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Capital Reserves

With most capital markets now requiring reserves estimates, the prudent thing to do is develop one in the first place.

The practice of performing Property Condition Assessments is relatively straightforward. Building components are easy to define. One of the more variable elements of a PCA is the formulation of a Capital Reserves budget. For the purposes of this newsletter, we will define Capital Reserves — or rather Modified Capital Reserves, per ASTM subcommittee E50.02 — as "certain recurring probable expenditures for material components or systems impacting the subject property use and tenancy, which are not typically classified as operational or routine maintenance expenditures."

When to Request a Capital Reserves Budget

The first question to be answered is whether a Capital Reserves budget should even be part of a Property Condition Assessment. The standard delineation used to be related to the nature of the transaction. If the client was taking an equity position, a reserve budget was required. If the client was simply providing a mortgage or was intending to flip the property, such a budget might not be required. Today, Criterium Engineers provides a Capital Reserves budget on almost every assignment. This is because clients have come to understand the impact of reserves on the financial viability of the property. Furthermore, the source of funding is not always known at the outset. With most capital markets now requiring reserves estimates, the prudent thing to do is develop one in the first place.

Defining the Scope

Capital Reserves are not to be confused with deferred maintenance items or existing defects. These should always be reported and quantified. If a Capital Reserves budget is requested, several factors will determine the scope. The consultant must know the client’s specific needs before a reserve budget can be developed. The following factors define those needs.

1. What is the length of time to be used in the reserve?

Typical finance requirements call for the reserve calculation period to be equal to the term of the loan plus two years. However, if financing is not sought or the buyer has other interests, a different term may be more appropriate. How long will the property be held? Is there staff to manage maintenance and plan for future costs? Does management have its own well-developed understanding of costs?

2. What items should be included in the reserve?

This seems obvious but is actually one of the most difficult questions to answer. What items are covered by normal maintenance as opposed to being capitalized? Condominium associations, which have a lot of experience with reserve funding, typically spell out these items in their bylaws or other legal documents. Such is not the case with most commercial buildings.

Does the engineer consider carpeting? What about caulking? If the condition of the property is below market comparables, should improvements be considered? Should the engineer consider equipment that is tenant owned or maintained? After all, the tenant could leave, and that equipment would then become the responsibility of the owner. What about ADA upgrades? Should items be included even if they are relatively inexpensive?

Typically, Criterium Engineers uses cost sensitivity as a discriminating factor. Items that exceed $5,000, singly or in aggregate, are included in the reserve. The client is free to change that sensitivity. Other guidelines are also requested at the start of an assignment.

 

3. How should reserves be characterized?

Many investors and Wall Street rating agencies have developed benchmark reserve budgets. For example, apartments range between $200 and $350 per unit per year; office space ranges between $0.06 and $0.30 per square foot per year. These are useful reference points, but the range is obviously quite large. That may be adequate for underwriting purposes but not for effective property management. Using industry averages generally leads to plugging in the maximum numbers that work. It does not promote the highest potential use of the PCA, which is to improve planning and optimize costs to generate the highest operating income.

Another question that the user should ask is whether the numbers provided by the engineering consultant should be present dollars or inflated dollars. Assumptions about inflation will have a significant effect on cash flow. Further, the user and consultant must decide what to do about capital expenditures that are outside the study period. Using the condominium reserve study example again, it is probably a good idea to update the PCA on a regular basis. In that way, long-term items will ultimately be captured while there is still plenty of time to establish reserves.

4. What standard should the engineer use?

Many resources have been developed that provide estimated useful lives for virtually all types of building components. Of course, these are only averages. In the real world, these components perform differently as a function of many things such as the amount of maintenance, effects of weather, and unusual use and operation. It takes more effort but produces far more accurate budgets if the engineer takes the time to truly estimate the remaining useful life of all components rather than just look it up in tables.

Another consideration is the type of repair/replacement that is anticipated. In certain situations, system components can be changed at far lower cost than replacing entire systems. Again, this requires additional time and judgment to estimate.


Reaching Agreement


The choices of what to include in a Capital Reserves budget are many. Criterium Engineers recommends this simple checklist to ensure that your scope is the same as the engineer’s".

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The Engineering Advisor is intended to enhance your knowledge of technical issues relating to buildings. For additional information on any subject, please feel free to call us. Our commitment is to provide you with timely, accurate information.
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