Often when providing Reserve Studies we are asked, “When funding replacement reserves, should we adhere to the national standards for a Fully Funded Plan (100% of depreciation) versus a Threshold Funding Plan (a plan based on a cash flow analysis with a contingency)?”
Before beginning this discussion, please note it has been our experience that one of the primary reasons for a budget shortfall, regardless of which plan is funded, is not due to selecting the wrong plan, but the omission of readily apparent expenses due to the inexperience of the consultant preparing the plan. For the following discussions it is assumed the consultant is suitably qualified.
First, one must clarify what is meant by funding depreciation. The point to make is noting a Fully Funded Plan funds far more than just depreciable assets. The plan must include the many expenses which are not depreciable assets; major skin repairs, painting, paving and concrete repairs, roof tune-ups, refinishing the pool, and major equipment overhauls are just a few examples. A plan, whether based on depreciation or cash flow, should include all expenses with a life beyond one year and a recommended minimum cost of $1,000, plus any life safety, code or critical repairs regardless of cost.
With these clarifications in mind, we have two observations pertaining to a Fully Funded Plan: (1) If only depreciable assets are funded, there is a very high probability that reserves will be underfunded resulting in a budget shortfall and special assessments; (2) If all expenses as noted above are funded, in most cases excessive cash reserves will accumulate, far more than needed to properly maintain the facility. Based on these observations, we find it difficult to justify a Fully Funded Plan, with one exception. If a catastrophic event occurs, there should be funds available to help address such an event, thereby limiting exposure for a special assessment.
Aside from having adequate funds available, there are two primary drivers for funding depreciation among common interest real-estate properties (condos, co-ops, time shares, etc.), which are (1) so everyone pays their share of all current and future expenses, and (2) to minimize the potential for a special assessment. We believe these are achievable with a Threshold Funding Plan based on a cash flow analysis. How?… by implementing these five parameters:
- Include all expenses with a life beyond one year and a minimum value of at least $1,000,
- Include all expenses regardless of their remaining useful life,
- Run the cash flow analysis for a minimum of 30 years, but never less than the longest remaining useful life,
- Realize the cash flow analysis must be recalculated each time after the year with the highest funding requirements occur, and
- Include a contingency based on the factors unique to the facility; age, type of construction, quality construction and maintenance programs, etc.
The consultant should help with contingency recommendations.
A primary reason reserves are underfunded when using a cash flow analysis is that most often some of the most expensive items with the longest remaining lives are excluded; above parameter number 3. For example, when the analysis is run for 20 years but a major expense such as a $500,000 chiller is excluded because it has a remaining life of 25 years.
When considering a Threshold Funding Plan, make sure the analysis takes into account the above five parameters. If these are followed and the consultant has done his job correctly, expectations for “everyone pays their share and the risk for a special assessment is minimized,” should be realized. In closing, just as it is important to have adequate funds, it too is important not to tie up valuable cash assets by over funding reserves.
About the Author:
John zumBrunnen is president and founder of zumBrunnen, Inc., an independent construction and building consulting firm founded in 1989 with offices in Atlanta, GA and Charlotte, NC. 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 the Association of Professional Reserve Analysts (APRA) and numerous other national and state associations. He has been a faculty member since 2003 for the University of North Texas, Coalition for Leadership in Aging Services (CLAS), a national certification program for aging services professionals (CASP), and authored their “Asset Management” training module. zumBrunnen has 40+ years’ experience in construction, property assessment, development, and reserve budgeting. He is the inventor of the FacilityForecast® software system and a respected industry author and speaker.