A Business Case for not making Reserve Fund contributions?
October 2014

Hockey season is well underway and my team isn’t yet eliminated from the playoffs – a few more wins and things might even be looking positive. Fall has been wonderful, with above seasonal weather, allowing us to almost finish the vast majority of our site inspections before the arrival of cooler temperatures and the fluffy white stuff.

Welcome to our October 2014 newsletter (our 50th monthly edition).
As always, we appreciate your questions and comments.

Ernie Paustian
Ernie Paustian

A Business Case for not making Reserve Fund contributions?

We were recently speaking with a property manager about the reluctance of some condominium owners to make reserve fund contributions, and in particular – commercial condominium owners. Our discussion turned to the belief among many business owners; that they would be better served by investing in their company – rather than placing funds in a reserve fund.

It is quite possible to begin making a business case for commercial condominiums which may support the position of limited reserve fund contributions, as is demonstrated in the Net Present Value (NPV) of future cash flow graph on selected 20 year cycles below.

In preparing the information, a number of assumptions were required:

  • that the estimated investment rate of 2.5%, financing rate of 6% and inflation rate of 2.5% would remain stable for the 20 year period;
  • that payment amounts were the same for all 3 scenarios – so the annual principal and interest cost = the leasing cost = the annual reserve fund contribution;
  • that a 20% premium would be earned before taxes on the annual principal and interest payment or lease payment for the equipment. Therefore, it was estimated that an annual return before taxes of the annual payment plus 20% premium would be generated as a result of the equipment investment;
  • we opted to make our model as simple as possible so we excluded real world issues such as the equipment remaining viable for the full 20-year period, excluding any repair or downtime costs, assumed consistent revenue & tax rates, and that the companies would continue to be a going concern. No consideration was given to capital cost allowance (CCA) half year rules, sales taxes or credits;
  • three tax rates of 10%, 20% and 30% were utilized to demonstrate how taxation changes the NPV. It was further assumed that the companies would be generating sufficient revenue to utilize the CCA and/or other income tax credits in the year generated;
  • In projecting the NPV, only the cost of one component was considered – a roof with an estimated future replacement cost of $500,000 in 20 years. A more diversified NPV model will be the subject of a future newsletter;
  • In calculating cash flows, it is assumed that the equipment is purchased and financed or leased at full cost (no down payment);

As the graphs represent a repair/replacement expenditure instead of an investment opportunity, with this scenario all of the estimated results in negative territory, with the values closest to zero representing the better results.

As indicated above, purchasing new equipment provides the most favourable NPV of the three scenarios due to the relatively high capital cost allowance tax benefits within the first few years. With the leasing option providing the next best NPV and finally the reserve fund contributions providing the final NPV results.

However, choosing how to fund (or not fund) the reserve fund based on the most favourable NPV of an individual condominium owner would be short-sighted for the Condominium Corporation. Making regular contributions to the reserve fund, along with maintaining at least an adequately funded reserve fund, would not be considered a poor business decision. We always recommend identifying the best solution for the individual Condominium Corporation.

Some of the intangibles and questions to ask:

  • Does the business owner hold the condominium asset throughout, or do they sell part way through? If they sell, is the asset price reduced because of a lack of reserve fund contributions?
    Alternatively, if they choose to make reserve fund contributions, how much of an increase in property value is realized upon selling?
  • What do the other owners within the condominium complex want to do? Do they truly understand any of the potential downside or risk?
  • When the roof replacement is required, will the business have the required cash flow, or will the replacement coincide with a downturn in the economy and limited cash flow?
  • What happens if the roof replacement is required sooner than expected?
  • Would the lack of reserve fund contributions be considered consistent with a fair and equitable practice amongst the other property owners, particularly in those properties with mixed commercial and residential uses?

One of the potential problems with providing these NPV graphs is the possibility for the results to be taken in the wrong context, or even worse – relied upon. We can’t overemphasize - this is a very basic model, with many assumptions. The results are intended promote discussion and are for demonstration purposes only. Relatively minor changes to any of the assumptions indicated here can produce significantly different results. We therefore recommend checking with your Reserve Fund Planner to fully identify the best option for the individual condominium corporation.

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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