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Reserve Fund Study Accuracy
How Accurate are Reserve Fund Studies? Are They too Conservative, Causing Annual Reserve Contributions to be Too High?
Questions about the accuracy of Reserve Fund Studies (RFS) come up regularly from owners and directors. They question the estimates used in their studies and some think reserve fund study providers are too conservative, causing annual reserve contributions to be too high.
A Reserve Fund Study calculates future Major Repair and Replacement (MRR) costs over the next 30 years for each common element or class of common elements and any assets (common elements for simplicity). There are indeed quite a number of estimates made in preparing these studies, the most significant of which follow:
- Nature and extent of MRR required.
- Life expectancies of the common elements.
- Current condition of the common elements.
- The year MRR will be required.
- Current costs of MRR that will be required.
- Inflation rate to use to calculate future MRR costs.
- Future costs of MRR that will be required.
- Interest rate to calculate investment income on reserve funds that accumulate.
- Future investment income.
- Future annual reserve contributions that can reasonably be expected to provide sufficient funds to pay for future MRR costs.
- Percentage increase in annual reserve contributions over contributions of the prior year.
Before we discuss each of these estimates, it is important to recognize that estimates of the future, by definition, will not be the same as future events. Estimates for the next year or two will be better than those farther into the future and this is one of the reasons that Reserve Fund Studies must be updated every 3 years.
1. The RFS provider bases their determination of the nature and extent of MRR that will be required on, amongst other things, the type of construction and equipment used in the condominium and their prior experience as to the nature of MRR of these elements. For instance, walls and garage floors may only require repair of cracks and other concrete damage, while carpets and roofs will require complete replacement at some point in time.
2. The life expectancy of many of the common elements can be estimated with considerable accuracy. For instance, prior experience shows that 25-year roofing lasts, on average, about 25 years, though it may only last 20 or 21 years or could last 27 or 28 years, depending on weather and maintenance. Pipes and windows also have fairly predictable life expectancies.
3. The current condition of the common elements is established by a visual inspection every 6 years. Visual inspections have limitations as the extent of MRR required may be hidden behind the surface and experience indicates that it is not uncommon that actual MRR expenditures exceed estimates.
4. The timing of MRR is based on current condition and remaining life expectancy of the common elements. An RFS performed late in the expected life of a common element will adjust the remaining life expectancy based on the condition at the date of the study. For example, 25- year roofing installed 15 years ago should have about 10 years left before replacement, but a site inspection may uncover signs of early failure indicating that MRR will likely be required in only 5 years. Changes in condition of the common elements over time is one of the reasons that reserve fund studies include a site inspection every 6 years.
5. The current costs of MRR are estimated from costs for comparable work obtained from trade sources and the history of costs accumulated by the RFS provider and are more or less accurate depending on the nature of the common element. For example, replacement costs for standard products such as windows and doors are easier to calculate than specialized common elements such as geothermal energy equipment.
6. The inflation rate for costs is estimated based on the RFS provider's view of the prospect of future inflation using prior inflation rates as the primary source.
7. The future costs for MRR are calculated from current costs, adjusted for inflation for the number of years between the date of the study and the year of expected MRR
8. The interest rate used to calculate estimated income from reserve investments reflects the RFS provider's view of future interest rates, generally based on historical long-term rates.
9. Future investment income is calculated using the interest rate assumption and average reserve fund balances in each of the 30 years of the study. In periods of low interest rates, estimated income based on long term interest rates will generally exceed actual income earned and conversely, in periods of higher interest rates, estimated income will generally be less than actual. These differences are adjusted when the next study is prepared.
10. Future annual reserve contributions are calculated so that the ending balance in the reserve fund for each year of the 30-year study is positive. Barring unforeseen circumstances, the Directors have committed to the contributions for the next 3 years as set out in the Notice of Future Funding of the Reserve Fund distributed to owners. Contributions after 3 years may change depending on the results of the next RFS.
The concept is that each unit owner pays towards the cost of MRR the same amount, inflation adjusted, for each year they own their unit. Most RFS providers limit above-inflation increases to the first 3 years of the study, with inflation-only increases for the remaining 27 years. We are informed that the Regulations in the amended Condominium Act, when proclaimed, may enshrine this practice in law. To do otherwise, burdens future reserve fund studies (and future owners) with large contribution increases.
11. Percentage increases are a simple calculation of the increase in estimated contributions over those of the prior year.
So, after all this, how accurate are reserve fund studies? The short answer is that no one really knows because studies have not been undertaken to compare 20 or 30-year-old reserve fund studies to what actually happened. As mentioned above, estimates of the future, by definition, will not be the same as future events and so we have to expect differences and those differences may be significant. Thus the questions – if no one knows how accurate they are or if they are too conservative, why do we depend on them so heavily and why does the Condominium Act require them? The answer to these questions is that the historical record supports the value of reserve fund studies.
The first two versions of the Condominium Act did not require periodic reserve fund studies. Condominiums registered before 1978 were required to put only 5% into a reserve fund, which was increased to 10% by the 1978 Act. Most condominiums followed this practice and by the 1990's early condominiums were 25 years old and found themselves facing large MRR without sufficient funds, significantly insufficient in many cases. This lack of funds resulted, first in delay in MRR with consequent building deterioration and when MRR could not be put off further, resulted in large fee increases, special assessments, borrowing or all three and these measures created a lot of hardship and a lot of discord in those condominiums. These difficulties, some of which persist to this day, are, in our view, the primary reason that reserve fund studies were mandated in the 1998 Condominium Act. Condominiums registered after the mid 1990's have also struggled with reserve contribution increases resulting from reserve fund studies, but they were and are in much better financial condition than their earlier counterparts.
Condominiums have now been in existence in Ontario for about 50 years and reserve fund studies started to be used frequently in the 1990's and have been mandated since the 1998 Act came into force in 2001. In all that time, for all the studies that have been performed, we think it safe to say that no condominiums have found themselves with an extra million dollars; reserve fund studies have proven to be, if anything, a little optimistic as to future MRR costs
The historical record is clear, no matter the potential for inaccuracy, having reserve fund studies performed and following their recommendations provides a much better result for those living in condominiums.