The Background on Inadequate Reserve Fund Planning
Deviations from standard gauging of fiscal-year reserve fund positions continue to surface. The answer as to why they persist touches upon misconceptions, biases, and habits.
Reserve fund planning is a budgeting process. While Reserve fund Studies (RFS) | Depreciation Reports (DRs) are fixed in time, boards | councils are responsible for actively managing the risk associated with the operating and reserve funds on a fiscal-year basis. Pro-active developments balance the need for expenditures with owners’ means for contributions to the reserve fund.
Reserve fund contributions are not a gift to future owners. While predictable scheduled reserve fund expenditures arrive infrequently, deterioration is visible to all, and occurs every day. By having owners pay their fair share of real estate deterioration – based on a standard measure of fiscal-year requirements – reserve fund contributions are the best way to normalise ongoing deterioration for owners that are enjoying the development’s common assets.
The law of large numbers – the principle that future events are likely to limit past deviations while having people converge towards a desired outcome – a regression to the mean – is expected to be at work. Good reserve fund planning expedites corrections by smoothing out expenditures and contributions over time. While some developments are moving towards this outcome, misconceptions rear their ugly heads and move the pendulum in the wrong direction.
The physical deterioration of the common assets, and the management of condo | strata finances, are only incompatible if the long-term goals for the development are not communicated to all stakeholders – from developers to owners.
An established standard approach to reserve fund planning already exists. Measuring the position of a reserve fund is very much like measuring a person’s net worth – although it involves more background knowledge, and a few more careful calculations.
What are People Saying About Depreciation Reports and Reserve Fund Studies?
The Real Estate Institute of Canada (REIC) – and its education provider: the Institute of Real Estate Studies (IRES) – have been promoting a standardised benchmarking version of reserve fund planning and reports across Canada since the 1990s.
The expressions ‘benchmark | benchmarking’ are frequently misused. For clarity, they do not refer to ‘average performance’, or to a ‘minimum acceptable standard’, the latter being the Canadian English meaning of ‘adequate’. Benchmarking can best be defined as: “…the overall process of improvement aimed at providing better value for money…” or as “…a systematic method of comparing performance… using lessons … to make targeted improvements…”.
Yet some people believe that a RFS is a different and grander document than a DR, and that only engineers are equipped to conduct either. This inaccurate view as serious implications for all stakeholders.
If this were true, RFS|DRs would exist simply to establish the value of assets up to a point-in-time, to determine their current cost based on general prescriptive service life-cycles.
In this view, a development with a 75 year lifespan, having 23 years old roofing shingles, needing its shingles replaced in two years, and then 25 years later, at a currently estimated replacement cost of $180,000, would lead an owner|buyer|lender to anticipate future liabilities prorated at $7,200 per year in today’s dollars – and so on for all the other components – regardless of future construction inflation, the performance of the asset in the field etc.
Why do this? This is what stakeholders need to decide where to invest at a point-in-time. This is how they decide if one project merits their attention more than another – their benchmark is return on investment (ROI), not the assets that are left to owners of a corporation once construction is completed.
The major problem with this approach is that while current replacement costs are the basis for fiscal-year based reserve fund requirements calculations, current costs have more to do with taxation, insurance premiums, and new construction, than with long-term fiscal-year based risk management.
This misconception of what a DR is, has for counterpart the embellishment of what is involved in a RFS. Some people believe that a RFS is more extensive, and involves an inventory of all corporation records (plans, manuals, warranties, registered documents, historical records of regular and required maintenance, operation and renewal schedules) – rather than what a REIC Certified Reserve-fund Planner (CRP) RFS|DR would entail: a review of such records to gauge existing maintenance habits that would affect the lifespan of reserve fund components, and the component inventory.
This mindset comes with the added misconception that each component would undergo an engineer inspection to establish the condition of each component– as if each component was to experience a separate engineering condition assessment, rather than a REIC CRP specified visual condition assessment. In fact, engineers who conduct RFS|DRs do not rely on them as condition assessment reports – they expect clients to pay for these separately.
More damaging, these deviations do without the most important part of reserve fund financial analysis – they stop at current costs and omit benchmarked current requirements – thus mis-calculating the amount of monies needed in the reserve fund.
This focus on current costs explains why we often hear engineers say: “I don’t know why they call them depreciation reports?”, or why some extend a projection of expenditures to 45 years to ‘capture’ expenditures – showing a lack of knowledge about reserve fund benchmark analysis.
Different optics are at work. The usual categories at our disposal to explain the acceptance of these beliefs only take us away from standardised reserve fund planning. The deviations are not political but professional – by training engineers and appraisers factor out particulars by focusing on averages, while developments are all about owners and their particulars.
Corporation common assets and personal finances deserve better – a solution already exists.
What is the Recognised Way to Conduct Reserve Fund Planning?
There is one viable type of fiscal-year based long-term reserve fund planning across Canada: the REIC CRP functional benchmark approach. Using it as a budgeting tool means fairly prorating future liabilities to current and future owners. Having two developments properly use it also means that two lots in two developments can be compared on the same footing – even more so if a corporation has phases or sections.
Net worth and reserve fund requirements both offer a financial snapshot at a point in time, to help track progress over time. The fiscal-year reserve fund requirements calculation is the best tool at our disposal for determining the fair imposition of draws on owners, and the allocation of their monies. Based on a standard approach benchmark component inventory, current requirements are an accurate measure of asset depreciation and of the needs of each development or section. It is then up to strata councils to establish their expenditure and contributions plans based on their tolerance to risk. Legislation indicates what is the sufficient floor amount, and the REIC CRP method provides the optimised ceiling amount.
The table below illustrates that planning based on current costs rather than with current requirements would derail the reserve fund and serve no one. Using current costs overestimates the amount of contributions ‘needed’ now. Projecting inflated current costs has an exponential effect on the amount of contributions assumed to be needed from the point-in-time of the calculations. The fact is that the reserve fund current requirements for each section fluctuate each fiscal-year, and that with benchmark analysis, adjusted fiscal-year based cumulative current requirements, reserve fund planning can prepare for each section’s needs in a realistic manner.
A REIC CRP functional RFS|DR is about what the corporation owns, its current benchmarked reserve fund financial position, and future fiscal-year standings; when components need to have major repairs and replacements scheduled; what these actions are likely going to cost in the future, and how much should be put aside on a fiscal-year basis to pay for them.
A board | council’s reserve fund planning is valid until all of this is revisited in the next round of analysis and discussion with a reserve fund planner. This is the recognised REIC CRP way to prepare for scheduled expenditures over the life of a development.
Expenditures are projected over a long period so that boards | councils can manage their risk by proactively planning the owners’ contributions for a few fiscal-years. This approach recognises the difficulty of accurately projecting future costs, but is a clear improvement on passive reactions, with surprise three-quarter vote special levy resolutions.
What happens if we step back and consider the influences that derail the process, and foster deviations in its products?
Why are Short-sighted Misconceptions so Damaging?
Some of the misconceptions lie with engineers – for whom RFS|DRs are sideline work. Other than for some components sometimes receiving extra attention – there is very little in RFS|DRs to be engineered. As of 2016 – an update is welcomed – no engineering school in Canada teaches a dedicated reserve fund planning course to engineers.
In other words, engineering has a place in RFS|DRs – most REIC CRP RFS|DRs come with a recommendation for trade and engineer inspections a few years before the planned expenditures become actual renewals – but reserve fund planning is to be functional by focusing on the depreciation of a corporation’s aging common assets. Reserve fund planning is about budgeting more than construction or building science.
The physical analysis leg of a RFS|DR must incorporate trades and specialist engineers’ findings, but a RFS|DR needs its other leg, the financial analysis, to be just as long – it too often comes short in engineers’ RFS|DRs. Engineered estimates are very specific and aimed at providing rough cost projections throughout the stages of concept development – many engineer RFS|DRs come with Class D estimates while even Class A estimates – expected to be within 5% to 10% of Quantity Surveyors new construction costs – would be inadequate as they are still not renewal costs.
From an engineer’s reserve fund planning standpoint, average cost estimates are to be used. Why? Because engineering is about tolerances – the ability to cope with changes and unplanned variations, and specifications – constraints that are incorporated into the new construction process.
This viewpoint accepts a level of imperfections and compromises. It aims for prescriptive averages rather than dealing with actual performance and realities. For engineers, deviations sit on a gradient of acceptability. Their way to deal with deviations is to rely on averages. For owners, this has little to do with post-construction common asset renewal costs. Owners rely on actual performance based numbers for budgeting.
In their process, engineers’ RFS|DRs skew actual renewals costs by using design costs, inflate future costs by stopping their analysis at current costs, but also deflate reserve fund requirements by excluding components from their inventory, projection, and scenarios – when a component has no expenditure fit within their chosen time-frame. From an owner’s standpoint, these unnecessary steps are time-consuming deviations that derail time-tested reserve fund benchmarking.
Interestingly, the professional practice guidelines of the Association of Professional Engineers and Geoscientists of BC (APEGBC) state that the first guidance document is the REIC’s reserve fund planning Technical Bulletins – these are all about functional reserve fund planning.
Functional reserve fund planning is certainly a point-in-time exercise. Its tally and adjustment of cumulative factors on a fiscal-year basis is centered on the on-site assessment of the performance of the benchmarked common assets – with benchmark analysis producing reserve fund requirements. This analysis is often missing from engineered RFS|DR reports.
Stopping the financial analysis at current costs means that depreciation is excluded, a site-visit not even needed, and planning improbable. Why? Because without a reserve fund benchmark to account for all component requirements, a projection leaves out some components and misleads owners as to the true cost of ownership.
Reserve fund planning is about maintaining and replacing aging common assets in terms of their actual performance during the economic life of a development – it’s about renewals, not new construction or design costs.
A three (3) year old development needing windows replaced in 35 years will not have that expenditure inputted in a twenty-five (25) fiscal-year projection. But 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 special levy suddenly appears.
Once the benchmark inventory lists a component, its expenditures are part of a reserve fund’s requirements. The practical result is that the corporation has the owners, based on their usage, contribute monies on a fiscal-year basis towards the eventual windows replacement. A projection’s time horizon – five (5), ten (10), thirty (30) fiscal-years – is much less important than either the benchmark or the economic life of the development. While scheduling expenditures is important work, these are estimates that by law are to be reviewed every three to 5 fiscal-years depending on the legislation. Projected expenditures only become real after inspections and tendering has lead to actual renewal projects with specific costs recognised at an AGM – whatever the risk in projecting future scheduled expenditures, the merit of doing so lies in in allowing us to determined owners’ fair-share of the depreciation of common assets on a fiscal-year basis.
Misconceptions about reserve fund planning also partly lie with real estate appraisers. The Appraisal Institute of Canada (AIC) has some guidelines on reserve fund planning – some line up with the REIC CRP’s – the Canadian National Association of Real Estate Appraisers (CNAREA) does offer 35 hours of after-schooling on producing RFS|DRs. The AIC’s latest Canadian Uniform Standards of Professional Appraisal Practice (CUSPAP) guideline does not identify the REIC CRP method as the only reserve fund planning method. Furthermore, while its current standard recognises the legislated floor for funding a reserve fund, article 13.1.7 is incomplete and misses out on stipulating that the REIC RCP is the standard, nor does it mention that current requirements are the foundation of reserve fund planning anywhere.
In fact, rather than recognising the REIC CRP approach, the University of British Columbia (UBC) relied on appraisers to create its Sauder School Real Estate Division Reserve Fund Planning Program (RFPP), presented as a competitor to the REIC CRP. It is geared to CRAs or AACIs accredited appraisers. Our review of the program’s documents indicates that while the benchmark and current requirements are mentioned, adjusted current requirements analysis is not posited as the foundation of reserve fund planning analysis. An accompanying negative impact of UBC’s involvement is that other colleges or universities within a certain radius cannot teach reserve fund planning due to provincial legislation.
When the market value of a development is needed for insurance purposes, for municipal tax purposes, or when a fire takes a development down, appraisers are called to do their standardized costing based on comparable nearby properties – but this appraisal process is generic, quick, third-party cost based, and has market-value at its core.
Engineered prescriptive design costing or appraisal new construction costing actually derail reserve fund planning’s exact time-consuming focus on the performance of depreciating assets in the field. Only this focus can improve the risk management of corporation finances.
Trusting engineer biases also has direct repercussions, as the Architectural Institute of British Columbia (AIBC) endorses their guidelines, and lenders rely on their opinions as well. The AIC does not explicitly state that the REIC CRP functional approach is to be followed – which has many appraisers turn to proprietary software solutions, and the very different way that United States’ community association reserves are planned for.
While some of the misconceptions also lie with REIC CRPs, it is instructive that most existing guidelines’ language focuses on the product – RFS|DRs, rather than on reserve fund planning – not formally taught to engineers or appraisers. Also troubling, many engineered RFS | DRs outsource some component reviews as part of their assignments – and charge clients for it – in violation of at least BC’s Strata Property Act (SPA).
Some engineers are wanting us to get further away from the REIC CRP approach and its adoption of the Uniformat II system for presenting components. They propose that we adopt the United States American Society for Testing and Materials (ASTM)’s ASTM E917 and ASTM E 2018 approach to costing, life-cycle analysis, and reporting. There are major issues with this direction, some of which are discussed below.
While some engineers make due with believing that accurately predicting actual costs is impossible – and fall-back on design costs and opinions of probable cost – they continue to provide estimates that are as far as 50 percent away from actual renewal costs. This approach to costing brings with it some important consequences, one of which is that engineers like to incorporate general contingencies that have more to do with new construction than planning.
Reading the APEGBC guidelines brings up the same language – design and scheduling, relative alternative costs, opinion of probable costs. Engineers further distance us from corporation needs with the third-party nature of their life-cycle costing. Engineering economics has life-cycle cost equal: first cost + maintenance and repair + energy + water + replacement – salvage value. Adapted to common assets this often becomes: designing + purchasing + constructing/installing + operating + maintaining + repairing + replacing + disposing. These costing deviations have serious implications. For developments, actual common asset renewal costs do not include operating regular or required maintenance and operating costs, and actual costs are closer to quotes than to national Quantity Surveyor estimates.
The fact that engineer estimates are different from renewal costs may partly explain why few engineers define or provide unit quantities and costs in their reports – limiting themselves to opinions of probable costs and contingencies. This is an issue raised by board| councils and property managers, as not sharing this information means that estimates cannot be verified, that new quotes cannot be compared to the values that should be in the RFS|DR, and more importantly, it means that corporations are not free to consult other providers for their opinions.
It is also a fact that REIC CRPs must disclose unit quantities and costs as per the IRES guidelines, and that the AIC as similar new language in their guidelines. Common sense dictates that black-box reports are tenuous for all sorts of reasons – if not on ethical grounds alone.
Why these habits and differences? Because the focus of engineers is on the economic analysis of different options at the point-in-time for choosing what to build, rather than on planning the repair and replacement of like-for-like components and elements over the economic life of a development. Their life-cycle method is suitable for determining initial building costs and alternatives – justified by potential lower future costs – an approach that is closer to order of magnitude cost-benefit analysis than to corporations’ existing needs.
Engineers’ work is geared to distinguishing economic choices – developers’ economic choices. Reading the ASTM documents, it becomes clear that the discount rate of future costs and the reduction of purchasing power is at the core of this analysis. 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 partly explains why in conjunction with unrealistic costing, renewal project construction inflation – or localising the analysis to the particulars of the development – is rarely undertaken by engineers. Doing without concern for construction inflation on the expenditures – or without the historical interest income rate of return on the monies in the reserve fund – often leads to pegging both at 2 percent: a sure way to deviate from realistic budgeting. Just as with net worth calculations, reserve fund planning inflation, interest, and escalation calculations must be realistic to be useful.
Ignoring these factors works when the focus is on short-term capital choices based on variations from averages, not when you are concerned with adjusted cumulative fiscal-year budgeting. Without benchmark analysis and scenarios that reflect fiscal-year to fiscal-year realistic adjustments, such projections exclude depreciation, some expenditures, and cannot be relied upon for long-term planning purposes.
The engineer approach can best answer two types of questions: is this a viable project for my capital, and what will be the cost on today’s capital when I want to dispose of the project?
Reserve fund planning needs other questions answered and is for a different stakeholder – owners: what are the current requirements to maintain the value of existing assets on a fiscal-year basis, and how are these fluctuating fiscal-year to fiscal-year so that we can best align expenditures to contributions?
As is usually the case, asking the right questions leads to the right answers. Development major repair and replacement capital spending isn’t about where to invest your money, it’s about maintaining existing assets on a sound tax-free basis.
If someone tells you: “I know that there is a set process; I know that following standards makes sense, but I like to do my own thing, focus on some of the components, provide design costs, and not do a benchmark…”, what should you do?
Where are Responsible Board | Council Members to go to from Here?
There is no reason why stakeholders should not have a clear answer as to how much and which experience, expertise and practice is needed to conduct reserve fund planning. Respecting the REIC CRP approach would filter out inconsistent, and non-professional work. It is also the best way to normalise the different perceptions of board | council members.
The current landscape has many associations governing the practice of their members – technologists and home inspectors associations also provide RFS|DR post-training self-interest driven courses to their members.
There are very few cases of members being disciplined for shoddy reserve fund planning. It is expected that some owners might put some pressure on boards | councils regarding the quality of RFS|DRs being acquired, now that the Civil Resolution Tribunal (CRT) is in operation in BC.
An engineer cannot get away with claiming that a RFS|DR is not really an engineer report, since an engineer RFS report has gone to court. The result is that all engineer reports hold the same weight once they are stamped. The sooner REIC CRP standards are adhered to, the better. Adherence across the associations will benefit all stakeholders, while protecting the interests of the public.
Hoping that engineers will suddenly come to the cross-Canada REIC CRP functional approach is not actually relevant to your corporation’s needs. While professional associations need to collaborate more so that the REIC CRP standards are respected by all stakeholders, REIC CRP functional reserve fund planning writers will continue to advise condo | strata boards to schedule and acquire specialised trade and building science engineer reports – and use all available valid findings in their reserve fund planning.
The REIC CRP functional approach is already here for all stakeholders to rely on – as many corporations have across Canada since the 1990s. Doing a site-visit to produce anything but realistic renewal costs is unhelpful to boards | councils. Representatives must know how corporation assets are performing, what its current reserve fund replacement requirements are, and how much to have their owners put away in the reserve fund on a fiscal-year basis. All stakeholders are affected when reserve fund planning is not taken seriously.
What is the place of prescriptive current cost RFS|DRs done by engineers? Since most focus on current costs – and often exclude components while adding general contingencies – engineer current cost reports are only really valid at the time of initial construction. We suggest that this type of report be given to all developments before they are stratified, when current costs are actual, before inflation takes hold, and component performance changes occur.
Misconceptions will continue to surface until we all get past condoning these biases and agendas – we need to get on the same page. Bringing up these deviations cannot be dismissed as nit-picking – the issue is as fundamental as believing that there is more than one way to calculate net-worth.
The best way to stop the mind from perceiving a familiar pattern where none actually exists – seeing faces on the moon or falling back on erroneous reserve fund planning – is to adhere to a standardised method of comparison.
If you want to ensure that your corporation finances are on the right path, to set your reserve fund contributions based on a nationally recognised approach, to make sure that you are meeting your fiduciary responsibility to the corporation, to allow buyers to compare two units in two developments on the same footing, then please make sure that you are getting a REIC CRP functional reserve fund planning RFS|DR. We all depend on it.