This paper focuses on the fundamentals of a replacement-reserve study and reserve funding plan (Reserve Study). Discussions are based on nationally accepted standards, most specifically National Reserve Study Standards (NRSS).
The best practice in executing a Reserve Study is to first identify immediate and long-term needs by commissioning a comprehensive facility assessment of all fixed and movable assets (an assessment). Although not a mandate of NRSS, assessments should be performed by an independent consultant in accordance with the American Society for Testing and Materials (ASTM) e2018-2008 Standard Guide for Property Condition Assessments.
An experienced consultant will identify critical repairs, deficient and poorly executed construction details, and not only include them in the budgets, but also provide various options to complete or correct. Additionally, recommendations for improvements should be provided to improve marketability, safety, and efficiencies. For those wanting to be “Green”, include an evaluation of energy use and environmental impact by commissioning audits such as the ASTM e2797-11 Building Energy Performance Assessment, ASHRAE Energy Audits, or a LEED-Existing Building Operations and Maintenance (LEED-EBOM) pre-screen assessment.
To digress slightly, the subsequent budgets and funding plans of a Reserve Study are entirely founded on the assessment data and, therefore, are no better than this data. Unfortunately, many reserve-study service companies elect to utilize junior staff members to conduct the field inspection/assessment, which is then reviewed in the corporate office by the more experienced staff member. This is a cost-saving technique for the service company that may result in substandard results for the client. The quality of an assessment correlates directly to “experience-experience-experience”. To get the most accurate data, ensure the consultant conducting the field assessment has years of relevant field experience in construction, inspection, and assessment. I recommend engineers with a minimum of 20 years of directly related experience. Due to time and budget constraints, the consultant typically has just one opportunity to spot and recognize a problem. He will rely on his years of training and experience, and possibly his intuition, to know what areas of a building and systems to focus on, and most importantly, what exactly to look for.
Assessment data should be formatted in accordance with NRSS reporting standards. Furthermore, formatting should allow for filtering data by various factors and report parameters: unit costs, accounting codes, locations (buildings), various departments (cost centers), report terms, and interest and inflation rates. Implementing these reporting formats in conjunction with an assessment will not only provide an accurate funding plan, but also bring added value by identifying and minimizing repair costs, lowering operating expenses and environmental impact, and optimizing purchasing power. Such results will improve marketability, enhance margins, and help ensure goals or mission. Comprehensive assessments and the funding of reserves are the precursor to initiatives such as strategic short- and long-term planning, energy audit programs, and capital projects, such as planning and executing major improvement programs, renovations, expansions, or replacements.
Every property owner can benefit from assessments and reserve studies. The need to assess and fund replacement-reserves particularly applies to properties owned or maintained by a common interest realty association (CIRA) such as condominiums, time-shares, cooperatives, etc.; state or federal authorities; and many private sector owners. Most notable of the private sector include retirement communities, churches, schools and college campuses, hospitals, nursing and memory enhancement facilities, assisted living facilities, hotels, general assembly facilities, REITs, and other similar types of facilities and owners. Benefits apply to both for- and not-for-profit owners. These are owners with a commitment to long-term ownership, quality, and performance. HUD and the federal government mandate reserve studies for all their properties, and more and more progressive states, counties, cities, and corporations are getting on board.
Capital replacement funding plans by definition are limited to depreciable fixed and moveable assets. However, large ticket operating expenses that do not occur on an annual basis should also be included in the reserve funding plan; i.e. major infrastructure and building repairs, or equipment or system repairs, tune-ups and overhauls. These operating expenses still need to be accounted for, but cost segregated from the depreciable expenses for reporting purposes. This is probably the most common omission in forecasting future expenses. Accounting ledgers of fixed and moveable assets focus on depreciable assets with replacement planning mostly based on IRS depreciation schedules. This practice does not account for early capital replacements and more importantly, excludes some of the most significant expenses such as major repairs, overhauls, and tune-ups. If these expenses are not reported and funded, deferred maintenance and ultimately financial distress may result!
There are two fundamental pricing methods: (i) “documented pricing”, pricing based on actual historical data and local vendor and contractor pricing, and (ii) “published pricing”, pricing benchmarked to a national average and adjusted by a city index multiplier (such as RS Means); each method has its place and benefits. If you need pricing for each item and individual budget (or building) to prove accurate, then use documented pricing. For most all the above discussed property types, this is the best pricing method. Please note that there will be many similar items that have the same unit pricing, so not every item is a unique price. Consultants and owners familiar with historical data, and using software with the ability to pool unit pricing data and do automatic updates for inflation, prove most efficient in managing documented pricing.
For large portfolios where individual pricing for an item or for one budget (or building) total is not as critical, and what is most critical is the overall pricing total for the portfolio, then published pricing may be the best method. Published pricing brings consistency to the pricing process when (i) teams of people are pricing and (ii) when there are large portfolios of buildings, with a wide range of building types in various cities. There can be large swings in some numbers, but in the long run, the numbers should average out. What is most critical here is that the city index multiplier must be accurate. If the city index multiplier is wrong, then every number will be affected. Here again, the best scenario is when the portfolio encompasses properties in multiple cities. Such an example would be a state authority with buildings in multiple cities of varying sizes, ages, and types. Pricing on some individual budget items or buildings or city indexes may prove high or low, but overall, the totals for the entire portfolio of properties should average out.
Funding plans take into account annual capital expenses (and possibly other expenses), unit counts adjusted for occupancy rates, current reserve fund balances, and projections for inflation and interest rates. These are the data and parameters necessary to provide a complete funding plan.
The following discussions on Funding Methods and Funding Plan Types will help assist in understanding the fundamentals of the various funding plans developed in accordance with various national standards:
- Community Associations Institute (CAI) and their Reserve Professional Designation Committee (RPDC)
- National Reserve Study Standards (NRSS)
- Association of Professional Reserve Analysts (APRA)
- US Department of Housing and Urban Development (HUD)
Once completed, the funding plan should be reviewed and approved by certified professionals, especially when a funding plan is mandated by covenants or statutes.
The above noted national standards recognize up to three (3) primary funding methods for developing a funding plan:
- Component Method (aka Fully Funded Method): This method establishes individual reserve accounts for each component with funding based on accumulated depreciation; funds cannot be moved between accounts. Should the plan be determined to be underfunded, the shortfall is made up one of two ways: (i) underfunded components are funded per the “Catch-Up Period” of funding depreciation based on the remaining life, or (ii) by special assessment.
- Cash Flow Method (aka Proportional Funding): This method provides the minimum level of required funding to meet peak years; something less than 100% fully funded. The funding level is determined by amortizing the aggregate pool of expenses over the specified term of years; funds are pooled into one account.
- Special Assessment Method: This is essentially a pay-as-you-go plan, funding one year at a time.
Funding plans based on the Component and Cash Flow methods minimize the potential for special assessments and deferred maintenance and are discussed in the following article: Pros and Cons of Different Types of Reserve Study Funding Plans. Funding based solely on special assessments is highly susceptible to large variations in funding levels and increases the probability of deferred maintenance.
John H. zumBrunnen is the founder of zumBrunnen, Inc., an independent building consulting firm based in Atlanta, Georgia (www.zumbrunnen.com). The recipient of a BS in mechanical engineering from the University of North Dakota and a member of LeadingAge, zumBrunnen has 35 plus years’ experience in construction, assessment, and property development. He is the inventor of the FacilityForecast® software system and a respected speaker in the industry.