Full funding – more than enough?
April 2014

April 2014 – It must be spring - The Stanley Cup Playoffs are well underway and the players on my favorite team are improving their golf swing…

Welcome to this month’s newsletter where we discuss a fully funded reserve fund, apologies again for the math.
As always, we look forward to your thoughts and comments.

Regards,
Ernie Paustian
Ernie Paustian


Full funding – more than enough?

Recent newsletters have focused on the potential problems relating to completing a reserve fund study using the Baseline and Threshold Funding Models. At the other end of the funding spectrum are Fully Funded models.

Some time ago, CHOA produced the following chart on the health of the Reserve Funds based on their funding level (View PDF PDF ).

For a reserve fund to be fully funded, the total accumulated depreciation within all of the components equals the balance contained within the reserve fund.

Fully Funded – 100% Funded. When the current (or projected) Reserve fund balance is equal to the Fully Funded Balance.

Fully Funded Balance – The amount of Total Accrued Depreciation equals the amount contained (or projected) within the reserve fund.

As an example and for the sake of simplicity, let’s assume a condominium has only 2 common property components – asphalt shingles and wood fencing. The shingles were replaced 15 years ago and have an effective age of 15 years, with a normal life span of 20 years. The fence was replaced 5 years ago with an effective age of 5 years and also has a 20 year normal life span – each component has a replacement cost of $20,000.

Accumulated depreciation =
Roof – effective age of 15 years divided by 20 year normal lifespan times $20,000 cost
  15/20 x $20,000 = $15,000
   
Fence – 5 year effective age divided by 20 year normal lifespan times $20,000 cost
  5/20 x $20,000 = $5,000


Accumulated Depreciation = $15,000 + $5,000 = $20,000 = Fully Funded Balance
Therefore, in order to be fully funded the reserve fund would require a balance of $20,000.

Ignoring any potential interest or inflation, in order to maintain the reserve fund at a fully funded level, contributions of $2,000 per year are required. This is because each component depreciates at 1/20 of $20,000 per year or $1,000 per year. Thus in 5 years when the roof is ready to be replaced, the fully funded reserve fund would contain $30,000.

Accumulated depreciation =
Roof – effective age of 20 years divided by 20 year normal lifespan times $20,000 cost
  20/20 x $20,000 = $20,000
   
Fence – 10 year effective age divided by 20 year normal lifespan times $20,000 cost
  10/20 x $20,000 = $10,000

Accumulated Depreciation = $20,000 + $10,000 = $30,000 = Fully Funded Balance
Therefore, in order to be fully funded the reserve fund would require a balance of $30,000.

Assuming the roof is then replaced:
Accumulated depreciation =
Roof – effective age of 0 years divided by 20 year normal lifespan times $20,000 cost
  0/20 x $20,000 = $0
   
Fence – 10 year effective age divided by 20 year normal lifespan times $20,000 cost
  10/20 x $20,000 = $10,000

Accumulated Depreciation = $0 + $10,000 = $10,000 = Fully Funded Balance.
Therefore, in order to be fully funded the reserve fund would require a balance of $10,000.

As indicated above, contributions of $2,000 per year are required to maintain full funding until time of fence replacement in 10 years, when the cycle repeats again.

In this simple example the overall dollar value is quite low and there are only two components. However it is very common for condominium complexes to have more than twenty components and total repair costs that range from several hundred thousand to several million dollars.

Although typically well protected in the case of early component failure and therefore less likely to be the subject of a special assessment, nonetheless, a fully funded reserve fund may potentially have other concerns (and the topic of a future newsletter):

Larger than required reserve fund contributions and the possibility of overfunding;

An assumption that the components will be replaced in perpetuity (and that the condominium will last forever);

The potential for a change in reserve fund policy;

Significant reserve fund balance upon dissolution.

Our previous newsletters have included the term fair and equitable on several occasions. For the most part, it’s my belief that a fully funded reserve fund typically contains a higher level of funding than necessary and is therefore not fair and equitable. Of course, there are always exceptions…

Thank you for taking the time to read our newsletter. At Delta Appraisal, we work with Property Managers and Board Members to set realistic budgets and to prioritize maintenance and repair projects. Our functional Reserve Fund Studies are unbiased. We are not competitors in property management or maintenance.

For more information about Delta Appraisal and our easy to read Reserve Fund Studies or to request a no-cost, no-obligation proposal, please contact us.

 

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