Published in the ECHO Journal, May 2007
Life is kind of divided up between beliefs that are real and those that are false, mistaken, fanciful, or fallacious. It would be nice to have a world, perhaps, where everyone agreed on everything. But we don’t. And one area where this is as common as anywhere else is in the somewhat prosaic area of reserve funds.
The Reserve Plan
One widely-held belief is that matters related to reserve funds are complicated and hard to understand. The reality is, they’re not. The notion of creating a reserve fund plan is actually pretty straightforward.
Let’s look at the facts. Creating a reserve plan is a straight line, step-by-step endeavor. You start with a number, do some basic addition and subtraction, and Voila! … you’ve got one. Don’t be-lieve me? All right, let’s go through it bit by bit.
First Step: Inspect the Property
With a good list of the property components, you can look at each piece and estimate two things: When the component will need to be replaced or repaired, and how much will it cost. At the same time, figure out how long it will be before each item needs to be repaired again.
Second Step: Make a Chart
Make up a table with the years across the top (let’s say 30 years, a typical span), and your list of components down the side. After you have entered the dollar costs into the lit-tle squares for one element you go on to the next. Not complicated at all. Then you add up the columns and get the total dollars for each year. The Estimated Annual Expenditures line is now com-plete. It’s phrases like “Estimated Annual Expenditures” that give people the jitters.
Ah, you say, but where do we get all those estimates? That’s easy: The inspection and the spreadsheet creation must be done by someone who is knowledgeable, experienced and trustworthy. They’re called Reserve Specialists or Reserve Planners and there are many around to choose from. The majority of Reserve Special-ists are reputable, but if you’re looking for one, take your time, check with other people and pick a good one.
Estimating Rates
Dealing with “rates” is another area where professionals can se-verely overcomplicate reserve studies. There are two rates: an es-timated future interest rate, and an estimated future inflation rate. In our opinion far too much time is spent agonizing over these rates. They are essentially unpredictable, so save yourself time and use today’s rates. That is, unless the pundits agree that we’re going through a period of unusually high or low interest and inflation rates, in which case you’d want to pare them down or nudge them up.
The point is that, in the case of interest income, the interest dollars you’ll calculate are so much smaller than the figures for expendi-tures that being “off” on your interest rate will be of little signifi-cance compared to being “off” on your expenditures estimates. In the case of inflation, you must prepare your plan in today’s dollars anyway, so the usefulness of having an inflated-dollars version of your plan is very much in doubt. People insist on it though, so you’ve got to have one.
Owners’ Contributions
The final input into the plan is your funding dollars. Those are the contributions to the fund that owners will be expected to make. Arriving at the funding dollars isn’t complicated either. You have an Opening Balance at the beginning of the first future year of the plan. You input funding dollars for each future year. These dol-lars, for your first go-round, will be similar to your current contri-butions. When you plug them in you’ll end up with balances for the whole span of the plan. The Opening Balance for Year 1 will have the funding dollars (plus the interest on your invested balanc-es) added to it, and the estimated expenditures deducted from it, year-after-year.
We used the phrase “your first go-round” above. This is because when you see the projected balances across the page you’ll see that the balances in some years, or bunches of years, look too low in which case you’ll have to boost the funding numbers (prior to, and perhaps during those years) to get them up where they should be. Or they could be too high, and you’ll make the opposite adjust-ment. These are called “put-and-take” or “what-if” exercises. They’re more time-consuming than difficult.
Well, we’ve come up with only seven, fairly digestible paragraphs that we think may be convincing enough to put down the belief (mistaken, fallacious) that the creation of reserve fund plans is mysterious, difficult and unlearn able.
Rounded Numbers
What about other fallacies? One of them is that long figures are somehow more respectable than short figures. People seem to be-lieve accurate “looking” numbers. If you tell them there are 34,567,972,342,615 stars in the sky they’ll trust you. But if you put up a sign that says “Wet Paint” they won’t! We see reserve fund plans all the time that provide annual balances of … $132,709 … $245,393 … $63,932 and so on. (sometimes even $132,709.12 … $245,393.46 … $63,932.19). We’d simply show them as annual balances of $133, $245, and $64, with one note somewhere saying “all figures expressed in $,ooo’s. The information you have with the shorter figures is quite sufficient to arrive at the same con-clusions and to make the same kind of decisions as with the longer numbers. And the page they’re on is more readable, the amounts can be comprehended more quickly, and … look at the ink you’ve saved!
In the same vein, let’s mention a related reality. We’re talking about a PLAN, here. The future that a plan portrays hasn’t hap-pened yet. And when it does happen it will not turn out to be the same as the future that was predicted. Getting wound up in deci-mal points does nothing for the health of your property’s reserve balances, and it sure doesn’t do your personal health much good ei-ther.
If this sounds “casual”, it’s not. Spend your energy making sure all components have been examined. Make sure that you obtain the best estimates available for the really costly items. Question your reserve planner on the sources of his or her figures. Isn’t there a book called “Don’t Sweat the Small Stuff”?
Regular Updating
Now, for one last belief for today, and our thinking on its reality. You may have a schedule whereby your reserve specialist comes back every three years, for example, to re-visit the plan. Where I live, the law mandates exactly that kind of schedule, with a full on-site inspection every second time, and a review only of the num-bers the other time. But there’s a quite widely-help belief that the insurance provided by that triennial review will fully-protect you from running into reserve fund difficulties.
The reality is that during the three-year gap, the property has been doing repairs and making replacements. And those expenditures have not been made for the same costs or at the same times are they were predicted. That’s why we feel very strongly about con-tinual, on-going updates to your plan amounts. Replace the esti-mated dollars with the real dollars as they come in, and look at the effects on your near-term and long-term reserve balances. By do-ing this, you’ll “catch” potential shortfalls, and you’ll catch them in time to take corrective action. They say it takes a supertanker 10 miles to come to a stop after they spot a flotilla of icebergs ahead. That’s why they have someone up on the mast to spot them in plenty of time. Do you see the connection?
One more reality. A quickie. What about the idea that doing all this is terribly time-consuming and therefore possibly costly. Un-true. For one thing, the major repairs and replacement that are paid for out of reserves average less that 10 per year. So, With a com-puter spreadsheet or reserve fund software (go to Google), you can update your expenditures, say, once per quarter, and keep totally on top of your balances very quickly and very easily.
To quickly summarize … we’re of the opinion that there’s plenty about reserve funds that people believe, that just are not true. We’ve covered a few, namely …
- Reserve fund planning is complicated and beyond the scope of ordinary mortals to comprehend. False.
- Reserve plans have to look like accounting statements with all the numbers shown to their last dollar or, even, their last cent. Mistaken.
- Deciding on the inflation rates and interest rates to use in the plan should be a major, time-consuming part of the process. Fallacious.
- Once a plan is established, it’s all right to stick it the drawer and start over again in 3, 4, or 5 years to make a new one. More than untrue. Dangerous is the word we’d use.
To conclude, may we put out an invitation to you. Please get in touch and tell us about other planning practices you’re unsure about. We’d love to give you our personal slant on them. Could even collect enough material for another article!
Graham Oliver is an author, and a contributor to reserve fund evo-lution. He is a Past Board President and now calls himself a Re-serve Fund aficionado. Graham has written, with a co-author, the book “Reserve Fund Essentials” from which some of the above ideas were taken. The book may be obtained though ECHO or by visiting Graham’s website at oliver-group.com/rfund. RFund, in-cidentally, is the brand name of his company’s reserve fund soft-ware package.