On the Vertical City Toolkit site, in the Report Card page, you see the chart below that plots a forecast of a user's Reserve Fund. By uploading a Reserve Fund Study (the RFS, as we will refer to it in this article), our app processes the data outputting the following chart.
The Study Forecast
The yellow line indicates the Study forecast – simply the the closing balance of each year of the RFS, which is uploaded by a client. The engineering firm which conducts this RFS has projected the building's future expenditures and how much each owner will be required to contribute to the fund. Interest and inflation rates are additionally factored into this projection.
The Simulated Forecast
The blue line is what we term the Simulated forecast. It is a forecast of the closing balance using a more sophisticated and realistic process of forecasting the existing data from the uploaded RFS. Typically, engineering firms conduct these future projections using little complexity. Financial forecasting is not an engineer's expertise. For the fixed cost they are being paid to produce these studies, there is little reason for them to invest their time improving this projection.
We have found that the variability in reserve fund behaviour can cause considerable fluctuation in projections and thus, if you want an accurate forecast, it would be wise to employ a more complex process for it. This is exactly what the Simulated forecast aims to do. We put to work some math techniques with big data and computing power to produce what is a more accurate projection of your Reserve Fund.
Revealing the Process
Here we want to highlight a few of the features that make our process a more reliable way of forecast than the process used in a RFS.
Systematic Error in Interest Calculation
A RFS assumes that all investments have a one year term, meaning they mature and return profits after one year and hence the cash become available to be reinvested every year too. In practice, the investments that a Reserve Fund are invested in follow a totally different pattern. They tend to be invested in longer term GICs – which mature every 2 to 5 years. That means the engineering firms are projecting that funds are reinvesting when the money is not truly available; systematically overstating the amount of interest earned per year.
Holding Cash Back
While a RFS assumes that all available cash is being invested and earning interest annually, in practice this is rarely the case. In our research, we have found that most condo boards typically hold a certain amount of cash reserves for emergencies. This will cause the Simulated forecast to be lower than the Study forecast says it will be because the RFS is assuming that more money will be invested and earning interest than truly is in practice if money is held back (i.e. if a condo board chooses to keep $100k in their account at all times, then that is $100k less money that is being invested).
Simulating Interest and Inflation Rates
Most Studies will assume a fixed, unchanging interest and inflation rate for the entire period of a RFS. This is not realistic. To obtain a more realistic view of how interest and inflation rates change, we model the probabilities using historical data and simulate the forecasts thousands of times using a technique called the Monte Carlo Method. This simulation technique gives us a range of expected rates that fluctuate yearly. Shown in the main image above as the lighter shaded blue area, the effects of a probabilistic view of the future rates are represented in the form of a range. To learn more about this process, you can read on here: 🌐 Article - Vertical City Toolkit - Reserve Fund Forecasting.