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Asset Management of Real Property – Part 2 of 9 – Replacement Planning and Budgeting

Replacement Planning and Budgeting Most providers struggle with how much repair and replacement reserve funds are necessary to ensure fulfillment of mission. Nationwide, most providers budget for replacement expenses on either a five- or ten-year budget plan, and rely primarily on historical data, depreciation schedules, and internal evaluations. Often, covenants establish reserve funds using depreciation […]

Replacement Planning and Budgeting

Most providers struggle with how much repair and replacement reserve funds are necessary to ensure fulfillment of mission. Nationwide, most providers budget for replacement expenses on either a five- or ten-year budget plan, and rely primarily on historical data, depreciation schedules, and internal evaluations. Often, covenants establish reserve funds using depreciation schedules. These budget processes are inherently in adequate and risky. The listing and assessment of all assets, and creating 20- to 30-year replacement reserve budgets, is the proper planning and budgeting process.

Forecasting repair and replacement schedules for any senior living community is a complex and detailed process. Replacement schedules seldom track with depreciation schedules, and for non-profit entities, there is no tax benefit to replace an item based on depreciation. Historical data is important in the budgeting process, but its application for forecasting future replacements can be erroneous, since so many factors can change.

For some, replacement timing is primarily a function of availability of funds, coinciding with either failure or obsolescence of an item. The more progressive and financially solvent a community is, the more factors there are to consider when making replacement decisions. Executing strategic planning methods will help manage the process versus reacting to it. One or more of the following drivers affect this process:

  • Financial strength – short and long term
  • Business model – progressive or defensive
  • Efficiency and obsolescence – when is it most cost beneficial
  • Changing demographics and competition – change in use
  • Covenants and contracts – financial and resident
  • Geographic location – climates and terrain
  • Government – changes in codes
  • Proper design, installation and ongoing maintenance – or lack of
  • Damage or loss – storms, fire, other disasters, vandalism, theft

There are four primary reasons to plan out 20 to 30 years versus budget planning with periods of time as short as 5 or 10 years:

1. Short-term projections will result in not reserving funds for those items with a longer life. Many of the most expensive replacement items have the longest life cycles; chillers, generators, roofs, etc.

2. If not all items are listed in a budget, then the likelihood of an item being overlooked for a period of years in a short-term budget is highly probable. This shortens the period in time to build up reserves for the item.

3. Reserves from year-to-year can fluctuate significantly. The 80/20 rule applies to most buildings where 80% of replacement expenses will occur around two periods during its life; i.e. for a 20-year design, these would be years 10 and 20. The more number of buildings involved, the more drastically the reserve amounts can fluctuate. A community may be stable at a relatively constant rate for several years, but then a time will occur when the replacement reserves can increase by multiple factors.

4. To minimize funding levels and fluctuations, begin replacement funding the year an item is placed into service.

To budget only 5 and even 10 years into the future is likened to driving a car at 70 miles an hour, and only looking 100 feet past the hood. You will be safe for the first 100 feet, but eventually you encounter an event for which you do not have sufficient time to react, and you crash.

To develop realistic repair and replacement data, the following considerations must be made:

  • Listing and amortization of all assets, regardless of life expectancy
  • Assessment of condition and life expectancy of each asset by experts
  • Pricing based on local and historical data, adjusted to future economic and environmental conditions
  • Proper forecasting of life cycles unique to each asset. Forecasts must reflect the various factors that impact replacement, such as business model and environment

To execute an effective replacement budget program requires a defined process and a qualified team. The process and team should be structured to ensure data will reflect the actual business model, and both the unique physical and financial needs of the community. This requires more than just in-house expertise. This is most successful in a collaborative environment with consensus where the team is a combination of an independent consultant(s) and the various department heads, managed by the executive office. Once complete, the provider should have a plan and budget they have ownership of, is affordable, and can readily maintain.

To ensure objectivity, the consultant managing the assessment and delivering the reports should have no conflicting business relationship with the community. Design professionals that have or may be engaged to provide strategic expansion planning, or project design and construction administration services, should not be the primary consultant. The potential to provide future services, or possible identifying design or construction deficiencies the professional is already a party to, may influence findings and recommendations. However, design professionals can and should play a role as a resource for planned strategic initiatives and modeling scenarios.

A successful asset management program requires assets be accurately tracked, assessed, budgeted, and funded. Accomplishing these fundamentals sets the stage for the final stages of the asset management process, establishing asset preservation and protection programs.

About the Author:

John zumBrunnen is Founder of zumBrunnen, Inc., an independent construction and building consulting firm founded in 1989. zumBrunnen has a BS in mechanical engineering from the University of North Dakota, completed the US Army Corps of Engineers Training Program in 1972, and is a member of LeadingAge and Community Associations Institute on national and state levels. zumBrunnen has 40+ years of experience in construction, property assessment, development, and reserve budgeting. He is the inventor of the FacilityForecast® software system and a respected author and speaker in the industry.