© 2013 UBC Real Estate Division

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.

Pros Cons

Zero-Balance contributions kept low

those who do not want to pay high

maintenance fees will be drawn to

this

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

Minimum Balance

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

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 over-

contributions by current owners

if a special levy is required, owners

wanting to sell their unit may find it

difficult to sell, or price affected

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

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

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© 2013 UBC Real Estate Division

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 Science

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

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 under-

funding a reserve.

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© 2013 UBC Real Estate Division

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

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© 2013 UBC Real Estate Division

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.)

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© 2013 UBC Real Estate Division

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.