CPD 891: Fundamentals of Reserve Fund Planning. Review & Discussion Questions: Guide 5

Transcription

1 CPD 891: Fundamentals of Reserve Fund Planning Review & Discussion Questions: Guide 5 1. Define each of the following acronyms: CRC, FRC, CRFR, FRFA, FRFR, ARFA. CRC = current replacement costs FRC = future replacement costs CRFR = current reserve fund requirements FRFA = future reserve fund accumulation FRFR = future reserve fund requirements ARFA = annual reserve fund assessment 2. Explain the difference between the three reserve funding models. Discuss the pros and cons for each. Consider the perspectives of both current owners and prospective purchasers in your analysis. Zero-Balance Minimum Balance Pros contributions kept low those who do not want to pay high maintenance fees will be drawn to this ensures that there is always a minimum to cover reserve expenses and hopefully the fund is healthy enough that there is no need for special levies 100% Funded plans for reserve fund expenditures to ensure adequate funds on hand and no special levies are required prospective purchasers like this, as they see past owners have paid their share of the depreciation/use of elements during their ownership period gives perception of a financially sound condo/strata and may help preserve unit market values Cons owners may have difficulty raising funds to cover special levies owners wanting to sell their unit at time that a special levy is implemented, may find it difficult to sell, or price affected amount of time to fix an item may be delayed due to the time it takes to raise funds funds are not being invested for future repairs contributions may not be enough to cover future expenditures and a special levy may be required if the minimum reserve balance is set too high, this may lead to overcontributions by current owners if a special levy is required, owners wanting to sell their unit may find it difficult to sell, or price affected higher annual contributions required, current owners planning to sell in short term may not like this as they are putting aside their money for the benefit of future owners

2 CPD 891: Review & Discussion Guide 5 Page 2 3. Research some condominium/strata projects in your area, either through reviewing MLS listings, talking to real estate salespeople, or talking to unitholders. Try to find out the following information, for a comparative analysis: (a) What proportion of condominium/stratas have a reserve fund plan? If not, why not? (b) Which funding model do they currently have and what is their future goal? (c) What proportion of their monthly condo/strata fees goes towards reserve fund accumulation? (d) Have there been any special levies lately? Any projected in the near future? (e) Do MLS listings for condo/strata units in your area typically refer to the health of the reserve fund as a selling tool? Alternatively, have you observed a pattern in value reductions for unhealthy reserves and special levies? (f) Can you detect any pattern in market values of condos/strata units that have healthy versus unhealthy reserve funds? Answers will vary depending on examples found students are encouraged to post their findings on the course discussion forum. 4. "Preparing a reserve fund study is in some ways more of an art than a science". (a) Do you agree with this statement? Art Past experiences and observations are put into the analysis of building components Analyst must make prudent provisions for all anticipated contingencies, if and when they arise Although analyses are backed by research, many subjective assumptions must be made Forecasting future inflation and interest rates inevitably requires some degree of guesstimating, with the expectation of revising these forecasts when the study is updated. There are industry guidelines for the expected life of reserve elements, but this ultimately depends on the circumstances; as well, estimating effective age is highly subjective Science Involves in-depth research and analysis to determine various variables (i.e., costs, inflation rates, investment rates, etc) Technical site and building analysis, for identifying and quantifying common elements, establishing conditions, and estimating lifecycle Reserve fund study planning follows a defined step-by-step process. Costs for reserve elements are generally fixed within a certain range (b) In preparing a reserve fund study, there are some subjective decisions to be made. Is the analyst better off in general to err on the side of conservative or aggressive? Consider each of the following specifically: choice of inflation rate, interest rate, estimated lifespan of items. The judgment call here may boil down to whether it is better to err on the side of underfunding or overfunding a reserve fund, should an assumption prove wrong. An overfunded reserve fund gives an excellent cushion or safety net for unexpected repairs, but at the cost of current owners paying higher contributions than they should. An underfunded reserve fund gives little buffer and may lead to unexpected special levies, as well as possibly undermining market confidence in the condo/strata project as a whole. If we assume that fully funded reserves are considered a good thing overall, then the associated rule would be it is better for analysis to err on the side of caution, in avoiding underfunding a reserve.

3 CPD 891: Review & Discussion Guide 5 Page 3 Inflation rate Inflation rate assumptions will have a greater impact on long-term reserve fund estimates compared to short-term estimates. In a stable economy, the short-term inflation rate tends to stay within 1% of the current inflation rate. The average inflation rate in Canada over the past 10 years has been close to 2%. Taking this into consideration, it is probably best for the analyst to apply a conservative inflation rate trend, unless there is specific evidence to indicate otherwise. Interest rate This will depend on historical earnings of the reserve fund and investment strategies, along with future trends. This will show what return rates they were able to achieve historically, and gives the analyst an idea of what they may be able to achieve in the future. However, it is probably best to be on the conservative side, as overestimating returns that are historically not achievable is unreasonable. But, at the same time, it would underestimate the future return potential to assume an overly conservative rate (such as simply having the funds in a bank account). Estimated life span An analyst is probably better off in the long-run to be conservative in his or her life span estimates. Conservative life span estimates may require a higher annual contribution, but long-term owners will likely be willing to pay the difference to ensure an adequately funded reserve fund. Of course, this may not be favourable for short-term tenants and owners who are looking to sell in the near future. 5. Compare and contrast different strategies for make-up assessments. Regular Make-Up Contribution: used for a very short time frame to bring the strata/condominium to reach a fully funded level. Unlike other make-up assessment strategies, this requires a relatively larger payment(s) from current owners. Phased-In Make-Up Contributions: used to lower the additional contribution payments over a longer period of time than a regular make-up assessment. This works to distribute the burden between current and future owners of the strata/condominium. 6. Revisit the Case Study 5.1 model and spreadsheet. This assumes a building that has an unchanged highest and best use of more than 25 years. (a) What would be different in the analysis if the building was older and suffering from extensive physical, functional, or external depreciation? If the property has extensive physical depreciation, this will be reflected directly in the reserve fund study by shorter life estimates for components and presumably by the more immediate need for a larger reserve fund to replace these components. Functional and external depreciation are not likely reflected directly in reserve fund planning, as these contribute more to the building s overall usefulness and appeal, rather than the physical capabilities of components to fulfil their requirements. As a building approaches the end of its functional life, there will have to be decisions made about its future use, such as substantial renovation, change in use, or possibly demolition and redevelopment. Extensive physical depreciation will contribute to both immediate management decisions and the longer-term highest and best use conclusion. For the immediate, there is little benefit in repairing or replacing components in a building facing demolition it may well be wise for the management to defer or ignore many repair issues. As the property falls into disrepair, this will likely hasten the change of use decision. (b) How would you account for this highest and best use issue in your analysis? The timeframes for reserve fund studies are set by legislation, so the analyst may not have much choice in this. However, this would likely be a situation where the analyst would prepare alternative studies beyond the legislative minimum, exploring the impacts of shortened lifecycle estimates. The fully funded reserve plan is usually held out as best practices for condo/strata

4 CPD 891: Review & Discussion Guide 5 Page 4 management, but this may be one example where this is not the recommended strategy as it may not be in unitholders best interests to fund a large reserve for items that are not going to be repaired or replaced. Without question, if the analyst has doubts about the long-term highest and best use, this is something they must discuss with the board/corporation, and seek advice on how they wish to proceed. (c) For a condominium/strata corporation, consider what is involved in changing the land use for a collectively owned property how might a corporation facing this situation benefit from professional assistance? The trend to condominium/strata ownership in Canada began in the 1970s and advanced quickly into the 1980s, with many conversions of older, existing properties. These properties are now well advanced in age and many are suffering from poor physical and functional condition. In Vancouver and Toronto, where land values are high, there is increasing pressure on many of these properties to be redeveloped. However, the prospect of redeveloping these properties is a complex endeavour, as it requires uniting the opinions of many diverse unitholders, and in particular, convincing people of the need or economic advantage of demolishing their home. There may be a solid business case for this, both with mounting costs for maintaining an old asset and potential profit in redevelopment, but at the same time, housing is an emotional decision. For a single owner/investor in an old apartment building, the decision would be relatively straightforward; but with collective ownership, this type of conversion will not happen easily. There may be a business opportunity for real estate professionals to help condominium/strata complexes navigate these decisions, when highest and best use is in question and a change of use is imminent. (d) The current replacement cost of the common elements may approach the requirements of a reappraisal for insurance purposes. Is this a potential added client service associated with reserve funds? What other associated services may arise from this work? Reserve fund planners who are also professional appraisers report that insurance reappraisals are an associated source of work that can stem from reserve fund projects. Once a building s attributes have been identified and quantified, and the replacement cost of its common elements calculated, much of the necessary work has already been completed towards establishing replacement cost for insurance purposes. Where the insured cost is not optimal, appraisers may find a good opportunity to approach the board/council and offer to complete this reappraisal work. On a different note, other professionals may find that reserve fund planning can lead to other types of follow-up work. For example, engineering firms there is great potential to secure further contracts for building condition reports and remediation contracts for site/building elements. 7. Consider a condominium that has no accumulated funds in its contingency reserves. Its physical age is 30 years and as of this year it has required substantial repairs and replacement of common elements. The condominium board has had to implement a $40,000 special levy per unit, roughly 20% of the market value of units. If the board had implemented a fully funded reserve fund 30 years ago, what monthly contribution over this period would have avoided this special levy today? Assume an interest rate of 3% per year (annual compounding). Discuss the implications of this from a reserve fund planning perspective. With an interest rate of 3% per year, an annual payment of $840 over 30 years would equate to a future value of $40,000. This amounts to approximately $70 per month. (To be fully accurate, using monthly compounding, the payment would be $68 per month; there is also a slight difference if payments are assumed to be due at the start or end of each month.)

5 CPD 891: Review & Discussion Guide 5 Page 5 For reserve fund planning, the assumption is that a smaller increase in monthly fees is preferable to large special levies later. This is more equitable, as past owners contribute directly to reflect their usage of the property over time. It avoids the negative market value implications of large levies when announced, or the impact of fear and uncertainty leading up to their announcement. It avoids the difficult situation of enforcing special levies for owners who cannot pay. However, the one negative, perhaps, is that owners 30 years ago may have preferred not to have to pay an increased condominium fee for something that will benefit future owners long after they will have sold their unit. And keep in mind if this decision were to be made today, in light of a project expenditure to be made 30 years from now, it is these owners who will be voting on this issue! This highlights the difficulty of realistically achieving a fully funded reserve fund plan. 8. Consider two condominiums, one fully funded and with commensurately higher monthly fees and another that has a zero balance reserve fund, with low fees but a high likelihood of future special levies. What do you think are the market value implications for these two properties? How might an appraiser account for these differences in making adjustments? It is likely that purchasers would see the fully funded condominium as lower long-term risk and therefore higher market value. Or, put another way, the increased risk of the zero balance condominium would likely reduce its relative appeal and its value. Though purchasers also prefer lower fees, assuming the difference is not massive, a sophisticated purchaser (with professional advice) should be able to discern the benefit these increased fees lead to. This market value difference could potentially be accounted for in several ways. For example, if special levies are known or impending, it is likely purchasers will demand immediate price concessions for these known or anticipated amounts. If the special levies are in the longer-term future, the value adjustment may not be as direct perhaps more of a subjective percentage to account for risk. Or perhaps the appraiser might attempt to capitalize the deficit from full funding, to account for the benefit of the full funding property having large cash reserves on hand for the benefit of owners.