A Long-Term Projection of Replacement Reserves

Transcription

1 A Long-Term Projection of Replacement Reserves Purpose This projection of Fairlington Glen s replacement reserves is a financial model, in Microsoft Excel, intended to estimate the effects of various assumptions on the association s eventual reserve balances, as well as its reserve funding ratio, over the next 20 years. It is also a stress test for the replacement reserves, intended to determine their adequacy throughout the period. However, it is not a forecast, as it relies on many assumptions that cannot be accurately estimated beyond a year or two, and it is biased by current economic conditions. The key assumptions, including inputs for reserve expenditures, inflation, interest rates, and the growth rates of operating expenses and reserve contributions, are all certain to change. Inflation Inflation is the most powerful assumption in the projection, and all other growth rates are tied to it. The rate of inflation is input at 2.8%, and remains at that rate for all 20 years. For reference, CPI inflation over the past 20 years has averaged 2.31%. Inflation can be volatile, of course. There have been notable spikes in inflation, such as in the 1970s, when inflation reached double digits. Over Fairlington Glen s history, , it has averaged 3.97%. A return to higher rates of inflation would necessitate higher rates of expense growth and reserve contributions, and invalidate these estimates. Expense Growth The starting point for the projection is the 2014 budget. The association s expenses are divided into two categories: operating and reserves. The operating expenses are assumed to grow at the rate of inflation, 2.8%, from 2014 through 2034, whereas reserve expenditures follow the recommended amounts from the 2013 REI reserve study, adjusted for future inflation. Reserve contributions are also assumed to grow at 2.8% annually from 2014 levels. In addition, reserve contributions are augmented by the interest income received on them because of the Glen s policy of reinvesting reserve interest income in reserves instead of spending it. Note that the projection assumes that the operating budget absorbs all of the tax on the interest income earned by reserves. Although that amount is zero in 2014, by 2027 the tax on reserve interest grows to 1% of the operating budget. Interest Income Interest rates have been at historic lows in recent years, below the rate of inflation, as the Federal Reserve has maintained a policy of quantitative easing since the financial crisis of 2008.

2 Recognizing that this situation is unlikely to persist for many years, I assume here that interest rates will gradually rise toward more normal levels, and eventually enable Fairlington Glen to earn higher yields on its certificates of deposit. Starting in 2015 at an overall interest rate of 0.50%, I increased the assumed rate of interest by 0.25 percentage points per year until reaching 2.0% in I also assume that only replacement reserves not needed for reserve expenses in the current year will be earning any interest, and that funds to be expended in each year are kept liquid for payments to contractors for the full year. Funding Ratio A key output of the projection is the funding ratio, which is the amount of replacement reserves divided by the accumulated depreciation of the association s common elements. The replacement reserves, net of the cost of some roof replacements that were in progress at year-end 2013, stood at $1,313,539. In the 2013 REI reserve study, the accumulated depreciation was calculated to be $6,619,893. Thus, the funding ratio was 19.8% at the end of Accumulated depreciation is also referred to as the full-funding amount, because an association with reserves equal to its accumulated depreciation would have funds sufficient to replace all its worn-out assets. It would be fully funded, with a 100% funding ratio. Each year, as the Glen s common elements physically wear out, accumulated depreciation grows directly as a result of decay. Also, inflation causes the dollar costs of replacement to grow even more over time. Therefore, we must account for both the physical decay of assets and the financial deterioration of dollars. In 2013, the REI study estimated a single year s physical wear and tear to be worth $301,746. The model increases this amount for inflation (compounding at 2.8%) each year thereafter. In addition, all of the Glen s previous accumulated depreciation is also increased by inflation. On the other hand, annual expenditures from reserves reduce accumulated depreciation, as reserve dollars are spent to replace worn-out assets. Thus, we can calculate each year s accumulated depreciation with this formula: Beginning-of-year accumulated depreciation Plus that year s inflation-adjusted annual depreciation Plus inflation adjustment for all prior years accumulated depreciation Minus annual reserve expenditures Equals end-of-year accumulated depreciation Meanwhile, the Glen s replacement reserves grow at a rate exceeding both the rate of depreciation and expenditure. Starting from a base of $588,410 in 2014, reserve contributions grow at 2.8% annually, and also earn interest that is contributed back to the reserve balance. The combination of positive reserve growth net of spending plus interest on reserves causes reserves to build up steadily over time (Exhibit 1).

3 Exhibit 1 Thus, both accumulated depreciation and the replacement reserves grow steadily over time, but the replacement reserves grow faster. The faster growth of reserves causes the funding ratio to rise (Exhibit 2). Under these assumptions, Fairlington Glen s funding ratio will rise from 19.8% in 2013 to 46.2% in 2023, 74.1% in 2028, and 94.3% by At that point, Fairlington Glen is almost fully funded, having almost dollar in replacement reserves for every dollar of accumulated depreciation. Reserve expenditures vary from year to year, following the 2013 reserve study s recommendations. The heaviest spending years are , when the parking lots are replaced. At that time, reserves fall sharply, but never below $3 million. The funding ratio drops slightly, and then resumes its climb toward full funding. Exhibit 2

4 Condo Fees In this study, condo fees are treated as a function of cost growth, and are simply an output of total costs. Since all costs are tied to the assumed 2.8% inflation rate, condo fee increases approximate that rate. Condo fees rise at a rate near 2.8% per year (in the range of 2.6% to 3.0%). The rate of increase varies because of fluctuations in interest income from replacement reserves, the level of which is driven in turn by the irregular pattern of annual reserve expenditures recommended by the 2013 REI study. In actual practice, future inflation rates will dictate the amount and volatility of condo fee increases, but since all of the inputs to this projection rest on the assumption of a single stable rate of inflation, these condo fee estimates are relatively stable as a result. In the projection, the percentage of condo fees consumed by reserve contributions will gradually decline from 39.9% in 2014 to 36.4% by 2034 (Exhibit 3). Both figures are well above the 20% of the total budget that went to reserve contributions a decade ago, when the Board recognized the urgency of increasing reserves. Exhibit 3 What-Ifs I tested the impact of earning different interest rates than described above on both the funding ratio and condo fee increases. My finding is that reserve growth is not highly dependent on higher interest rates. For example, holding the interest rate earned on reserves at 0.30% throughout the entire 20-year period only marginally slows the rise of the funding ratio. On the other hand, a spike in inflation could be very detrimental to the reserves, if not responded to properly. Raising the inflation rate, with the operating budget and reserve contributions

5 growing at the same rate as inflation, slows the rise of the funding ratio, because inflation increases accumulated depreciation. However, even at a high inflation rate, as long as the Glen Board raises condo fees in line with inflation, the reserve funding ratio will continue to rise, albeit more slowly. For example, even at sustained 10% inflation, with all parts of the budget rising at that same rate, the funding ratio reaches 45.6% in The risk of that scenario, of course, is that the Board would be under co-owner pressure not to raise fees in line with inflation, and rising replacement costs would not be met with commensurate reserve increases. Then the funding ratio would collapse. For example, in the 10% inflation scenario, if reserves were increased by only 5% per year, the funding ratio would drop to 6% by 2023 (assuming the parking lots are replaced as planned), and end 2034 at 9.6%. Conclusions The projection bears good news, with a caveat: Fairlington Glen s replacement reserves will be adequate for meeting the future capital expenditures recommended by the 2013 REI reserve study, if future budgets (and condo fees) simply increase at about the rate of inflation. The current level of annual reserve contribution, if also increased at a rate tied to inflation, is already high enough to raise the reserve funding ratio steadily over time, putting Fairlington Glen in a very strong financial position in 20 years. But to get there, the Board must maintain the financial discipline of raising each year s reserve contribution in line with the previous year s inflation rate -- for 20 years. William Worsley, CFA May 10, 2014

6 FAIRLINGTON GLEN Long-Term Budget and Reserve Projection Growth Rates (inputs for all years) CPI Inflation 2.8% Operating Expenses 2.8% Reserve Expenses From REI Reserve Contributions 2.8% Reserve Funding Ratio (output) % 5 Years 34.8% 10 Years 46.2% 15 Years 74.1% 20 Years 90.8% Blue indicates manual inputs 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Reserve Funding Ratio Year-by-year inputs Interest rate on Replacement Reserves 0.60% 0.30% 0.50% 0.75% 1.00% 1.25% 1.50% 1.75% 2.00% 2.00% 2.00% 2.00% Reserve Expenses (2013 dollars from REI) (392,542) (608,588) (310,900) (263,129) (343,763) (294,312) (171,146) (51,642) (20,765) (802,506) (1,307,256) (79,035) Reserve Expenses (future dollars) (392,542) (625,628) (328,554) (285,856) (383,912) (337,889) (201,988) (62,655) (25,899) (1,028,931) (1,723,026) (107,089) Output section Condo Fees 1,434,432 1,467,878 1,510,034 1,553,352 1,598,035 1,644,377 1,692,813 1,743,660 1,796,816 1,845,736 1,893,202 1,948,902 Other Income 9,268 5,900 6,758 11,566 17,229 24,994 36,765 53,892 75,714 70,888 52,483 66,439 Total Income 1,443,700 1,473,778 1,516,792 1,564,918 1,615,265 1,669,371 1,729,577 1,797,552 1,872,530 1,916,623 1,945,685 2,015,341 Operating Exp. (incl. contingency resv) 903, , , , , ,417 1,011,980 1,040,316 1,069,445 1,099,389 1,130,172 1,161,817 Replacement Reserve Interest Before Tax 7,052 3,900 4,758 9,566 15,229 22,994 34,765 51,892 73,714 68,888 50,483 64,439 Tax on Replacement Reserve 21% ,009 3,198 4,829 7,301 10,897 15,480 14,466 10,601 13,532 Replacement Reserve Contributions 533, , , , , , , , , , , ,552 Total Expenses 1,443,700 1,473,778 1,516,792 1,564,918 1,615,265 1,669,371 1,729,577 1,797,552 1,872,530 1,916,623 1,945,685 2,015,341 Reserve Beginning Balance 1,165,976 1,313,539 1,280,221 1,561,310 1,906,842 2,177,393 2,519,630 3,027,938 3,711,622 4,473,329 4,247,165 3,329,051 Reserve Expenses (392,542) (625,628) (328,554) (285,856) (383,912) (337,889) (201,988) (62,655) (25,899) (1,028,931) (1,723,026) (107,089) Replacement Reserve Interest Before Tax 7,052 3,900 4,758 9,566 15,229 22,994 34,765 51,892 73,714 68,888 50,483 64,439 Reserve Contributions 533, , , , , , , , , , , ,552 Reserve Ending Balance (December) 1,313,539 1,280,221 1,561,310 1,906,842 2,177,393 2,519,630 3,027,938 3,711,622 4,473,329 4,247,165 3,329,051 4,061,954 Net Reserve Growth 147,563 (33,318) 281, , , , , , ,707 (226,163) (918,115) 732,903

7 Beginning Reserve Full-Funding Amt 6,710,689 6,619,893 6,489,816 6,661,857 6,890,342 7,036,347 7,241,900 7,598,808 8,115,014 8,692,682 8,294,028 7,200,951 Inflation Addition to Full-Funding Amt - 185, , , , , , , , , , ,627 Annual Depreciation 301, , , , , , , , , , , ,852 Reserve Expenses (392,542) (625,628) (328,554) (285,856) (383,912) (337,889) (201,988) (62,655) (25,899) (1,028,931) (1,723,026) (107,089) Ending Reserve Full-Funding Amt 6,619,893 6,489,816 6,661,857 6,890,342 7,036,347 7,241,900 7,598,808 8,115,014 8,692,682 8,294,028 7,200,951 7,704,341 Reserve Funding Ratio 19.8% 19.7% 23.4% 27.7% 30.9% 34.8% 39.8% 45.7% 51.5% 51.2% 46.2% 52.7% Reserve Contribution Pct of Income 36.9% 39.9% 39.9% 39.7% 39.6% 39.4% 39.1% 38.6% 38.1% 38.3% 38.8% 38.5% Inside Clarendon Condo Fee (in 2013-equivalent dollars) Condo Fee Growth Rate - 2.3% 2.9% 2.9% 2.9% 2.9% 2.9% 3.0% 3.0% 2.7% 2.6% 2.9% 41% Reserve Contribution Share of Income $1,500,000 Reserve Growth Net of Spending 40% $1,000,000 39% $500,000 38% $- 37% 36% 35% $(500,000) $(1,000,000) 34% $(1,500,000)

8 Millions $14 $12 Reserves vs. Full-Funding Amount Reserves Full-Funding Amount $10 $8 $6 $4 $2 $ % 2.00% 2.00% 2.00% 2.00% 2.00% 2.00% 2.00% 2.00% 2.00% (22,229) (72,144) (91,478) (37,558) (290,040) (440,625) (137,722) (107,000) (538,019) (79,035) (30,963) (103,302) (134,654) (56,833) (451,178) (704,615) (226,402) (180,823) (934,673) (141,148) ,006,546 2,065,564 2,126,171 2,188,873 2,251,742 2,315,391 2,382,924 2,452,619 2,521,179 2,595,098 82,620 98, , , , , , , , ,395 2,089,166 2,163,676 2,239,904 2,320,554 2,394,316 2,464,492 2,548,745 2,636,919 2,709,777 2,804,493 1,194,348 1,227,790 1,262,168 1,297,508 1,333,839 1,371,186 1,409,579 1,449,047 1,489,621 1,531,330 80,620 96, , , , , , , , ,395 16,930 20,183 23,464 27,233 29,521 30,891 34,402 38,283 39,186 43, , , , , , , , , ,373 1,022,215 2,089,166 2,163,676 2,239,904 2,320,554 2,394,316 2,464,492 2,548,745 2,636,919 2,709,777 2,804,493 4,061,954 4,908,879 5,721,279 6,540,897 7,479,877 8,059,656 8,417,455 9,295,817 10,264,583 10,510,880 (30,963) (103,302) (134,654) (56,833) (451,178) (704,615) (226,402) (180,823) (934,673) (141,148) 80,620 96, , , , , , , , , , , , , , , , , ,373 1,022,215 4,908,879 5,721,279 6,540,897 7,479,877 8,059,656 8,417,455 9,295,817 10,264,583 10,510,880 11,599, , , , , , , , , ,298 1,088,462

9 ,704,341 8,309,399 8,870,828 9,428,722 10,092,496 10,393,296 10,462,223 11,024,804 11,662,606 11,578, , , , , , , , , , , , , , , , , , , , ,886 (30,963) (103,302) (134,654) (56,833) (451,178) (704,615) (226,402) (180,823) (934,673) (141,148) 8,309,399 8,870,828 9,428,722 10,092,496 10,393,296 10,462,223 11,024,804 11,662,606 11,578,694 12,300, % 64.5% 69.4% 74.1% 77.5% 80.5% 84.3% 88.0% 90.8% 94.3% 38.2% 37.9% 37.6% 37.3% 37.2% 37.1% 36.9% 36.7% 36.7% 36.4% % 2.9% 2.9% 2.9% 2.9% 2.8% 2.9% 2.9% 2.8% 2.9% 4.0% Condo Fee Growth Rate 3.0% 2.0% 1.0% 0.0%