If you are not familiar with the concept of a reserve fund, we suggest you read the following article before reading on: 🌐A Strong Foundation: The Crucial Role of the Reserve Fund.
An integral part of managing the reserve fund is enlisting specialists – engineering firms – to produce a reserve fund study to determine the strength of the fund vs. expected expenses. These reserve fund studies must be produced every three years, as per the Condominium Act, 1998, of Ontario. The condominium board might request studies from multiple engineering firms, discern which one they will use, and then inform the owners of the results of the study, typically resulting in changes to condo fees.
A Reserve Fund Study can be broken down to the following:
The Physical Analysis (Common Element Assessment)
The Financial Analysis (Plans for Future Funding)
The essence of the reserve fund study is a physical assessment of the building, specifically, assessing the worthiness of the common elements. Common elements are parts of the building that are shared between all owners. It's these common elements – elevators, windows, etc. – that a reserve fund study is concerned with.
In a typical setup, a condominium board will engage an engineering firm to produce a study. Once the firm agrees on the scope of work, they will send their staff to the condo to conduct a thorough analysis of the building.
The engineer's main goal is to asses the current condition and expected life expectancy of the building's common elements and the estimated costs to replace or repair them.
With an inventory of common elements and their expected costs, the engineers have what they need to produce the financial projections – the tangible and actionable part of the study.
The Recommended Funding Plan (or 'the notice of future funding' as it is sometimes called) is what a condominium board uses to set the reserve fund contributions expected from the owners (a significant portion of the monthly condo fees).
A study will take into account the current financial status of the reserve fund and incorporate the expected future anticipated cost of all common elements to project a funding plan across a 30 year period or more. This will show the minimum balance of the fund during the period and for each projected year:
Estimated cost of future repairs, based on an assumed inflation rate
An assumed inflation rate
Recommended amount of contributions from the owners
Estimated interest being earned on the reserve fund, based on an assumed annual interest rate
An assumed annual interest rate
An opening and closing balance, taking all of the above into account
Here is an example of a reserve fund study:
The method used for these projections is simple, but can sometimes be misleading. Without going into too much detail, here are some reasons why:
Inflation/interest rate(s) are rudimentary assumptions, and usually fixed. In practice, these fixed assumptions do not reflect real world situations (especially over long time horizons) because rates are always changing in response to economic conditions.
The calculation of interest earned each year in the reserve fund is based on the assumption that the entire fund is available in cash every year to be re-invested. In practice, this assumption is not accurate because most investments have a maturity term greater than one year. Because of this reason, a portion of the fund must remain in the investment; making it unavailable for use (as cash) until the investment matures.
To learn more about both of these misleading assumptions and how they influence the projections inside a reserve fund study, you can continue learning here: 🌐Discovering the Simulated Forecast.
The goal of the reserve fund study is to get a recommendation for how much the owners should be contributing to the fund every year. These studies provide immense value; without them, forecasting contributions becomes impossible. That said, we believe that more precision is always useful and boards can do more to reduce the risk of a reserve fund having insufficient funds to pay for required expenses.
Vertical City Institute
While the reserve fund study process is fairly straightforward, there are many ways that the process can cause issues.
Our service provides an independent way to evaluate your reserve fund study. It produces more accurate forecasts by using a more realistic analysis method, with better assumptions, and by simulating a range of possible outcomes instead of a single calculation. To learn more about this tool, you can read more about it here: 🌐Vertical City Toolkit - Reserve Fund Forecasting.