February 2015
Uncertainty can be reasonably estimated! Uncertainty can and should be rationally managed!
Reserve fund studies are, by design, an attempt to predict the future. They are a best guess as to when funds will be necessary to maintain the infrastructure of a condo building.
As with all efforts to predict the future, every reserve fund study contains some degree of uncertainty. Many board members have a fear of that uncertainty; a fear resulting from a lack of understanding. They fear that some surprise costing hundreds of thousands of dollars will one day blind-side them. This can lead to what can be described as “slush funding” – arbitrarily allocating un-rationalized amounts of money to the reserve fund. These funds often come from operating surpluses.
This can result in an overfunded reserve fund.
The condo corporation should not be using its taxing power to obtain greater amounts of money from its owners than are needed for its effective operation. Condo boards should understand reserve fund study uncertainty to avoid over-funding of the reserve fund.
Uncertainty can be reasonably estimated! Uncertainty can and should be rationally managed!
Reserve fund studies are, by design, an attempt to predict the future.
A Reserve Fund contains five sources of uncertainty:
- Consistent underestimates on the part of the reserve fund study preparer such that the average cost estimate of repair or replacement components throughout the study is measurably below actual average cost;
- Board expansion of the scope-of-work originally contemplated by the reserve fund study preparer;
- Government actions such as tax increases or changes in building code;
- “Behind the wall” and other surprises. For example, opening a wall and finding unexpected corrosion or perhaps a code violation that must be corrected, or a burst water pipe that pours water into the lobby; and
- Discovery of an additional component that had been missed or not included in the original preparation of the study.
A reserve fund study includes two contingencies for dealing with these uncertainties.
Each reserve fund study contains a “contingency” that is usually found near the bottom of the study. This is a specific setting aside of a predetermined amount of money each year to deal with uncertainty. It is a “funded contingency”. When these funds are used to cover some underestimated project, they do not have to be repaid to the reserve fund.
The second contingency in a reserve fund study is not prefunded. It consists of the sum of all component estimates – millions of dollars – over the life of the study, a minimum of 30 years. This is a total amount of money estimated to be needed to cover all identified work in the reserve fund study. This total amount of money can be utilized, or tapped, when unanticipated work is necessary. These funds are available for use when reserve fund work is not fully funded and must be repaid.
The intent of this pool of money is to fund the total estimates of all components in the reserve fund study. If monies are “borrowed” to pay for unanticipated work it creates an underfunded situation. Those monies, which have been internally borrowed, must be returned to the reserve fund. These were not contingency funds and their use has created what can be described as an “unfunded contingency”. The amount of money borrowed becomes an “unfunded liability”. This situation applies in jurisdictions where “Cash Flow” funding is utilized. All Canadian provinces and most states in the USA operate in this manner. For jurisdictions utilizing “Full Funding” of the Reserve Fund, borrowing from this pool of funds is not allowed.
Condo corporations borrowing from this pool of funds must repay it to the fund. One way of doing this is to repay the money through an assessment to condo owners. Another method is to amortize the unfunded liability over the first 3 years of the next reserve fund study. That is, have condo owners pay a little more in fees each month to ensure the entire amount is repaid during the course of the next reserve fund study.
The five sources of uncertainty identified in this article can represent differing financial pressures and amounts. Assuming a condo corporation comprised of 200 – 250 suites:
- Underestimates of component expenses – Most preparers do a good job of estimating costs. Some estimates may be over and some under bringing an average to something in the order of +/- 2% – 3% of total expenditures. If total expenditures over the period covered by a reserve fund study is $30,000,000 a 2% – 3% margin of error, $60,000 to $90,000, over a 30 year period should be manageable.
- Board expansion of scope-of-work – This can vary greatly and is totally controllable by the board. Expansion of work from what is provided in the reserve fund study of $½ million to $1 million is likely to be beyond a funded contingency. Smaller amounts, from minor expenditures to perhaps $100,000 may be manageable.
- Government actions – The introduction of the HST added 8% to total 30 year expenditures. In the case of a $30,000,000 total the HST increase added $2,400,000.
