Your Condo Reserve Fund – Understanding Your Most Important Financial Asset

May 2014

A Guide for Condo Boards and Residents

Your Condo Reserve Fund is a guide designed to help condo owners and boards understand the Reserve Fund. It has been prepared by Harley Smith in collaboration with Toronto Condo News.

Harley served on the Board of Atrium II for six years. As Chair of its Building Committee, Harley began to focus on Reserve Fund Analysis after realizing that his own building’s reserve was underfunded. With a background in pensions, which are reserve funds on a much larger scale, Harley became aware of a funding gap that could have resulted in a major assessment nine years in the future. He made the Board and Finance Committee aware of this and convinced them to embark on a three year catch-up program to prevent the need for a Special Assessment. Harley also served as Treasurer and Chair of the Finance Committee for Atrium II.

Atrium II was 2012 Condo of the Year in Toronto.

Your Condo Reserve Fund was first published in Yonge-Sheppard Condominium News in three installments.

Part 1 The Condo Reserve Fund

Part 2 Reserve Fund Details

Part 3 The Reserve Fund Study

Your Condo Reserve Fund is available in the Condo Archives at www.TOcondonews.com.

One of a condo corporation’s most valuable assets is its Reserve Fund. This fund contains money necessary to maintain the physical infrastructure of a condo building. Properly managed, the Reserve Fund ensures a building is well maintained. It helps to raise both the standard of living for condo residents and the resale value of condo units. A poorly managed Reserve Fund can result in a lower standard of living for residents while making it harder to sell condo units. It can also lead to an unexpected Special Assessment or higher monthly common element fees which, if unpaid, can result in loss of one’s home.

Reserving is more complex and has more rules than the standard operating account through which most condo bills are paid. It involves more than depositing funds into a bank account, paying bills and ensuring cash flow remains positive. Thus, some directors shy away from reserve fund management. They abdicate an aggressive role in its management and may suggest this is to be left to experts.

The purpose of this guide is to unravel some of the mystery surrounding reserve funds. Relevant sections of the Act and Regulations are referenced to assist others in exploring areas of interest in more detail.

(All references to “the Act” mean the “Condominium Act, 1998” — Ontario Statutes)

The Condo Reserve Fund (RF)

The Condo Reserve Fund is, first and foremost, a pool of money. It is set aside and invested for the purpose of repair and replacement (R&R) of the many elements in your building that will ultimately require maintenance.

Fund income is collected from owners along with the monthly expense fee. Earned interest is included in the assets of the fund.

The Act defines those elements that will require maintenance as “components”. Structural, mechanical and aesthetic items that will one day require R&R are defined as “component inventory”. A checklist of all possible components may exceed 400 items. Size and the complexity of the building will determine the number of components in your inventory. It can vary widely but in a typical high-rise building may range from 100 to 200 components.

The Act rigidly confines the use of reserve funds to R&R. It implicitly excludes all other uses – most notably, and perhaps counter intuitively, capital expenditures. Occasionally, some refer to the Reserve Fund as a “capital account”. This is an incorrect use of the term – an absolute misnomer.

Consider a condo that does not have a guest suite but desires to add such an amenity. The capital cost cannot be charged to the Reserve Fund. It is an operating expense. The board of a condo, with this objective, may utilize a couple of funding strategies;

1. consciously accrue an operating surplus over one or more years large enough to cover that capital expenditure, or
2. accrue the funds in a separate operating account designated for the purpose.

Ultimate control and interpretation of “eligible expenditure” in the Reserve Fund is exercised by the corporate auditor. No board ever wants its audit report containing a note that says in effect “In our opinion the Board is in violation of the Act”. Thus, when there is doubt or ambiguity about a possible Reserve Fund expenditure, there is abundant wisdom and prudence in checking its eligibility with the auditor in the initial planning stages.

A board may elect to charge any eligible Reserve Fund expenditure to the operating budget. Charging operating expenditures to the Reserve Fund, however, is not a common occurrence.

The board does not require the consent of owners to make any expenditure from the Reserve Fund. Expenditures from the operating fund that result in “substantial change” (as defined by the Act) can require owners to authorize the change by votes in favour ranging from 66 2/3% to 90% depending on the extent of the change.
Source: The Act, Section 93 (1) & (2), Section 95 (1) and Section 97

Reserve Fund Details

Benefits of maintaining and prefunding the Reserve Fund

There are four important reasons to maintain and prefund the Reserve Fund;

1. Proper planning will ensure that money is always available to meet the maintenance challenges that every single building inevitably faces.
2. It simplifies the owner’s charges to a predictable annual amount to be included in the monthly common expense fee making the owner’s personal financial management much easier. The alternative approach – PAYGO or “pay as you go” – could have an owner contributing a few hundred dollars to the Reserve Fund in one year then tens of thousands of dollars in the next year with little advance warning. PAYGO results in a substantial and constant variation in annual contributions to monthly maintenance fees.
3. When planning is done poorly and inadequate monies are reserved, the dreaded “assessment” is the consequence. In such instances the Board must simply bill every owner with a proportional share of the unfunded liability usually (but not always) requiring payment in a relatively short time frame.
   Assessments resulting from Reserve Fund shortfalls are always the result of incompetence or naive and uninformed planning. It may have been prompted by political pressure to keep fees low – below their required level. That practice is a “ fly now, pay later game” with a rude awakening at the end. Assessments are often in the $10,000 to $20,000 range but have ranged as high as $100,000. They can cause financial hardship to some owners and even require the remortgaging of suites. High net-worth individuals could be forced to disrupt good investment planning by requiring the sale of securities at a less than an optimal moment.
4. The issue of fairness. Some might ask “Why should I pay to repair elevators (or any project) that will be done years down the road?” The answer is simple – because that current owner is causing wear and tear on those elevators today necessitating tomorrow’s repair. It is fair that those who perpetrate the need for repair pay for it. If you loaned a tool or household appliance to a friend and that person wore it out, you would reasonably expect to be compensated.

Establishing the Reserve Fund
All aspects of timing are carefully defined by the Act and Regulations. A condo corporation must establish a Reserve Fund at its inception. Contributions to that fund are dependent upon amounts determined within a current Reserve Fund Study. New condos that have not yet undertaken a Reserve Fund Study follow a standard formula. The Act requires a contribution of 10% of the operating budget to the Reserve Fund until the first study is accepted. At that point, the requirements of the Reserve Fund Study determine the contribution level.

As a condo building ages the contribution to the Reserve Fund will rise as a percentage of the common expense fee. Because each building is so different in its requirements, there is no formula that drives the percentage. For older buildings the proportion of the owner’s dollar going to maintenance as opposed to operating expenses will increase. Very much as a generalization, a building that is 25 years old may see the percentage increase to 25% – 30%. It is unusual for the percentage to reach 32%. If the fund has been poorly managed and is in catch-up mode there is no guideline.
The act requires that monies designated for a Reserve Fund be maintained in a separate bank account; administered, invested and accounted for separately from operating funds. Thus, a separate bank account and brokerage account must be established. Your property management  company will normally provide guidance and administer the bank account.

Managing Reserve Fund Assets
The condo must establish one or more brokerage accounts in Ontario with a Schedule I or Schedule II bank (as per Bank Act of Canada); a trust company, a loan company or a credit union. The institution must also be a member of the Investment Dealers Association of Canada and insured by the Canadian Investor Protection Fund. Investments must be registered in the condo corporation’s name or held in a segregated account under the name of the corporation.

Investments must be made in “eligible securities” as defined by the Act. The definition is made up of only very risk averse, fixed-income securities. This includes; bonds, debentures, GICs, deposit receipts, term deposits and/or similar financial instruments issued or guaranteed by the Government of Canada or a Canadian province. Rules are the same for both operating fund and Reserve Fund investments with one exception; operating fund investments must have 90 day liquidity. There are no liquidity restrictions on Reserve Fund monies.

By resolution, the board must authorize one or more directors to give trading instructions to the broker. The financial institution will require such authorized persons to complete all forms applicable under Federal law for such persons with this authority. The forms are both onerous and invasive to the person’s personal financial status but are held in confidence by the broker.

The board must have an investment plan that ensures liquidity of assets to respond to the cash requirements of projects scheduled for repair. Typically the rate of return on a brokerage account will be higher than on the checking account. For this reason monies should be retained in the brokerage account as long as possible. Careful planning and proper timing of investment vehicle maturities should ensure “just in time money” transfers from the brokerage account to the checking account. Source: The Act, Section 115 (1) – (8)

Responsibility for the Reserve Fund; planning, management and administration
The condo board is ultimately responsible for the Reserve Fund and will usually appoint the treasurer as the officer responsible for its management, administration and investment.

The Reserve Fund Study (RFS)

Integral to Reserve Fund management is the Reserve Fund Study. It is a strategic plan intended to bring order to the process of maintaining your building. The Act requires the Reserve Fund Study to cover the next 30 years. It is a two part plan.

1. It estimates the cost to repair or replace each component. It also identifies the most probable year during which those repairs/replacements will be required by determining the remaining life expectancy of each component. Costs are inflation adjusted.
2. It then plans for the funding of those costs. This is an exercise in financial planning and is called the “funding plan”.

The Condo Act requires that the Reserve Fund Study be carried out under the direction of a qualified preparer as defined in that Act. The preparer is responsible for the quality and accuracy of the engineering. The Act also defines or specifies many of the processes and standards under which the plan is prepared. Competent preparers know and understand what is required of them.
While the Act does state that a Reserve Fund Study must be undertaken and that it cannot be done internally, there is abundant common sense in creating a plan that provides:

1. a very good estimate of the cost to maintain your building over the long run and when repairs or other work is likely to be necessary;
2. for the orderly and smooth collection of funds in advance so that when repairs are needed, money will be available;
3. ample opportunity for the board to prepare for major projects, and also to plan for and alert owners to the disruptions and personal inconveniences that accompany many big projects.

Source: The Act, Section 94(1)

The preparer normally recommends a funding plan. The board is ultimately responsible for the funding plan and may alter the preparer’s recommendations.

There are times when a board alters the plan for political reasons. This may be for the simple reason of reducing monthly fees. When this kind of motive is operative, fiscal trouble lies just down the road. The board’s funding plan must be financially sound for the long term. The Act says it “must be adequate for the purpose for which it is established” but fails to define “adequate”. Thus, much controversy exists surrounding the specific meaning of this clause. What is clear is that a plan which is not financially sound for the long term is likely to result in higher costs to the corporation than what is anticipated in the plan.
Source: The Act, Section 94 (8); Regulations under the Condo Act, Section 33 (1) & (2)

The preparer is selected by the board and is usually under some form of contract to do the study. Most frequently an engineering firm is selected. Oftentimes the preparer is simply referred to as “our engineer”. Frequently the engineering firm selected as preparer is one that provides consulting services and performs engineering work for the condo on an ongoing basis, generally referred to as the “engineer of record”. Working with an engineering firm familiar with your building – its strengths and weaknesses – is advantageous. It facilitates rapid identification and prioritization of the building’s maintenance needs.

The Act/Regulations defines three kinds of Reserve Fund Studies and identifies them as Class 1, 2, or 3. The difference lies in the amount of detailed inspection and examination required by the preparer. Less detailed work leads to less time and lower cost. A Class 1 study, labeled a comprehensive study, is the most rigorous and detailed. A study of one type or another must be done every three years. Over a ten year period at least one of the studies must be a Class I (comprehensive) study.
Source: The Act, Sections 27 & 28

Creating a Reserve Fund Study

The preparer of a Reserve Fund Study must;

1. assemble and review all relevant plans, documents, warranties and guarantees (relating to the building construction and alteration), its grounds and underground accesses, along with current maintenance/service contracts; and
2. conduct such visual site inspections of components as are appropriate, and where needed conduct appropriate engineering tests; and
3. interview appropriate corporation directors, officers, employees and agents primarily to determine board plans and policies, but sometimes contractors may be consulted if they are in a position to expose deficiencies.

Source: Regulations under the Condo Act, Section 30 (1) – (5)

A preparer will utilize a Reserve Fund Study template, frequently a complex Excel spreadsheet with many algorithms. The preparer will input data and supplement this document with a detailed narrative that analyses and reports the building’s condition.

It is common to include a “contingency” line to buffer against the reality that it is impossible to estimate expenditures with pin-point precision. The amount may vary widely – but something in the range of 5% to 10% of the total value of all expenditures is reasonable. Amounts will be spread across all years of the study.

Funding Options for Reserve Fund Studies

Reserving is the process of prefunding any matter of importance. Pension plans are prefunded to provide for employee retirement. You might decide to “save up” for a big vacation down the road.

There are two funding methods that can be used in Reserve Fund Studies:

1. The “Cash Flow Method” (CFM) embodies the notion of a “pool” of monies made up of the sum of all inflation adjusted estimates plus relevant taxes. It allows that over and under estimates on any given project be part of the pool and require no specific project-by-project accounting.
2. The ”Full Funding Method” (FFM) requires that the estimate in respect of each project is separately accounted for. Any expenditure over the estimate requires subsequent special approval and advice to owners.

Regulations (Sec. 29(v)) in Ontario prescribe the CFM. Similarly all Canadian jurisdictions and most American states prescribe this method. A few states prescribe the FFM.

Timing for Reserve Fund Studies

New condos must have a first study done within one year of registration of its declaration. Once established, all condos must have studies done within three years of the previous study. However, the board may elect to have a study completed in less than three years. Under normal circumstances more frequent studies are not required. In the event that a major project goes very seriously over the estimate, or should heretofore unidentified components of significant size be added, it becomes prudent to redo the study to ensure an adequate and appropriate funding level. On rare occasions a government action may prompt an early study. When the HST was introduced, it hit condos and in particular the Reserve Fund very hard. It would be a matter of board strategy if, when and how to replenish the fund(s) to avoid any anticipated financial shortfall.
Source: The Act, Section 94 (4) & (5)

Responsibility for the Reserve Fund Study

The board bears ultimate responsibility for the Reserve Fund Study. It usually delegates liaison activities to the treasurer, committees or the property manager. If the condo has a building committee and/or a group responsible for building aesthetics, they may have significant input to the study. The preparer is responsible for the engineering, other analyses and for the recommendations in the study. This includes accountability to their professional association and the body that licences them to practice. The board bears ultimate responsibility for the funding aspects of the study. There is a taxing dimension, and possibly political considerations, that should be considered by the board. Each owner’s share of funding is added to and forms a part of the monthly common expense fee.

Section 32 of the Regulations defines who is qualified to be a preparer and, in summary, lists the following;

• Architects and Architectural Technologists
• Engineers and Engineering Technologists
• Ryerson graduate with certain defined degrees
• Professional Quantity Surveyors
• Accredited Appraiser, Canadian Institute
• Real estate agents with the designation of Certified Reserve Planner.

A preparer must be properly insured.
Source: The Act, Section 94(6); Regulations under the Condo Act, Section 32(1),(2),(3) & (4)

Since the task is so focused on engineering, a majority of studies are done by engineers or their related technologists.

There are a number of persons not allowed to undertake a Reserve Fund Study by virtue of potential conflict of interest. They include a director, an officer, property manager, owner, or their spouse et al. The preparer must have an arms-length relationship to the condo corporation.
Source: Regulations under the Condo Act, Section 32 (2)

Communicating the Reserve Fund Study to Owners

Within 120 days of receiving the Reserve Fund Study from the preparer, the Act requires the board to review it, prepare a funding plan and accept the study. Within 15 days of acceptance the board must provide owners with a summary of the study and the funding plan highlighting differences in the preparer’s recommendations and the board’s final plan. Board representatives can and should work with the preparer in the preparation of the funding plan. This facilitates agreement of the funding plan prior to its presentation to the board and reduces the likelihood of changes to the plan.
Source: The Act, Section 94 (8) & (9); Regulations under the Condo Act, Section 33 (1) & (2)

The Regulations require that the notification to owners be in a prescribed format known as the “Form 15″ and the attached Cash Flow Statement”. This is the distillation of great quantities of mathematics and evaluation into one page to aid in understanding the plan over the prescribed 30 years. It reveals the annual increase in contributions to the fund in each of the 30 years and additionally shows the total cash contribution, estimated expenditure, estimated interest income and estimated closing balance for each year.
Source: Regulations under the Condo Act, Section 33 (3) – See also Section headed “Form 15”