Published in the ECHO Journal, March 2009
We could make this the shortest chapter in history by simply saying, “There isn’t one!” That’s right, there is no real relationship between the operating budget of a co-owned property and its reserves funding—whether it be a condo, a townhouse, or a gated homeowner’s association. If operating costs get higher, they do not cause expenditures for major repairs (and hence the funding needed to pay for them) to become higher. As well, properties with high operating costs do not necessarily spend more on major repairs than properties with low operating costs.
This example will show why.
We have Condo A and Condo B, both about the same size. Condo A has operating costs that include 24-hour front-desk security seven days a week. Condo A was designed poorly, at least in respect to its heating, ventilation and air-conditioning. Heat escapes in winter through single-ply windows. Heat comes in during the summer due to big expanses of glass facing south. Condo A has an oil-burning heating system. These and other things contribute to high operating costs.
Condo B has a one-shift per week-day security person. Its architect was energy-savvy and took pains to design this structure in an energy-efficient manner. The fuel used in Condo B is natural gas but it is supplemented by solar panels on the roof.
Both buildings, however, have about the same contributions requirements for their reserve funds—say, $40,000/yr. But Condo A has an operating budget of $400,000/yr and Condo B an operating budget of $200,000/yr. For Condo A, the contribution to reserves would be equal to 10% of its operating budget and for Condo B it would equal 20%. So, if the “rule” were 10%, Condo A would be funding properly and Condo B would be underfunding, by half.
Do bus driver’s salaries have a relationship to the price of Lexus cars? Yes, I guess they do. Bus drivers require pay hikes over time. Lexus cars prices will increase over time. But to suggest that bus drivers’ wages should be tied to the price of Lexus automobiles would be unacceptable, to put it mildly. There’s no “real” relationship between them. To end this part on a light note, someone found, we kid you not, that there is a very close correlation between the salaries of school teachers in Minnesota and the price of rum in Havana. Not one of us, we’re sure, would argue that one causes the other!
Funding should be determined by a thorough line-by-line study of anticipated repairs and replacements. It’s as simple as that. An over-simplified rule-of-thumb like a percentage of the operating budget may be easy to understand, but it doesn’t make sense.
Predicting Operating Costs and Reserve Fund Expenditures
It’s useful, we believe, to examine the differences between the two kinds of “money out.” One kind, anticipated operating costs, end up as an Operating Budget. The other kind, estimated expenditures from the reserve fund, end up as part of a Reserve Plan, which usually results from a Reserve Study.
What, actually, are some of the more typical operating costs? The biggest single category for multi-unit condos is utility costs—electric power, gas perhaps, (or oil), and water. Staff costs can be high as well—a building superintendent, a property manager, a front-desk security person. Calling in repair people for minor repairs, contracting out the landscaping and snow removal work are other on-going costs.
The biggest category for townhouse developments or single-family homes would be costs related to grounds maintenance.
One of the principal characteristics of these operating costs is their predictability. They are, simply, very predictable. For one thing, the forecasting horizon is short. One year in most cases. And we all know (think of weather forecasts) that the weatherman’s outlook for tomorrow is likely to be a lot more accurate than his outlook for next week. Anticipated operating costs can be “out” of course, but they’re not likely to be out by much.
Reserve fund expenditures have an “air” of predictability. They’re derived from a “study,” which has the sound of something quite profound and unassailable. And they’re presented in voluminous detail, which seems impressive. But reserves expenditures, in actual fact, are often astoundingly out-of-whack. It’s not unusual to estimate that a boiler overhaul will cost $X only to find that when they “open her up” they find it’s deteriorated so much that a new boiler is required. It‘s also not unusual to incur damages that are by their very nature almost defined as unpredictable. Damage from severe weather conditions, new state and municipality laws that require special safety and security installations, and so on.
Reserve fund plans generally span 20 or 30 years; and even if you build in an inflation factor, it doesn’t begin to insulate the plan from cost changes that bear no relationship to ordinary inflation calculations.
Controlling Operating Costs and Reserve Fund Expenditures
Operating costs are also relatively more controllable than major repair expanses. If a severe winter resulted in higher outlays for water damages, you might cut back on the flower beds a bit to keep the “grounds” category within budget. You can decide to give the resident manager a raise in pay, or not to do so. The results of some operating cut-backs, however, are quite visible. When housekeeping is less frequent, or if the front desk is not occupied on weekends, people are apt to notice and, of course, complain. But that’s another story.
Reserve fund expenditures are generally intended to be made “as scheduled” in the reserves plan. But sometimes they have to be incurred earlier than the plan called for. If balcony railings have become unsafe, there’s no choice but to get them fixed. So the timing can be off from the planner’s estimates. Similarly, the cost of the work can differ, sometimes greatly, from the predicted levels. It’s easy to imagine that a boiler replacement job predicted in 2008, to be carried out in 2014, might be required earlier, or come in at a price at some considerable variance from the plan numbers.
Given our observations on predictability and controllability, it’s not hard to see why simple ratios or rules-of-thumb are (1) hard to arrive at, and (2) likely to be quite unreliable. Please keep that statement in mind even though there are some rules-of-thumb that, in a pinch, you may want to consider using.
Let’s summarize by restating the position we staked out at the start. There is no causal relationship between operating costs and reserve expenditures. Tackle your planning for these two kinds of costs as two distinctly separate exercises. Your plans and budgets will be much better if you do.
Graham Oliver is the president of Oliver Interactive, Inc. His company is principally involved with reserve fund issues and offers software and other tools to help planners and Boards create and maintain healthy reserves. He is, also, the co-author of the well-reviewed book “Reserve Fund Essentials.”