Published Article on “Reserve Fund Planning Misconceptions” in the Canadian Condominium Institute (CCI-BC)’s “Condo News”
The following article was recently published in the Canadian Condominium Institute (CCI) BC Chapter’s “Condo News”: http://www.ccivancouver.ca/
Why do Misconceptions about Reserve Fund Planning Persist?
Measuring the position of a reserve fund is like measuring a person’s net worth – although it involves specific knowledge, and a few more careful calculations.
Reserve fund contributions are not a gift to future owners. Predictable scheduled reserve fund expenditures are infrequent, yet component deterioration is visible to all, and occurs every day.
Reserve fund planning is a fundamental part of the budgeting process. While legislation provides the adequate floor amount, the REIC CRP approach provides the optimised ceiling amount. A DR is part of stakeholders’ risk-management and decision-making process.
By having owners pay their fair share of a development’s deterioration – based on a standard measure of fiscal-year current requirements – benchmarked reserve fund contributions are the best way to account for deterioration, while owners are enjoying a development, and gaining real-estate value.
Benchmarking is a process of improvement that provides better value for money by using a systematic method for comparing on-going performance. It builds on past results measured in a standard manner to make targeted risk-management improvements.
Good reserve fund planning expedites adjustments by matching expenditures and contributions over the long-term. It allows decision-makers to know how much liquidity they need on a fiscal-year basis, while investing the rest of reserve fund monies.
The physical deterioration of a corporation’s common assets, and the management of its finances, are only incompatible if the long-term goals for the development are not communicated to all stakeholders – from developers to owners.
Measurement deviations on a reserve fund’s current position and future standings are undesirable. The answer as to why they persist touches upon habits. These are not political but professional – factoring out details by focusing on averages serves a purpose that does not help an aging development’s particular needs.
What Are Existing Reserve Fund Planning Standards?
The Real Estate Institute of Canada (REIC) and its education provider: the Institute of Real Estate Studies (IRES) – have been promoting a standardised benchmarked version of reserve fund planning across Canada since the 1990s, and accrediting increasing numbers of Certified Reserve-fund Planners (CRPs).
Using the REIC CRP approach as a budgeting tool means that liabilities are fairly distributed to all owners on a fiscal-year basis. Having two developments properly use it also means that two lots in two developments can be compared on the same footing – vital if a corporation has phases or sections.
Believing that only engineers are equipped to conduct reserve fund reports, or that only engineers can undertake reports for larger developments has serious implications for all stakeholders.
If this were true, reserve fund reports would exist to establish the value of assets at a point-in-time – by determining their general prescriptive service lifecycles current costs – regardless of future construction inflation, investment income, and the actual performance of components.
Current cost estimates are what some stakeholders need to decide where to invest their capital at a point-in-time. This is how to decide if one project merits attention more than another. This measure is about return on investment more than the on-going performance of components once construction is completed.
Certainly current costs are used for calculating reserve fund current requirements, but current costs have more to do with taxation, insurance premiums, and new construction than with life-of-development, fiscal-year to fiscal-year, risk-management. Stopping the analysis at current costs cuts reserve fund planning short by mis-calculating the amount of monies required in a reserve fund.
Doing so explains why many people say: “I don’t know why they call reserve fund reports depreciation reports?”, or why some reports extend a projection to 45 years, demonstrating a lack of knowledge about benchmarking.
A REIC CRP functional report is about what the development owns, its current reserve fund financial position, and its future fiscal-year standings. It is about scheduling less than yearly component major repairs and replacements. It is about what these events are likely going to cost in the future, and it is about how much should be put aside each fiscal-year to pay for them.
Net worth and reserve fund current requirement calculations both offer a financial snapshot at a point in time, to help track progress over time, and provide a direction. Fiscal-year based reserve fund requirements offer the best budgeting tool for determining the fair imposition of draws on owners, and the allocation of these monies.
Based on a component inventory’s tally of one-iteration current costs for each component, benchmarked current requirements are used to establish the needs of each development, phase, or section, based on the effective age of each component, and the scheduling of expenditures.
The table below illustrates that planning based on current costs rather than on current requirements would not serve stakeholders well. With benchmark analysis, reserve fund planning prepares each section by allocating contributions based on current requirements. Reserve fund planning provides a realistic allocation of contributions to each section, which a focus on current costs alone can only derail.
With the REIC CRP approach, expenditures are projected over a long-period so that decision-makers can manage their current fiscal-year risk. They do so by proactively planning owners’ contributions based on fiscal-year to fiscal-year adjusted cumulative requirements.
While accurately projecting future requirements is intricate – REIC CRP reserve fund planning is iterative and to be redone each fiscal-year – it is a clear improvement on passive reactions, ad hoc measures based on the changing value of a development, or the past value of an operating budget.
What happens if we step back and consider what derails the reserve fund planning process, and fosters deviations in its products?
Why are There so Many Deviations from the Existing Standards?
Engineering has a crucial place in reserve fund reports – REIC CRP reports recommend the scheduling and acquisition of specialised trade and building science engineer reports – and use all available findings in their reserve fund planning – typically a few years before the planned expenditures become actual renewals.
Other than for some components receiving extra attention if an expenditure is to occur in a near fiscal-year – there is little in reserve fund reports that is to be engineered. The physical analysis leg of reserve fund reports must incorporate trades and specialist engineers’ findings, but developments need their other leg – the financial analysis – to be just as long.
Many engineer reserve fund reports are based on Class D estimates, while even Class A estimates – within 5 to 10 percent of Quantity Surveyors new construction costs derail reserve fund planning – by taking the focus away from aging developments’ actual major repair and replacement renewal costs.
Some engineers are wanting us to get further away from the REIC CRP approach and its use of the Uniformat II system for presenting components, by proposing that we adopt the American Society for Testing and Materials (ASTM)’s approach to costing, lifecycle analysis, and reporting.
None of these deviations are necessary. The guidelines of the Association of Professional Engineers and Geoscientists of BC (APEGBC) state that their first guidance reserve fund planning document is the REIC’s functional reserve fund planning Technical Bulletins. Yet few engineer reserve fund reports adhere to these guidelines.
While the Architectural Institute of British Columbia (AIBC) endorses engineer guidelines, the AIC does not explicitly state that the REIC CRP functional approach is to be followed. This explains why many reserve fund reports turn to black-box software solutions, or to the different way that United States’ community association reserve funds are planned for.
Moreover, the language in these guidelines focuses on the product – reserve fund reports, rather than on the reserve fund planning process – which is not formally taught to engineers or appraisers.
By stopping their analysis at current costs this type of reserve fund report miscalculates current requirements, while also excluding components from their inventory if the scheduled expenditure does not fit in a projection’s timeframe.
A three year old development needing windows replaced in 35 years will not have that expenditure inputted in an engineer reserve fund report. The REIC CRP method will account for this renewal in the benchmark analysis, and that eventual fiscal-year’s adjusted cumulative requirements will have accounted for the windows so that no surprise ¾ vote special levy suddenly appears in the future.
Once the benchmark inventory lists a component, its expenditures are part of a reserve fund’s benchmarked current requirements, which are used to determine the owners’ fiscal-year contributions to the reserve fund, towards the eventual windows replacement. A projection’s time horizon – five, ten, thirty fiscal-years – is less important than the benchmark, and the economic life of a development.
Misconceptions about reserve fund planning also partly rest with real estate appraisers. The Appraisal Institute of Canada (AIC) has guidelines on reserve fund planning – some correspond to the REIC CRP’s, as both require the full disclosure of unit quantities and costs.
Yet when the market value of a development is needed for insurance purposes, for municipal tax purposes, or for when a fire takes a development down, appraisers are called to do costing based on comparable nearby properties – their appraisal process is generic, needed quickly, third-party cost based, and has market-value at its core. This has little to do with reserve fund planning.
Fundamentally, engineers’ and appraisers’ work is geared to distinguishing economic choices – developers’ and buyers’ economic choices. The focus is on the short-term, not on adjusted cumulative needs from fiscal-year to fiscal-year, once the developer and engineer are long-gone.
This explains why – along with unrealistic costing – construction inflation is rarely considered effectively by engineers. Excluding realistic construction inflation on expenditures – or the historical interest income rate of return on the monies in the reserve fund – often has these reports pegging both at 2 percent. To be relevant – just as with net worth calculations – reserve fund planning inflation, interest, and escalation rate calculations must be realistic.
Ignoring these factors matters less when the focus is on short-term capital choices. Such habits derail reserve fund planning’s focus on the performance of depreciating assets. Using variations from averages is not useful to adjusted cumulative budgeting.
What are Strata Council Members and Stakeholders to Focus on?
REIC CRP functional reserve fund planning adjusts cumulative variables on a fiscal-year basis. It does so based on the visual assessment of the performance of an active aging inventory. It relies on benchmark analysis to produce a reserve fund’s current requirement ceiling, and optimised ceiling contribution amounts.
Conducting a site-visit to produce anything but realistically scheduled renewal costs is unhelpful to decision-makers. Stakeholders must know how two developments’ components are performing, what their current reserve fund current requirements are, and how much owners are to contribute to the reserve fund on a fiscal-year basis.
Arresting financial analysis at current costs means that depreciation is excluded, a site-visit irrelevant, and risk-management unlikely. Without a reserve fund benchmark to account for a development’s common assets, such reports mislead stakeholders as to the true-cost-of-ownership.
To ensure that a development’s finances are on the right path; to set reserve fund contributions based on a nationally recognised approach; to make sure that decision-makers are meeting their fiduciary responsibilities, please ask for REIC CRP functional reserve fund planning reports that use current requirements. We all depend on it.