Understanding Capital Reserves
Ten years ago I had never owned a condominium, and was blissfully unfamiliar with collective responsibility for a property's maintenance and upkeep. That changed shortly thereafter when my wife and I were reviewing the financial disclosures for a purchase and were faced with a seemingly simple question: does this property have a healthy capital reserve?
It turns out that's a much more complicated question than we were prepared to answer at the time. Fast forward to today and we have served on the board of directors at multiple properties where we have been intimately involved with budgeting and planning for the future. With the guidance of everything from commercial property planners, to reserve study analysts, to day-to-day property managers. I feel like it's finally a subject I understand well ... and I wanted to use that knowledge to help others.
The Budgeting Cycle
The board of directors for something like a condominium project is typically responsible for drafting and approving an annual budget. This process ensures that there is sufficient revenue to cover both routine costs that come up every year, referred to as the operating budget, as well as setting aside enough to cover capital costs over the long run with contributions to a capital reserve fund.
This board generally consist of owners who may have no particular expertise in finance or property maintenance. They're an elected group of volunteers whose job it is to ensure that the collective investment is properly maintained with adequate funds for both short and long-term expenses.
Operating Budget
Predicting operating costs one year in advance is relatively straightforward, if frequently time-consuming. The bulk of the operating budget is fixed: paying for employee salaries and other pre-negotiated contracts. Other costs are fairly predictable, such as utilities and so forth that don't fluctuate much from year to year aside from inflationary pressures. Still, there's room for surprises with rate hikes, particularly in insurance, or an unusually cold winter or water leak that goes undetected for a prolonged period resulting in unsually high usage - but these can typically be handled with a modest contingency.
The real outlier, from an annual cost perspective, is likely to come in the form of capital expenses. You can go for many years between needing major roof work, but when it does come due the costs can be staggering. That's where the capital reserve fund comes in.
Capital Reserves
Capital expenses can and do vary wildly from one year to the next. The graph on the adjacent image is the actual year-to-year expense prediction for one of our properties. They really do vary that wildly! That's why it's essential, and typically legally mandated, that collective ownership such as a condominimum protect the interests of owners by having an adequately funded capital reserve that acts as a "shock absorber" for these big fiscal bumps in the road.
So the big question is: How Much is Enough?
In years with minimal expenses steady contributions should build up the fund, so when the big project needs to be taken care of you have more than enough set aside to cover it. Forecasting more than a couple of years out seems tricky but it's also absolutely essential. Trying to cover a multi-million dollar shortage in required funds with a special assessment will come as an unwelcome surprise to owners - and is a disincentive for buyers looking for a well-managed property.
The alternative is putting off essential maintenance you can't afford. It's one thing if an inspection says you don't need to do the work yet, that's just fiscal responsibility. It's another to put off work because you can't afford to maintain a roof that's just starting to leak, or a known structural problem because it hasn't led to the collapse of anything essential just yet. If you're lucky, failure to keep up with maintenance only leads to more expensive problems, and if you're less lucky lives can be lost.
It's essential to look out far enough to understand what your cash flow looks like over the long haul, and what level of annual contributions are required to meet your obligations. The annual budget can set you up for success, or it can lead you down a path to disaster, one year at a time. Your guide in determining the level of funding is typically mandated by law in the form of a periodic reserve study.
Reserve Studies: Pros and Cons
Here's what a professional reserve study can do well...
- Detailed cash flow analysis over a period of decades. While many may scoff at the idea of long-range forecasts, it's absolutely essential to anticipate major expenses even though they won't necessarily be required exactly when forecasted. You'll still need the money within a few years, and inflation just means the work will be that much more expensive when it is done. You'll be glad you've been saving regardless of exactly when it's needed.
- Funding level recommendations. Knowing how much to put aside to keep up with your obligations is the whole point.
- Steady guidance in the form of a "fully funded" figure. The meaning of fully funded is a complex topic addressed below, but the basic idea is simple: the fully funded figure represents how much you should have saved to be on track to cover every single expense when it comes due.
Here's what a professional reserve study can't do...
- Predict the future with any certainty. No fiscal forecast is a guarantee. The goal is get close enough so that dealing with the inevitable surprises is within your means.
- Provide interim guidance when assumptions change. Reserve studies happen only occasionally, so when you're planning an unanticipated project, or get an updated cost estimate that is well beyond expectations, it can be difficult to gauge the impact without an updated study.
- Replace detailed knowledge about your property. Reserve studies are based on a cursory review of major capital assets, not an in-depth inspection. They rely heavily on industry averages and self-reported information about past maintenance.
In practice, reserve studies can be a garbage-in / garbage-out proposition. With inaccurate, incomplete, or out-of-date records they will provide misleading guidance. Without knowledge about your specific property they may also rely too much on industry averages that don't adequately capture your needs.
They reflect a point in time, both in the state of the property and your knowledge about it. Between one study and the next you will get updated estimates, discover missing expenses, or otherwise invalidate the assumptions used to create the study. Waiting for the next mandated update means missing opportunities to make better informed decisions.
In short, reserve studies are necessary but they may not be sufficient. They're also difficult to interpret without a little extra guidance. Hopefully the next section will help to make it all a little clearer.
Making Sense of % Funded
If "fully funded" means you're on track to have saved everything needed for every expense by the time it comes due, then isn't 100% funding the only rational course of action? It turns out it's not that simple.
Having 100% of the required funds is really only necessary when every expense comes due in the same year. Under most circumstance you'll have some money set aside for expenses that aren't due yet, and it's a time-honored practice to draw from these funds to pay for expenses that are due today.
This amounts to borrowing from the future.
Isn't this dangerous and unsustainable? Not at all, if properly managed. The good news is we're never going to run out of future. There's always more of it, and there's not even any interest to pay when you're borrowing from your future self. The trick is ensuring that you're sufficiently funded to deal with the "lumpy" nature of capital expenditures - and that you're not getting progressively further behind until you run out of funds.
Consider the following graph of a hypothetical % funded level over a 30-year period:
The fact that it never hits 100% isn't the issue. It's the fact that it forecasts running out of funds entirely around 2031 that should give you pause and suggest immediate action to avoid this fiscal nightmare.
There are three essential variables that impact your cash flow over time. It's important to understand the role each one plays:
- Savings. This is what determines your initial % Funded level. One-time adjustments to savings, as from special assessment or a loan made to operating funds, will tend to move the entire graph up or down without changing its overall slope.
- Annual contribution. This determines whether your % Funded tends to get better, worse, or trend roughly flat over the long run. There will always be short-term ups and down any time you're not 100% funded because you're borrowing from the future and then paying it back over time. Trying to correct for this year-by-year with contribution changes is something of a fool's errand.
- Contribution increase rate. This controls whether the graph tends to follow an exponential curve or a straighter course. Annual increases that don't keep up with inflation will make the graph curve downward regardless of the initial slope. Matching inflation will keep the general trend on a straight line (which might be diagonally up, down, or flat.) Increases at a rate above inflation will make it curve upward over time.
In the graph above, the biggest takeaway should be that the present % funding level is simply too low. The slope as illustrated by the dashed trend line looks flat enough, but there simply aren't sufficient savings to absorb anticipated major costs. In this instance, a one-time assessment is probably justified if inspections and additional quotes aren't able to bring expected costs down.
Capital Plan is Born
This is effectively the history of, and the inspiration behind, deciding to write a full-fledged macOS app for capital reserve planning: Capital Plan. The goal was to make it possible to make better capital funding decisions by visualizing cash flow and expense forecasts in real time as changes are made, without having to wait for the next reserve study.
It has already helped multiple properties keep up-to-date records, make decisions, and save money in the years between required professional studies - while also being a tool for what-if explorations by the board, a site manager, or a treasurer and their finance committee.
Whether or not the app itself suits your needs, I hope some of these insights have been interesting and informative. The app's PDF manual is freely available to download, so you're certainly welcome to peruse it for more tips and insights into the capital planning process.