Is It Necessary To Fully Fund Depreciation?
Often when providing Reserve Studies we are asked, “When funding replacement reserves, should we adopt a Fully Funded Plan (funding accumulated depreciation) or is a Threshold Funding Plan (based on a cash flow analysis with a contingency) adequate?”
Before beginning this discussion, please understand that funding plan selection is of secondary concern. Adopting an inappropriate funding model is rarely the factor that drives a budget shortfall. The primary reason for a budget shortfall is the omission of readily apparent capital expenses. This happens when the capital reserve study is performed by a preparer who is inexperienced in reserve studies and in capital planning.
Get this: If your Reserve Study fails to cover ALL the capital needs to be encountered by an organization, your reserve study will fail to fulfill its intended purpose; you will eventually find yourself in a negative cash flow position.
It is imperative that the reserve components include more than just depreciable assets. Reserve components should cover ALL CAPITAL EXPENSES that are the responsibility of the association.
The NRSS (National Reserve Study Standards) offers a 4-part test that helps determine what expenses qualify for inclusion in a reserve study. An expense must meet all four of these criteria to qualify:
- Association Responsibility – The expense must be the current financial responsibility of the association. These expenses are typically associated with the common elements as defined by the association’s governing documents.
- Limited Useful Life Expectancy – The expense must have a “reasonably anticipated” limited useful life. The useful life limit does not have to be driven by physical deterioration. Functional or economic obsolescence may be enough to justify replacement.
- Predictable Remaining Useful Life – The next occurrence of the expense must be reasonably predictable. Wild guesses are inappropriate. A reasonable estimate can be based on the association’s history, the preparer’s judgement, qualified expert opinions, published data, etc.
- Minimum Threshold Cost – Finally, the expense must be more than what can be readily absorbed by the association’s operating budget. Also, if the expense is not knowable within a reasonable certainty after prudent research, then it fails this test.
By these metrics, every depreciable asset should be included as a reserve component, but so should such expenses as major building skin repairs, large painting projects, paving and concrete repairs, roof tune-ups, refinishing the pool, and major equipment overhauls. Remediation of construction defects can also qualify. All these can be considered capital improvements and can pass the 4-part test. Importantly, these are expenses that are beyond the scope of a typical operating budget.
Now that we have defined what goes into a reserve study, let’s move on to funding models.
Our argument in favor of the Threshold Funding Plan
A Fully-Funded Plan reserves for accumulated depreciation. If all relevant expenses are funded according to a fully funded model, excessive cash reserves will likely accumulate, far more than necessary to properly maintain the facility. This is a hyper-conservative approach. You can probably find better places to invest extra cash.
A Threshold Funding Plan is built using a cash flow analysis incorporating a minimum reserve fund balance, which varies with the overall size of the capital budget and with the association’s risk tolerance. A Threshold Funding Plan is usually adequate to fund capital expenses while avoiding excess cash accumulation.
These are the typical primary objectives for setting reserves among common interest real-estate properties.
- Ensure adequate funds are available to cover capital needs as they occur.
- Ensure everyone pays their share of all current and future expenses.
- Minimize the exposure for a special assessment.
- Avoid overfunding and tying up cash unnecessarily.
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,
- Re-evaluate the reserve components and recalculate the cash flow analysis every 3 years
- Include a contingency based on the factors unique to the facility; age, type of construction, quality construction and maintenance programs, etc.
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, the association will realize equitable participation in funding and minimal special assessment exposure.
In closing, just as it is important to have adequate funds, it is also important not to tie up valuable cash by over-funding reserves.
About the Author:
Rob Milam is CEO of zumBrunnen, Inc., an independent construction and building consulting firm founded in 1989
