If you are planning an acquisition or budgeting for your existing portfolio, you have asked yourself the question, “how much should I set for reserves?”
Recently, my friend John and I were chatting about how smart money follows a basic premise when making an acquisition decision. John is a building engineer and his job is to analyze the segmented components of office buildings so that investment firms can understand what the useful life of each piece of the building may be.
John explained that on one building, his company learned that the window systems installed on the high-rise had 5 years remaining and that the report they produced noted the system’s end-of -life and provided the client with an analysis of costs to replace the windows. The client used this key report to set their reserves target over the 5 year period and plan adequately for the window system replacement.
One mistake we see many investors make is not adequately understanding the useful life of the building systems owned or being acquired. When adequate reserves have not been set to meet the replacement and repair of the property, the owner scrambles to draw on credit lines, refinance the property, spend tenant security deposits, raise money through a capital call, or even resort to not repairing the problem. Such behaviors can also raise the bank’s attention to maintenance of the property and pose some problems for the owner when he is asked about necessary repairs.
If you are budgeting your reserves and are wondering how much to include, consider hiring a building engineer to analyze your property. You might be delighted to know that planning for reserves is much easier when you have an idea of what to expect versus wondering what might go wrong in a few years or putting some money aside because that is what your colleague or banker told you to be the correct amount.
And if you are buying a building and have already planned for your engineering study, here is a tip:
Remember that reserves are savings. They are not expenses because they are not recurring annual costs to operate the property. What do you think the IRS would say if when you filed your return, you deducted reserves as an expense?
Reserves are designed to be spent as capital expenditures over a 5, 10, 15, or 20 year period. That means when you calculate your net operating income, reserves should be placed below the line, not above it. Most appraisers and banks will disagree because they like to account for reserves above the net operating income line partially because it ensures that sufficient cash flow is in place for replacements, but also because the added reserve line item reduces the net operating income and subsequently decreases the loan amount offered to the borrower.
When it comes time to sell the property, you either liquidate the reserves as part of your reversion, or leave the fund in place for the next owner.
About the Author: Jeremy Cyrier, CCIM is the President of MANSARD, a market research driven commercial real estate brokerage and advisory firm, and member of the CCIM Institute faculty. You may reach Jeremy at Jeremy@Mansardcre.com.
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