Many buyers purchase a condominium unit and start paying common element fees without truly knowing how the fees are used. Many owners remain in the dark about the true purpose of a condominium reserve fund and how it is managed. It is common for many new owners to assume common element fees are primarily used for amenities.
The details of how the condominium corporation manages the collected fees becomes much clearer for the small percentage of owners that join the board of directors for their condominium.
For those still unsure, monthly common element fees are used to fund the operations of the condominium corporation and are also used to support the condominium reserve fund. The reserve fund is used for repairs or replacements of any common elements of the condominium. The portion of the fees that are diverted to the reserve fund are prescribed by a periodic reserve fund study.
There are many issues that can be of major concern for condominium boards and owners with respect to their reserve funds. The following are some of the major issues that all condominium boards should be aware of.
Differing Engineering Opinions on Future Expenditures
Reserve fund studies are typically prepared by an engineering firm. The primary value of an engineering firm, with respect to a reserve fund study, is to evaluate the condition of the condominium building and provide a reasonable estimate of the future expenditures required to repair and replace components of the building. Condominium boards and owners rely heavily on the expertise of engineering firms to produce a reasonably accurate estimate of future expenditures.
An issue for condominiums stems from the fact that different engineering firms have different projections for future expenditures. In some cases the differences can be extreme.
From our research, the differences can exist for a variety of reasons including:
Engineering firms can take a conservative or aggressive view regarding the lifespan of a component that has a large historical variation in longevity
Engineering firms can have differing opinions on the method of repair or replacement which can drastically change the cost estimate.
Condominium boards have been known to push for changes in major repair schedules in order to reduce reserve fund requirements and in turn reduce common element fee increases.
Engineering firms project different inflation and interest rates. Firms will also differ on the amount of leeway they give boards to adjust their assumptions.
Condominiums that change their engineering firm to conduct a future reserve fund study can find that the expenditure schedule changes drastically. In turn, the common element fees paid by owners can increase or decrease drastically.
While obtaining a second opinion is always a prudent decision, in the case of reserve fund studies, a second opinion can introduce an unexpected jump in costs.
Human Biases That Lead to Under Funding
Condominium board positions are voluntary positions that go through an election process. As an elected volunteer, most board members would like to focus on serving the corporation to the best of their abilities without any confrontations or uncomfortable conversations with their owners. It's not a criticism of boards, just an explanation of human nature - we all tend to choose the path of least resistance. In general, people put more emphasis on negative outcomes and experiences than positive events.
How does this bias relate to the reserve fund? The management of a reserve fund requires few choices by the board. Despite that, these few choices will end up informing the larger strategy that millions of dollars of reserve fund money are put towards. A small bias toward safer or riskier investment will manifest and be magnified across time. It's our experience that due to the bias of avoiding conflict, boards sometimes fall in the trap of always choosing the safer investment path - which may or may not be what is needed for the reserve fund they are tasked with managing at a give point in time.
One way or another, on average, human biases will always take hold of those in positions of power, reverting behaviour to the mean and influencing decision making. We encourage boards to use software as a tool because of its stark objectivity and ability to turn what feels grey into black or white. By pairing human intuitions with software, we optimize our ability to make better decisions, and in the case of reserve funds; leading to a happier boards and owners.
Biases Toward Under Performing Estimates
Reserve fund studies, produced by engineers, provide an estimate of the yearly size of your reserve fund portfolio in the future. However, due to methods used to produce yearly estimates, projections can often over estimate future fund sizes.
Fixed Rate Assumption
Reserve fund studies need an assumption of interest rate for investment returns and an assumptions of inflation to adjust future expenditures. In the standard process fixed rates are used for the entire study.
In some case, boards are able to insert future interest rate or inflation rate assumption changes. Trying to predict a future value of a rate is not a good practice but many engineering firms will accept the input given by a board.
The best way to get a more accurate reserve fund study is to use a system that simulates many evolution of rates. By using many simulations, you can see a reasonable range of outcomes. Processes that create an evolution of rates typically use historical data and industry accepted quantitative financial techniques.
Holding Back Cash
Reserve fund studies also tend to over estimate the size of the portfolio in the future because they assume that the entire portfolio is fully invested to generate investment income. In practice, this is rarely the case.
Most property managers will hold back a portion of the reserve fund in cash. The cash is held to provide liquidity to cover the costs of any emergency issues that may arise unexpectedly. The amount of the reserve fund held in cash can be significant. Ultimately any balance held in cash will impact the estimate of investment returns.
It is important to note that the consideration of holding cash versus the reduction in investment income is rarely evaluated by property managers. Another point to consider is that payment to contractors are often done in the weeks or months after the performed work is completed. The assessment that is not often considered is the determination of how much cash could be accessible in a few months. By knowing the amount of cash you could access in a short window, you may still be able to mitigate emergency issues and keep more of your reserve fund invested.
Vertical City Institute
While there are other reserve fund challenges that condominiums face, the list above should be enough to demonstrate the need for diligence. Our mission at Vertical City Institute is to help all condominiums have a brighter future. Knowing what can go wrong is important so that you pay attention to the right things and ideally prevent anything from going haywire.