Whether through normal wear and tear or because of a specific event like an accident or storm, it is a simple fact that major components of commercial properties will need to be replaced over time. In some cases the needed maintenance and repairs will be relatively minor and their cost can be paid from normal operating funds. In other cases, the cost may be such that paying it from operating funds would cause a major disruption in cash flow. Property owners need to prepare for these big ticket expenses by regularly “reserving” money from operational cash flow. These funds are commonly referred to as “replacement reserves.”
In this article, we will discuss what replacement reserves are in commercial real estate, how they are calculated, and why they are important to the health of a commercial real estate investment. By the end, readers will have a better understanding of replacement reserves and should be able to use this knowledge in their own evaluation of CRE investment opportunities.
At First National Realty Partners, we always include a line item in the operating budgets of our investment properties to ensure that they are property capitalized. This is both a best practice and a way to protect our investor’s capital. To learn more about our current investment opportunities, click here.
What Are Replacement Reserves?
Replacement reserves are funds that are set aside from a property’s normal operating cash flow to pay for the eventual replacement of building components that need to be repaired or replaced.
For example, suppose that a property owner estimates that they need to replace the roof on a multifamily apartment building in 8-10 years. Rather than incur the expense all at once in the future, they can set aside a little bit of money each month so that the expense is fully funded at the time it needs to be paid.
Why Replacement Reserves Are Important
The goal of reserving funds is to prevent any major disruptions to cash flow and to plan for big ticket expenses. For example, suppose that the above-mentioned property had $75,000 in annual cash flow available for distribution, but the roof was going to cost $100,000. If this expense had to be paid from operating funds in one year, it would wipe out an entire year of profits and then some. Surely real estate investors would be unhappy about this type of disruption.
Or, in a worst case scenario, the expense is so much that the owner has to go to investors and ask them to put in more money to fund it. While this is a somewhat common event, it can be tricky to message and could cause the property owner/manager to lose credibility.
Adequate replacement reserves are also important for lenders because they indicate a borrower’s ability to make necessary repairs. If they are unable to do so, it could cause a cascade of negative events for the property. For example, if the property falls into a state of disrepair, it could become unattractive to tenants. If the property loses tenants, it also loses income. If the property were to lose enough income, the borrower may be unable to make their required loan payments.
How To Calculate Replacement Reserves
The replacement reserve calculation is unique to each property and it requires detailed analysis and advanced planning.
The first step is to make a detailed assessment of the property to determine which items need to be replaced/repaired over a long period of time, say 10 years. Usually, this occurs prior to purchase, but it is also an ongoing activity. For example, the assessment may conclude that the parking lot needs to be resurfaced and that the HVAC system and roof need to be replaced.
Next, for the identified items, a further determination must be made as to when the repairs/replacements need to happen based on the remaining useful life of the building component. From the list above, suppose that the parking lot work needs to happen in three years, the HVAC system in five years, and the new roof in ten years.
With the time frame in mind, financial analysis must be performed to determine the cost in present day dollars. Then, this cost needs to be projected into the future to determine the cost at the time it will be incurred.
Finally, the total cost must be divided by the time until it will be incurred (usually months) and these funds must be set aside from normal operating funds. For example, suppose that the HVAC system replacement will cost $50,000 in 60 months. As such, the property owner should set aside $833 per month for 60 months. This way, they will have the full $50,000 to pay for the cost when it is incurred.
The bottom line is that the total replacement reserve amount is equal to the sum of all identified repairs, plus a cushion for unforeseen expenses. Each month, or year, a planned amount is set aside as part of the budgeting process to pay for these capital expenditures in the future. However, there may be some occasional disagreement over how these funds are classified on the property proforma.
Where Should Reserves Be Located on The Proforma?
Disagreements over the classification of replacement reserves centers around the question of whether they should be displayed above or below the Net Operating Income (NOI) line in the Proforma. In order to understand why this question can be controversial, it is first necessary to understand what Net Operating Income is.
Commercial real estate properties are valued based on the amount of Net Operating Income they produce and it is calculated as total income less operating expenses. For example, if a property had $1,000 in income and $500 in operating expenses, the resulting NOI would be $500. With this in mind, the question surrounding reserves is whether or not they should be classified as an ongoing operating expense, in which case they would be included in the NOI calculation, or if they should be classified as a one time expense, in which case they would be excluded. There are arguments for and against.
Technically, reserves are an operating expense in the sense that they represent an ongoing expense for the property owner. Under this argument, they would be included above the NOI line. When this is the case, NOI is lower, which could also result in a lower valuation. Typically lenders like to see it this way since it is more conservative.
On the flip side, the argument against it says that these are one time expenses that are incurred at certain points in time. And, when the money is set aside in a replacement reserve fund, it isn’t technically being spent, it is really being “saved.” For these reasons, reserves should go below the NOI line on the proforma. When it is done this way, NOI and property valuations are higher. Usually brokers and agents will do it this way to maximize value.
To illustrate the impact of this difference, suppose a property had to set aside $50,000 for reserves annually. If this expense was included as an operating expense, NOI is $200,000. If it is excluded as an operating expense, NOI rises to $250,000. At a 7% real estate cap rate, the difference in value is $715,000.
For borrowers and real estate investors, it is important to recognize where the reserve expense appears on the proforma and to understand how it impacts underwriting and valuation.
Replacement Reserves and Private Equity
As professional real estate investors, private equity firms should always plan for major expenses by establishing a reserve account for each of their properties. For investors, the important point is to determine if the reserve amount is sufficient to pay for future expenses.
Private equity firms are incentivized to minimize reserve expenses because doing so increases the amount of cash flow that could be distributed to investors in the short term, of which they are one. But, the best firms are realistic and are careful to adequately fund the reserve accounts because failure to do so ultimately hurts them in the long run.
Real estate investors working with a private equity firm should work to determine how reserves were calculated and do their own research to ensure they are sufficient.
Summary & Conclusion
Replacement reserves are funds that are set aside from a property’s operating cash flow to fund future capital expenditures.
From a real estate investment standpoint, adequate reserves are important because they provide the capital necessary to keep a property in good working order.
Calculation of the necessary replacement reserves is both an art and a science. Property owners/investors must evaluate each of the building’s major components and their remaining years of useful life. They must also calculate the replacement cost and then budget as necessary to ensure they have the required funds to replace the component when the time is right.
The placement of the reserve expense line item can be a source of debate. There are equally valid arguments for its placement above and below the NOI line item. For investors, it is important to recognize where it is and the valuation implications of its placement.
When working with a private equity firm, real estate investors should determine how the firm calculated the necessary replacement reserves and do their own due diligence to ensure they are adequate.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.