December 2015
When a reserve fund study is undertaken numerous assumptions are necessary to determine what the proper reserve fund owner contributions should be.
While each condo board is required to establish its own investment policy, it is unlikely that most condo boards do little more than accept the assumptions made by others.
Two important factors affecting monthly owner contributions are interest and inflation rates. Unrealistic assumptions for either of these rates can result in an over or under funding of the reserve fund.
A study of over 50 reserve fund studies by fifteen reserve fund study consulting companies identified wide variations in the rate assumptions used. In this study, looking at one specific reserve fund cash flow study for a condo corporation, changing from historical averages to future expectations reduced interest income and required increased owner funding of about $25,000 per unit over a 30 year period.
Interest Rates
Assuming too high a level of interest income can result in a reserve fund deficit that will have to be paid by owners.
Assuming too high a level of interest income can result in a reserve fund deficit that will have to be paid by owners.
Selecting an interest rate based on 30 year historical rates assumes an interest rate of 1% to 2%. Narrowing this to 10 year historical rates raises the rate to 7% or higher. This higher rate of interest that is assumed suggests more interest income on reserve fund balances. The likelihood of this higher rate of interest in the near term is quite low given government actions, the housing market, government deficits and debt levels.
Inflation Rates
Using artificially high inflation rates may overstate repair and replacement costs in a reserve fund study thus overfunding the reserve fund. Using artificially low inflation rates could result in reserve shortages requiring that unanticipated reserve fund shortfalls be funded. Neither scenario is good for condo owners.
The inflation rate chosen can have a dramatic effect on repair and replacement costs in a reserve fund study. Some choose the Consumer Price Index (CPI) as an estimate for future inflation. For many reasons the CPI generally understates inflation. It often bears no correlation to repair and replacement costs in a condo building. Using artificially high inflation rates may overstate repair and replacement costs in a reserve fund study thus overfunding the reserve fund. Using artificially low inflation rates could result in reserve fund shortages requiring that unanticipated reserve fund shortfalls be funded. Neither scenario is good for condo owners.
Condominium boards should be looking at interest and inflation rates utilized in their reserve fund studies. Applying a reasonableness test along with some common sense rather than accepting the rates utilized in a reserve fund study without discussion could avoid future financial problems.
The study was undertaken by Graham Segger of MSA Research. Details on the study first appeared in the Fall 2014 issue of CondoVoice Magazine.
Toronto Condo News consulted with three companies that provide reserve fund studies for condo corporations – Brown & Beattie, CCI Group and Criterium-Jansen Engineers. All explain that their reserve fund studies use rate assumptions incorporating recent and long-term history, and future expectations. Current factors likely to result in use of higher rates for reserve fund studies include anticipated rate increases in the USA commencing later this month, domestic inflation and recent devaluation of the Canadian dollar.
