Replacement Reserves- Understanding the Fundamentals
Long and short-term housing rental businesses use a financial operations tool to maintain, repair and upgrade the physical facilities. This tool is known as replacement reserves in the real estate industry. In almost all cases it is a contractual agreement requirement between the mortgage lender and the borrower. The financial arrangement between the parties is simply a stipulated amount paid monthly to the mortgagor who holds the funds in trust. At agreed increments the borrower submits receipts to the mortgage company of actual maintenance, repairs and upgrades for reimbursement.
There are several underlying fundamentals of replacement reserves every owner and manager of housing rental operations must understand to correctly implement, utilize and comply with the terms of the mortgage note. In addition there are accounting issues related to replacement reserves that should be followed so as to present fairly the financial results of this activity. To assist the reader in understanding the fundamentals of replacement reserves this article explains the logical and legal framework of replacement reserves; how good planning and budgeting assist in utilizing the proceeds held in trust; and finally, how compliance requires proper accounting.
Logical and Legal Framework of Replacement Reserves
Modern day housing has a higher maintenance cost per unit of investment than historical construction. This is a result of lower quality construction materials and the ever-changing codes compliance of local government. Natural entropy wears out existing materials primarily flooring, appliances and cabinets. In addition, original construction specifications were general in order to keep overall costs of construction down. After 20 years, problems develop with plumbing, mechanical and structural components necessitating expensive repairs and upgrades.
To offset these unavoidable costs good management of rental income property demands setting aside some funds in anticipation of these future costs. This is called replacement reserves. It is very common in the housing rental industry which includes:
A) Apartment Complexes
B) Condo Associations
C) Resort Facilities
E) Property Management Brokers (Single Family Dwellings)
G) Nursing Care Facilities
H) Retirement Homes
The basic concept is to set aside cash now for future needs. The problem with this is that future needs are unknown as to timing and cost. To Illustrate, assume a 300 unit complex costs $15 million to construct. The engineer states the entire structure will last 40 years before requiring replacement. In today’s dollars, owners would not want to set aside 1/40th of the total each year to have adequate funds available to replace the dilapidated structure 40 years later. Therefore, the owner’s would need to set aside $375,000 per year to have the necessary funds in reserve.
In reality, this is excessive as the structure will last much longer than 40 years. The real value for any housing rental unit is making sure the unit is well maintained in somewhat modern condition. This includes keeping the inside up to date and clean. Various parts of the unit wear out at different rates. Management must understand these cycles. Here are some basic cycles associated with the various parts of a rental unit and the facility:
Construction Item Expected Life Cycle
Carpet/Vinyl 5 Years
Appliances 7- 10 Years
A/C Systems 15 Years
Cabinets 15 – 17 Years
Bathrooms 20 Years
Roofs 25 – 30 Years
Concrete Walkways/Curbs 35 Years
Windows 30 Years
Pool 30 Years
Fencing 30 Years
Stairways/Railings 25 Years
Exterior Siding 45 – 50 Years
Structure 70 Years
Drainage/Sewage 45 Years
The higher cost components such as structure and exterior materials have longer life cycles than interior components. The interior items such as flooring and appliances are abused by the occupants including pets; therefore their cycles are more frequent. The overall effect is a lower set aside amount per year.
Most mortgage lenders require a percentage of the construction costs as a minimum balance held in escrow by the mortgage company. A typical $15 million project will have around $175,000 or a bit more than 1% of the construction value in reserve. Since most loans are no more than 75% of the fair market value of the real estate, the escrow amount is calculated as a function of the original loan balance. The replacement reserve balance can be as little as 1.75% to as much as 7% of the loan balance. The primary drivers of this value is the relative age and condition of the real estate facilities. Newer facilities will only need 2% balances and older units will require higher percentages. A typical $10,000,000 property only 10 years young with a $7,000,000 loan may only have a $150,000 escrow minimum. This escrow is negotiated in the terms of the loan package and is established at loan closing.
Each monthly loan installment has five separate elements:
1) Loan Interest
2) Loan Principal
3) Real Estate Tax Payment
4) Insurance Escrow
5) Replacement Reserve
Most replacement reserve installments are between .08% to .13% of the original principal borrowed per month. A $5,000,000 loan will require at least $4,000 to as much as $6,500 included in the payment to increase the replacement reserves each month.
This is a significant burden to cash flows for any mid-size or small apartment complex. This is why it is important for management to understand planning and budgeting of facilities maintenance to use these funds wisely.
Planning and Budgeting
Lenders encourage the property management team to maintain the property. As management replaces carpet, appliances and cabinets it is allowed to turn in the receipts as evidence of compliance. The mortgage company then reimburses the complex for these expenditures from the replacement reserves.
There are several peculiarities involved with reimbursement.
First, the frequency of applying for reimbursement is dictated in the loan documents. Most loan intervals are once a year but some allow quarterly application for reimbursement.
Secondly, the replacement reserve account customarily has a minimum balance with some exceptions. These exceptions include major renovations, co-payments for insurance compliance related to a disaster (fire, storm or water) and a codes compliance inspection discrepancy. The lender yields if the amounts spent are in the best interest of the lender to protect and/or improve the collateral.
Third, often the allowed items for reimbursement are restricted to non regular maintenance items such as:
– Carpet Replacement
– Mechanical Equipment (A/C Systems, Water Heaters, Boilers)
– Roofs, Exterior Siding
– Landscaping (Trees, Flowers etc.)
– Filters and Treatments (Yard, Playground, Pest Control, Fungus)
– Pool Maintenance
And finally, there is an application process including forms, receipts and pictures with a turn around time of 30 – 60 days.
Given these drawbacks, management must properly plan the repairs to maximize unit availability and budget cash to pay for the appropriate items. The reader can summarize that if the application process allows for an annual reimbursement then a lot of cash is fronted in the interim awaiting reimbursement. A typical 200 unit complex may pay out upwards of $125,000 in fronted money in a twelve month period. This is why it is critical to have adequate working capital on hand at the beginning of the year.
Good property managers keep excellent unit, building and site maintenance records. This allows the manager to foresee impending needs and associated costs. With knowledge of tenants vacating and natural cycles (most tenants move during the summer months) a budget for restoration and upgrades can be created with greater certainty. As long the overall costs do not exceed the annual replacement reserves requirement; the complex will not have to dip into operating funds to pay for these replacements.
Overall the key is to create two different budgets for the complex. One budget addresses the replacement reserves utilization while the other deals with regular maintenance. The following is a simple table that separates the two types of property operations.
Replacement Reserves Qualified Regular Maintenance
New Carpet/Padding Carpet Cleaning
Vinyl Replacement Floor Patching
New Appliances Appliance Repairs
New Cabinets/Countertops Countertop Overlays
Water Heaters Plumbing Repairs
A/C Unit Replacement Ductwork Cleaning/Filter Replacement
Bathroom Remodels Tub Inserts/Re-grouting
Stairwell Replacement Deck/Stair Railings
Exterior Siding Landscaping
Drainage Ditches/Ponds Parking Lot Sealing/New Markings
Roofs Swimming Pool Operations
Concrete Replacement Pool Liner
Pool Pump and Drainage System Gutters/Downspouts
A 20 year old complex will average $1,400 to $1,900 per unit per year for both items combined. This includes the internal labor to manage and conduct regular maintenance. Naturally an intensive and consistent maintenance schedule reduces the long-term outlays for capital replacement costs. Those complexes with a hard working, knowledgeable maintenance staff can easily keep overall costs per unit down in comparison to complexes that utilize outside resources. Larger complexes have economy of scale to reduce the cost per unit.
Typical replacement reserve values per unit per year range from $325 to $675 depending on age and overall conditions. This makes mathematical sense. The core items for replacement are carpet and vinyl every five years and appliances every 10 years. This costs around $4,000 per unit in the aggregate every 10 years. This minimum core replacement program equates to $400 in reserve per unit per year.
No matter what, even if the complex doesn’t utilize all replacement reserve funds available, it doesn’t mean the complex has given up its rights to the funds. It merely increases the reserve replacement fund balance held by the mortgagor. This is true because the proceeds are held in trust for the benefit of the complex.
To understand this the reader must comprehend the compliance and financial accounting associated with replacement reserves.
Compliance and Accounting for Replacement Reserves
When the mortgage is issued, one of the elements of the loan found on the HUD form is a dollar figure for money held in trust by the mortgagor. It is held in the form of cash. Most housing rental operations report a separate current asset referred to as trust funds. This account is set up as a parent-child account structure and contains both the trust funds held by the mortgagor and monies held on behalf of tenants – deposits, prepayments and security funds. The organizational structure looks like this:
ABC Garden Apartments, LLC
Balance Sheet (Limited Presentation)
December 31, 2015
Petty Cash $ZZZ
Operating Checking – WF#1234 ZZZ,ZZZ
Payroll – WF#9876 Z,ZZZ
Sub-Total Operations Cash $ZZZ,ZZZ
Held by Mortgagor:
Real Estate Taxes $ZZ,ZZZ
Property Insurance ZZ,ZZZ
Replacement Reserves ZZZ,ZZZ
Sub-Total Trust Funds – Mortgagor ZZZ,ZZZ
Held for Tenants:
Sub-Total Trust Funds – Tenants ZZZ,ZZZ
Sub-Total Trust Funds $ZZZ,ZZZ
TOTAL ALL CASH $ZZZ,ZZZ
Notice replacement reserves is one sub account of money held by a third-party. All of the funds held by the mortgagor are held for the benefit of the complex. This is no different from those funds held by the complex for the benefit of the tenants. The initial entry is basically a debit to replacement reserves and a credit to either cash (operations) or the long-term liability mortgage note depending on the source of the funds.
As each loan payment is made, the replacement reserves increases with a debit entry for the amount related to that element of the loan payment. Naturally the offset is cash as the payment is made from the operating account. To discover the value of the loan payment for the respective parts, the mortgagor usually provides a breakdown with the coupon for the loan payment.
As the reserves continue to build throughout the calendar year the account balance will peak just prior to the replacement disbursement to the complex. The replacement payment is authorized for expenditures related to capital maintenance or improvements (upgrades) as identified in the loan terms. Remember most mortgagor holders only reimburse once a year. How does the complex account for the capital expenditures in between reimbursement periods?
Most housing rental operations use a modified income statement to identify cash and accrual expenditures for all complex operations including capital outlays.
The final section of the expenses area of the income statement (profit and loss statement) is called the costs of capital and includes the following items:
* Interest on the note for the accounting period
* Capital Maintenance Expenditures
The capital maintenance account identifies all costs expensed for building restoration and renovation work. This refers to those costs allowed by the replacement reserve terms. As funds are used to replace flooring, appliances, mechanical systems and cabinets the debit is temporarily stored in the capital maintenance account. This allows management to understand how much cash was used year to date to maintain the real estate in its original condition.
Prior to preparation of the final reports for year-end, these capital maintenance costs are transferred to fixed assets as improvements to real estate. A schedule is completed for the year and depreciation schedules are produced too. Depreciation for these capital maintenance expenditures is calculated and entered as a year-end closing entry.
THE KEY TO UNDERSTANDING REPLACEMENT RESERVES IS THAT IT IS STRICTLY A BALANCE SHEET FUNCTION. ACTUAL CAPITAL EXPENDITURES ARE TEMPORARILY REPORTED IN THE INCOME STATEMENT FOR INTERIM FINANCIAL REPORTING PURPOSES.
The paperwork for the capital maintenance items is sent to the mortgage company for approval. When the check is issued, a debit is made to the cash account and a credit is entered into replacement reserves. In effect reversing the accumulated increases in the replacement reserves account during the past year.
What happens if the complex doesn’t get all its money back?
As stated before, the funds are held in trust for the benefit of the complex. The terms of the note identify the various possible outcomes. Most note terms require a minimum balance to protect the mortgage lender in case of default; in effect, they would have funds available for repairs.
Any funds in excess (unused) are carried over to the following time period (quarterly or annually) and may be used for reimbursement at that time.
Some terms require a continuously increasing minimum balance each ongoing year, usually 2% – 5% per year. Basically, an inflationary protection clause.
As for compliance, many mortgage notes that are part of bond issues or government backed loans or actual government loans require annual audits for both the financial statements and the trust fund accounts. Loans of less than $7 million may exempt the complex from these audits but still require quarterly and annual financial reports. Therefore proper accounting as illustrated above is essential to properly comply with loan terms.
Summary – Replacement Reserves
Replacement reserves is a financial tool used to maintain, repair and upgrade capital assets in the housing rental industry. Money is set aside each month as a part of the mortgage payment and held in trust to benefit the real estate rental units. The complex operations seeks reimbursement of actual costs incurred for capital maintenance items (new flooring, appliances, mechanical equipment, cabinets, etc.).
The loan terms with the mortgage holder requires a minimum balance held in trust on behalf of the complex. The trust fund increases in value with each mortgage payment made. Any available balance is used for reimbursement of actual costs incurred.
To properly account for replacement reserves the complex identifies the amount held in trust for its behalf on the balance sheet as a current asset. All expenditures for capital maintenance, repairs and upgrades are temporarily reported as capital maintenance, a sub account of costs of capital on the income statement (profit and loss statement). At year-end, these capital maintenance costs are transferred to the fixed assets section of the balance sheet and expensed via depreciation. ACT ON KNOWLEDGE.
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