AECOM's Matthew Anthony on reserve fund studies
Matthew Anthony, senior consultant with AECOM Middle East, explains the benefits of reserve fund studies.
Implementing an accurate service charge is in the best interest of both owner and occupier. To reach the desired accuracy, consideration must be given to reserve funding, as a service charge that focuses solely on day-to-day operations. Falling short when reserves are required has the potential to not only cause cash flow issues for owners, but may also lead to service interruption for occupiers.
Those with an economic background will already have an understanding of what is meant by reserve funding. In the real estate context, reserve funding has two distinct functions, which are defined by the Royal Institution of Chartered Surveyors (RICS) in their Service Charge Code of Practice. The ‘reserve fund’ is for periodic works that take place less frequently than once per annum, such as redecorations of common areas.
The ‘sinking fund’ is for the replacement of assets when they reach the end of their operational life, such as lifts, chillers, roof coverings, cladding and flooring. In the Middle East it is common for reserve funding to be referred to as ‘capital reserve fund’ with a focus on asset replacement.
In Dubai, the Real Estate Regulatory Authority (RERA) has recognised the importance of reserve funding, making the provision of a capital reserve fund, a pre-requisite for the approval of service charge budgets.
This saw reserve fund provisions being made, but in many cases the funds established by community/property managers were token gestures without any real understanding of whether they would be suitable when called upon.
RERA have therefore gone further by stating that the reserve fund “must be based on a study of the costs of renewing and replacing the common areas and assets over a minimum 10-year period.”
This level of prescription recognised the need to link the fund to the assets it intends to cover, ensuring as far as reasonably possible that the fund is sufficient.
Awareness of the risks associated with real-estate property ownership should be enough motivation to get reserve funding correct. If there was a film entitled Capital Reserve Funds, then ‘mitigation of risk’ would be the tagline. Admittedly it would be quite a dull film for casual viewing, but then a sensible approach to risk mitigation will never form the plot to the next Hollywood action adventure.
With a market that is now seeing far more developers building to own rather than building to sell, developers themselves are becoming aware of the need for sensible, long-term asset management over more ‘adventurous’ short-term asset disposal projects. While the risks and benefits would appear to be relatively intangible in the short term, there are some spin off benefits to the process of conducting a reserve fund study that can be realised immediately.
For example, asset register verification and asset condition assessments provide valuable information to critically evaluate current maintenance regimes, contractor performance and provide a basis for contract renegotiation. In this respect, it would be in the property owner’s best interest to instruct a third party, independent from the current service providers, and preferably the supply chain, to conduct the study so that advice given is an unbiased analysis.
While not the primary reasons for conducting a reserve fund study, these short-term benefits show how closely linked such studies are to good asset management practice.
RERA’s directive has opened up the market to a new specialist service provision: capital reserve fund studies. To conduct a study and calculate the required annual contributions to a capital reserve fund, the property manager, usually an owner’s association under the Joint Ownership of Property law, needs to have access to an up-to-date asset register. Furthermore, an understanding of the life expectancies of the assets and their capital replacement costs is necessary.
Consideration also needs to be given to their actual condition and suitability of maintenance regimes measured by performance against expectations, factoring in relevant regional variables such as climate. Finally, economic factors such as inflationary impact on future replacement costs at the end of asset life cycles and interest accrued on funds held must also be calculated.
The skills required to calculate an accurate capital reserve fund are therefore quite broad. A property manager may require access to engineers and surveyors to understand the condition of the assets. Life cycle analysis expertise will be required from a facilities management perspective, ideally with access to regional capital cost information to allow base figures to represent true replacement values.
An understanding of the economic data, what data is relevant and how to apply it is also necessary and perhaps not something that a property manager would feel confident with. Accuracy is therefore elusive to all but those who manage to master these skills — or at least engage with those who can provide skilled advice.
A property owner or owner’s association with access to this information will find that not only can they budget for the true costs of operating a building, but these budgets will be stable due to the mitigation of unforeseen capital expenditure. This in turn will transform asset and facilities management into a proactive rather than reactive function.
Of course, breakdowns will occur and some reactive maintenance will always become necessary. Compared to the cost of replacing large amounts of expensive equipment however, either at the end or towards the end of its useful life, the impact on the service charge will be minimal.
This goes a long way to protecting the value of an asset, both for the investor and occupier. In this case, the building experiences fewer disruptions to service delivery, and the capital replacement costs of assets are apportioned equally amongst those who have benefited from them over the course of their operational life.
Without an accurate reserve fund, these costs usually fall on whoever happens to occupy or own the building at the time asset replacement becomes necessary. Not only is this inherently unfair, it is against best practice and can lead to problems recovering service charges as large variations are produced year-on-year with little explanation to, or understanding by, the people asked to foot the bill.
Occupiers faced with a large service charge bill generated by the need for replacement of equipment may also dispute the validity of the charges. This occurs despite RERA’s efforts to create transparency through the recent introduction of the Service Charge and Maintenance Index.
From an owner’s viewpoint the risk of unforeseen capital expenditure is only half the story. A building that lies half empty, or attracts lower rental, yields due to apparent mismanagement or disruption of services, impacts on the capital value too. Reputational damage is harder to measure financially, but this must also be considered a risk if services are cut or disputes create negative or unwanted attention.
Accurate capital reserve funds have many financial and operational benefits, most notably the mitigation of unforeseen capital expenditure and interruption to building services. RERA’s directives in Dubai demonstrate recognition of these benefits as part of a wider, proactive, strategic approach to asset management. RERA’s directives do not guarantee accuracy, however.
Ultimately property owners need to understand the benefits to realise the value of conducting a comprehensive capital reserve fund study, rather than seeking merely to comply with legislation. It is my hope that the rest of the region follows Dubai’s lead, if not from a need to comply with subsequent legislation, but from a deeper strategic understanding of the benefits of doing so for both owner and occupier.
The future of the region’s built environment depends on it.