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By Altus Group | April 25, 2017

Should a Reserve for Replacement be a “Regular” Part of Operating Expenses as Both a Sophisticated Management Practice and a Valuation Method?

From Al Jolson and Ella Fitzgerald and Henry Wadsworth Longfellow, we have learned that “into each life some rain must fall”. When that rain finds its way into your commercial/industrial income-producing building however, it’s not May flowers that are uppermost in an owner’s or tenant’s mind. Rain is made up of water (except in some really odd circumstances that border on the apocalyptic), and water is insidious. My former office had rain drops, and eventually a rain flood, coming through the ceiling in the centrally-located library. It took two years, and eventually a complete roof replacement, before we discovered that the initial source was an overlooked HVAC drain gutter line on the southeast corner of the 11,000SF flex structure. My parish church, when a westerly wind blows during a storm, hosts a “miracle” – water coming THROUGH the massive schist stones of the French Gothic edifice.  It is like something from the Book of Numbers with Moses striking the rock in the desert.  Folks say “you can’t get water from a stone”.  Well, in my church you can!

Ever see pictures of those giant sinkholes which mysteriously appear in the middle of a neighborhood or industrial park…or even a lake.  The total destruction, the very disappearance of whole structures, is an awful wonder.  That is ordinarily a matter for the insurance company and a psychiatrist. But how about something less dramatic?  Maybe when some of the “bones” or coverings of a building’s roof get old and begin to sag or creak.  Or a twenty-year-old overworked elevator needs to be switched out in a building that has many more years left in its economic lifespan.  What if your manufacturing complex is vexed by the Nature-encouraged cracks in your parking lot or walkways?  Or the windows-and-sashes become so old as to no longer be effective at keeping the weather on the outside?  Or the HVAC neither heats, not cools, nor ventilates sufficiently. As many, including my Dad, put it: Stuff wears out.

But how fast does “stuff” wear out?  And how much should an owner put aside to cover those possibilities/eventualities?   Do reserves for replacement need to be within the net operating income of the asset’s books?  First, let’s get more specific about what constitutes a replacement reserve. The Appraisal Institute defines it as: an allowance that provides for the periodic replacement of building components that wear out more rapidly than the building itself and must be replaced during the building’s economic life (The Appraisal of Real Estate, 12th Ed.).  The same book references those reserves as part of a building’s “operating expenses”, along with fixed and variable costs.  And therefore included in the calculation of the net operating income.

That inclusion approach is not universally accepted, nor consistently taught in valuation courses.  Why the divergence of thought?  Well, certainly brokers and their selling clients will try to improve their presented values/bottom line by taking any reserve out of the NOI. Conversely, buyers will take the more conservative included-in approach when developing a pro forma.   Banks will agree with that conservative approach.  Most lenders sleep better at night if they successfully minimize risk in their underwriting efforts.  They need to be sure that a property’s cash flow is sufficient to not only repay any loan offered, but also to support the need to maintain the structure in a condition to survive-well its holding period.

And there are trickier parts of handling a reserve when considering the valuation of a property.  Most appraisers or other valuation professionals calculate the value of a property based on capitalization rates that are taken from the market, from comparable properties which have transferred in the area.  But what if the comparables used by the evaluator are properties where the replacement reserves is already deducted to resolve to the NOI? If the appraiser then applies the discovered cap rate to a property where reserves are not deducted above –the-line, the resultant values would be wildly divergent.  A potential buyer’s due diligence needs to very closely investigate the source and methods used by the pro forma developer.

So where does the reserve get held?  I suppose in a small operation, you could keep the reserved funds in a cigar box (ok, maybe that’s a bit TOO small).  Or separately saved in a bank account.  Or in a protected escrow account.  Large mall operations and/or massive industrial complex owners with deep pockets will sometimes not “actually” reserve the dollars necessary to maintain the quality of a business enterprise, but they will have a calendar of expenditures which will be spent as necessary.  These funds may come from a central source within the corporation or REIT or other structure.  But they will be available, and they will be spent.  Otherwise, most any asset will begin to experience the degradation of aging components.  And that degradation will not go unnoticed – tenants will complain and/or demand relief, small “deferred maintenance” issues will become major capital (and sometimes emergency) events.

There has to be real money available to correct, update, fix. There’s nothing magical about it. Some time ago, the Oracle of Omaha (Warren Buffett), could have been talking about the sources of funds for reserves when he said: “Does Management think the Tooth Fairy pays for capital expenditures?”  Maintaining a building in a position to attract and maintain tenancy requires owners/managers to spend money in a planned and observant and competitive way – or they will find themselves with an emptying asset. Every tenancy has a “flight to quality” streak baked into it; if a tenant can afford to fly to a better asset because their present circumstances no longer provide safety or comfort or expected well-working amenities, they will fly.

So…back to the earlier question.  Should  a reserve for replacement be a “regular” part of operating expenses as both a sophisticated management practice and a valuation method?  There are proponents on both sides, but the clear answer is that reserves have to be considered both as a progressive maintenance issue for lessors to hold onto lessees AND as a carefully-calculated part of any valuation effort. Where the dollars are stored or booked or saved is a matter of the context of asset ownership and management. But the needs cannot be ignored in either the care of a building or in the accounting for the dollars needed.

Otherwise, the rains may indeed fall.  Inside, and wherever the Fates may lead it.

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