC CRP calculation standards and formatting, and it requires that a DR writer has errors and omissions insurance costing at minimum $1,400 for one year. A DR cannot be transformed into another document, nor can it replace or be replaced by another document.

A functional report as defined by the REIC CRP approach already provides a standard across Canada. Current costs are used to calculate benchmark current requirements, and one cannot call a ‘capital asset plan’ a functional reserve fund report.

A capital asset plan tells you how much things will cost now and nothing about reserve fund current requirements. Current market costs are relevant for developers, buyers, insurance companies, and municipal authorities, not to owners and strata corporations.

Strata Councils’ reserve fund planning process is a every fiscal-year exercise for the duration of the life of a development. In BC, strata councils are to manage owners’ regular contribution draws based on fiscal-year current requirements.

Compared to other provinces, BC strata councils do not have to match a ceiling amount, but must set a course towards a ceiling amount, anywhere between the statutory floor 25% of last fiscal-year’s operating budget, and the REIC CRP functional approach current requirement ceiling calculation.

DRs are to at least provide a scenario with the ceiling amount of monies that is to be in the reserve fund based on the depreciation of the common assets, and the amount needed to bring the reserve fund to a neutral position once the optimised regular contribution ceiling amount is imputed in all future fiscal-years over a projection.

Focusing on expenditures over the next five to ten years is a different task all together. Reviewing and scheduling expenditures is part of reserve fund planning, but more importantly, the scheduling of expenditures and other variables is to be reviewed at least every three fiscal-years when a new DR is required.

A strata council’s reserve fund planning is best seen as proposing required major repair and replacement expenditures above and beyond annual maintenance, and as managing reserve fund monies on a fiscal-year basis.

While the cost to replace all assets today – a capital asset plan would say $4,000,000 – is a taxation, investment, or insurance concern, a DR writer’s job is about determining the maximum amount of monies that should be in the reserve fund today, based on the deterioration of the assets at the time of the assignment – say $1,200,000. Setting the full funding amount at current requirements of $1,200,000 rather than at current costs of $4,000,000 is clearly not the same.

The speaker states that components and elements can be excluded if they are projected to have an expenditure beyond a certain number of years, which is contrary to the standard REIC CRP approach that requires that all components in the inventory be tallied for one expenditure of each component, which is the basis for the current requirements calculation.

The speaker is suggesting that rather than using a standard that can be used to compare developments, developments are free to include and exclude anything they like, or to replace components with newer technologies, thus making comparisons between developments difficult, and DRs less than useful, as with the speaker’s approach, two developments reserve fund positions can hardly be compared.

The need for a standard approach is paramount, has been identified since the 1990s by the REIC CRP approach, and should not be tampered with.

8.   “Effective age is subjective and you can get the writer to change it for any component over the projection. Costing methods such as RS Means can have costs be from 10% to 60% of from actual costs”

The speaker leads listeners to believe that strata councils can argue with writers about future costing, and second guess their judgment.

The speaker references roofing. He is absolutely right to say that a roof can last longer, or less longer than what is prescribed in the available costing books. The speaker is also right to state that at some point, conducting major repairs on an asset that is past its effective age is misguided. But ultimately, the effective age of a component is determined by the visual assessment of components during a DR writer’s required site-visit.

At a basic level, getting cost estimates ‘just right’ is less relevant when one considers that varying one cost for one component in a component inventory with 90 components has a limited impact on the current requirements calculation, and that moving an expenditure to future fiscal-years only increases costs and the likelihood of a ¾ special levy. The law of averages is at work, correct costing more than five fiscal-years ahead is tenuous, and projecting costs is only relevant in so far as it helps to determine a current fiscal-year’s reserve fund requirements.

In reality, the short term focus on some assets only, and on their annual maintenance only, is a major reason for the need to reserve fund plan. Reserve fund planning allows for the assessment of all of the common assets over the long-term, based on their performance at the time of a DR writer’s site-visit.

In addition, using renewal costs that are realistically inflated in a projection is the best way to determine if a replacement makes more sense than continuing with annual operating expenses and less than annual major repair expenditures. Considering all three possibilities at once and over the long-term is sound risk-management.

Actual quotes make sense as they are specific to each development’s risk-management. The speaker is right to state that if a strata council has quotes, then these can be used in the projection of expenditures. As DRs are required every three fiscal-years, this is the actual horizon for acquiring quotes that pertain to future expenditures, shifting the focus away from calendar year thinking in the process.

9.   “DRs are about big ticket items and you can defer making contributions for some big ticket items”

Focusing on only some of the assets derails reserve fund planning, and goes against CRP standards. The speaker does not make explicit the criteria for including a component in an inventory, nor that major repairs are part of that inventory.

A component inventory is about age defined major repairs and replacements that occur less than once a year, and must include all common assets that will need either over the life of the development.

A strata council in year 50 of the life of development might suggest eliminating the need to reserve fund for replacing the roof shingles, as less than 20 years are left before the termination of the development. But since DRs are required every three fiscal-years, and since strata councils sit one fiscal-year at a time, a current fiscal-year council cannot eliminate that scheduled expenditure.

10. “DRs are about how long assets last, how much you need to replace them in the future”

This would indicate that there is some leeway as how much needs to be in the reserve fund, and that this determination is arbitrary.

DRs are the product of reserve fund planning, and are supposed to provide all stakeholders with the position of the reserve fund, based on a standard interpretation of what components make it into an inventory.

DRs are about how much needs to be drawn on the owners this fiscal-year based on the performance of the items in the component inventory as projected over thirty fiscal-years.

This understanding sets the determination of the benchmark ceiling amount to have in a reserve fund as well as the optimal ceiling amount to have owners contribute to a reserve fund.

The bottom line is that a strata council is to have owners pay their fair-share of the depreciation of common assets on a fiscal-year basis.

11. “Having maintenance plan and DRs work together makes sense”

In fact, the approved budget AGM package document needs to include budget notes that explain not only the proposed reserve fund allocation, but more importantly the actual, approved and proposed reserve fund expenditures over two fiscal-years, the current and the next.

The speaker mentions the SPA ‘stick’ requirement for DRs, and the use of DRs by lenders as the ‘carrot’ to lead strata councils towards DRs. This has nothing to do with fiscal-year based reserve fund planning, and detracts from explaining what DRs truly are about.

Operating Budgets are daily, monthly, and less than annual expenses that are repeated every year. Reserve fund monies are for expenditures that happen less than once a year.

In reality, active strata councils clean up both operating and reserve fund line items and amounts so that they each work optimally, not to have one work for the other, or shift the problems of one to the other.

12. Suppose that looking five to 10 years ahead you realise that you need $100,000 to cover scheduled expenditures, and suppose that you have $100,000 in the reserve fund, you might not need to increase contributions. And if you increase contributions, matching inflation might just be enough”

Total amounts at the end of several years have little do to with fiscal-year based reserve fund planning. Owners contributions are in fact to be set in terms of the deterioration of the components in an inventory, which provides the current requirements calculation for the reserve fund.

The speaker suggests that the determination of the level of contributions is to be related to end of calendar-year accounting, with contributions matching the consumer price index. This is misguided as at least, the increase in contributions is to offset construction inflation.

In fact, reserve fund planning is about a fiscal-year to fiscal-year perspective, and as such, matching inflation when contributions are already not enough to meet the current requirements sets up the strata corporation for ¾ special levies.

From a fiscal-year to fiscal-year perspective, if construction inflation is 2.80%, then the increase in contributions needs to be at least 4.10% just to break even, and this is before considering that the historical investment income return on the monies in the reserve fund is often below 2.80%.

Sound reserve fund planning uses construction inflation and the historical rate of return on investment on monies in the reserve fund. Just as with net worth calculations, real numbers must be used consistently in reserve fund planning.

13. “Linear costing for a component means that you are over-contributing to the reserve fund”

Focusing on one component detracts from the reality that the REIC CRP method is actually based on a sinking tabulation method.

As long as a component is identified in the inventory, reserve fund monies can be used towards an expenditure for it, and not just for it alone.

The BC approach has it right: having a reserve fund position between the SPA legislated floor and the CRP ceiling is sound risk-management.

14. “Don’t fully fund. The reserve fund deficiency line determines full funding at the end of 30 fiscal-years and that has reserve funds have too much money in them. When it comes to funding we really want to change the industry, and to migrate DRs to short term plans that have you save efficiently to not have too big a reserve fund, as too many reports use the full funding scenario and simply vary the inflation rate in the other two scenarios”

The speaker showed a graph with full funding reached at the end of 30 fiscal-years. This is not the REIC CRP standard.

Efficient funding is less than scientific and very much subjective. To that effect, Canadian English defines ‘adequate’ as the bare minimum, while American English defines it as sufficient.

This view puts the focus on the amount of money in the reserve fund at the end of 30 fiscal-years, not on adjusted current requirements over each fiscal-year, or the position of the reserve fund from fiscal-year end to fiscal-year end based on the current requirements at the time of the DR assignment.

The REIC CRP functional approach recognises that since so many changes can happen over the years, its benchmark calculation can only be based on the performance of the common assets that make it into the reserve fund component inventory, during the current fiscal-year of an assignment, before construction inflation, interest income, and scheduled expenditures come into the picture.

A person’s net worth calculation is for the current fiscal-year. The same applies to a reserve fund’s position. It’s position is to be measured based on the current requirements ceiling amount in the current fiscal-year. Try going to a bank and saying that your net worth will be ‘today’s value plus X dollars in 30 years’ and that you should be lent money based on this future value.

To make it clear, the reserve fund position is determined by dividing the end of fiscal-year reserve fund balance by the same fiscal-year’s reserve fund current requirements, which provides a percentage ratio from fiscal-year to fiscal-year, and that is easier to compare across developments.

The REIC CRP functional approach provides a comparable across development ceiling amount for current requirements, and an optimised amount for regular contributions. No scenario is to have a fiscal-year with respective values above these numbers. In fiscal-years with large total expenditures, planned 50 percent vote special contributions are possible above and beyond the benchmark ceiling amounts. As these are planned now for the future, they will not require ¾ vote special levies, and their monies are to be deposited and to accrue interest income in the reserve fund.

In truth, the value of the REIC CRP approach is in that the current requirements are adjusted from fiscal-year to fiscal-year in consideration of a combination of the optimised regular contributions amount, construction inflation, interest income, contributions escalation, and planned expenditures during each fiscal-year.

All future forecasting is tied to the current requirements benchmark calculated at the time of the DR assignment. The value of a REIC CRP functional DR is in its projection of the adjusted reserve fund current requirements. This provides a profile of needs tied to the current fiscal-year, and assumes that the projection is reviewed every three fiscal-year.

15. “We like to have a zero-based scenario that meets the SPA’s 25% of the last operating budget, a baseline adequate funding that has just-in-time contributions, and full funding is really the Cadillac conservative scenario”

The ‘zero-based’ term actually applies to the fact that each fiscal-year the cost for major repairs or replacements is reset to zero, no to the scenario themselves.

The idea is to reflect that the common assets physically deteriorate or depreciate on a fiscal-year basis, and that by setting the cost of the component at its current cost at the time of each DR assignment, reserve fund planning is renewed, and the current requirements can be calculated.

As no operating budget of the future can be predicted, the best that a floor scenario can be plans for an increase each fiscal-year of the SPA required floor amount by the construction inflation over the 30 fiscal-years in a projection, remembering full well that common assets major repairs and replacements have little to do with hydro bills or photocopying costs.

The speaker’s baseline adequate funding actually ties contributions to expenditures alone, rather than to adjusted current requirements. This is misguided as it does not factor in all other variables, and would have contributions increase and decrease over the fiscal-years. Few strata councils look forward to decreasing contributions once they have been increased.

It is best to interpret the current requirements ceiling calculation as a standard rather than as an prescription since so many variables are at stake. In the end, it is up to a strata council to establish the next fiscal-year’s owner’s reserve fund contributions based on their risk tolerance, although all DRs are to include the current requirements ceiling scenario.

16. This was on a slide but not discussed: “3/4 votes needed for special levies and for reserve fund expenditures”

This misleads regarding the flow and management of special monies and does not reflect what the Strata Property Act (SPA) and Strata Property Regulation (SPR) lay out:

In Fact: Reserve Fund Planning If Don’t Have a DR
  1. 50 percent simple majority vote as part of annual budget approval for contributions to the reserve fund – no separate resolution needed.
  2. Separate resolution 50 percent simple majority vote needed to pay for a Depreciation Report out of the reserve fund.
  3. Separate ¾ vote resolution  needed for any reserve fund expenditure out of the reserve fund.
  4. Separate ¾ vote resolution needed for special levy for a project in a separate restricted account that is neither the operating or the reserve fund.
In Fact: Reserve Fund Planning If Have a DR
  1. 50 percent simple majority vote as part of annual budget approval for contributions to the reserve fund – no separate resolution needed.
  2. 50 percent simple majority vote resolution for planned special contribution to the reserve fund above and beyond regular contributions IF the special contribution was planned in the DR before and not in current fiscal-year – monies and interest accrued to be part of reserve fund management.
  3. Separate 50 percent vote resolution for spending money out of the reserve fund IF expenditure is for a component listed in the DR – including the DR and DR updates.
  4. Separate ¾ vote resolution for reserve fund expenditure IF expenditure is for something not listed in the DR component inventory – replaces ¾ special levies AND monies can be managed and interest accrued in reserve fund.
  5. Still possible to propose a separate ¾ special levy at a SGM or AGM for a project and to have the monies in a separate restricted account that is not the operating or the reserve fund – but why would you?

The complexities of how monthly strata fees are allocated to the operating fund; the reserve fund, and the special levy fund, and how they transit from one to the other during and after the fiscal-year, was not addressed.

3.    What Do Strata Councils Actually Need to Know About Reserve Fund Planning and Depreciation Reports?

What follows are the basic points that any strata council member needs to know to 1. participate in strata corporation financial risk-management; 2. to understand their role in reserve fund planning each fiscal-year and 3. To explain DRs to any owner.

1.   The fiscal-year and strata council annual budget meeting dates are key to sound reserve fund planning

Strata corporation are tied to their fiscal-year and have annual budgets based on fiscal-year critical dates.

Reserve fund planning is undertaken every fiscal-year by a strata council no later than at the annual budget meeting.

Strata finances are simplified once reserve fund planning and the acquisition of DRs begins, as operating expenses and reserve fund expenditures are now on the same 50 percent simple majority vote basis.

As the strata council is to review the DR, and conduct its reserve fund planning with the DR writer in time for the annual budgeting meeting, the DR contract assignment must be undertaken at least 6 months before the annual budget meeting date.

At the annual budget meeting the strata council reviews both the operating and reserve fund budgets line items.

By focusing on the less-or-more than each fiscal-year cut-off, regular and required maintenance become the focus of the operating budget, and the Repair and Maintenance line item can be reduced accordingly to refer only to expected operating expenses or surprises.

By cleaning up their operating line items and amounts, some strata councils are able to shift that portion of the strata fees into reserve fund contributions without increasing strata fees. This means that with the same level of strata fees, contributions to the reserve fund are increased, and in effect that the reserve fund position is improved.

After consideration of the operating budget, strata council attention can shift to planning reserve fund expenditures, scheduling the acquisition of quotes and expert inspections, on tendering bids to schedule work well-ahead of the actual project(s).

Each fiscal-year, a strata council also reviews how much liquidity is needed in the current and the next four fiscal-years, and determines what type and what duration of investment vehicles to invest the remaining reserve fund monies.

After six years or the acquisition of 2 DRs, a strata council will be managing at least ten years’ worth of investment vehicles every fiscal-year, as according to the SPA, accepted vehicles must mature within 5 years of investment.

Thinking that owners can get better returns on the money by investing themselves and then contribute via ¾ special levies is easily explained as misguided, since the money owed by owners to the reserve fund is for one fiscal-year’s worth of common asset depreciation at a time, regardless of owners duration of ownership.

What is owed to the strata corporation to cover common asset depreciation must be contributed each fiscal-year, and the strata council is then responsible for managing the monies.

2.   By using a standard measure of current requirements, based on a component inventory’s tally of all one-time expenditures for each component, the projection of scheduled expenditures over 30 fiscal-years is used to determine the adjusted benchmarked current requirements from fiscal-year to fiscal-year for the current and next fiscal-years until the next DR.

By tallying up one-time expenditures into a benchmark calculation of current requirements, no component is excluded while current requirement calculations are based on the age of the development and the condition of the components.

By tallying up onetime expenditures for each component, the benchmark current requirements calculation can be compared from development to development.

The reserve fund position calculation divides the end-of fiscal-year reserve fund closing balance by the current requirements amount to provide a percentage ratio.

The next fiscal-year’s current requirements are adjusted in a standard manner to provide a profile of fiscal-year current requirements that is particularly useful when it comes to allocating reserve fund contributions to respective sections if these are part of a development.

3.   Reserve fund planning has regular contributions escalate at a stable rate over a projection so that owners can better plan their personal finances.

Once the first DR is acquired, a one-time large increase in regular contributions may be necessary and be scheduled for the next, or over the next three fiscal-years, until the next DR. Postponing ajustements until the next DR is simply bad reserve fund planning as legally, changes happen on a fiscal-year basis.

Imposing on the next DR three fiscal-years down the road the need to escalate the contributions to have the reserve fund in a position that meets stakeholders expectations can only lead to higher mortgage rates and to likely ¾ special levies.

In BC, the strata council is responsible for budgeting regardless of what the DR recommends, and is not necessarily to follow the DR writer’s recommendation.

Strata council reserve fund planning and stakeholder review of DRs raise the accountability of all parties.

Having regular contributions to the reserve fund increase in a predictable manner makes each owner’s finances easier to plan, and protects the position of a development’s reserve fund in relation to other developments.

About Author: Jean-François

With experience gained in construction, project management, field reviews, inspections, report writing and as strata president, J.-F. has cross-industry expertise guaranteeing that you will participate in a process geared to improving the corporation's finances and to setting the condo | strata board | council's planning to stand the test-of-time.

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