A replacement reserve is another name for a dedicated fund meant to finance the periodic replacement of a building's components to offset any wear and tear that comes with age. Every commercial real estate investor should have one of these line items in their annual budget.
With that in mind, we've taken a closer look at replacement reserves below. Keep reading to learn more about what they are and why they're important to investors, as well as how to correctly budget for your own future costs.
What are replacement reserves?
In commercial real estate, replacement reserves are funds an investor will put aside to cover any major replacements or refurbishments that need to be done to the property. However, rather than funding ongoing maintenance costs, reserves should specifically be used to pay for capital expenditures to the property, such as resurfacing an attached parking lot or replacing old carpeting and paint in the building's common areas.
It can be helpful to think of replacement reserves in the context of multifamily property. Specifically, most homeowners associations and condo associations have a reserve requirement, or dedicated statutes outlining how much money needs to be kept in a reserve fund at any given time. In this case, having a reserve requirement helps ensure adequate reserves at all times. It also helps the community association avoid having to charge residents a special assessment fee when a major project needs to be done.
Typically, rather than having these future costs catch them by surprise, most people plan for the expense of these capital items from the start. In fact, most investors will include replacement reserves in their budget, whether as a fully projected line item or simply an estimation of the amount of funds that should be put aside in a bank account.
Why is a replacement reserve important to real estate investors?
As an independent investor, making sure you have adequate replacement reserves for your investments just makes good business sense. Realistically, it may be even more important for you than for a community association: While the governing body of a condominium association can depend on multiple residents to fund their reserves, you only have yourself and your team to foot the bill for these costs.
Whether you keep a replacement reserve account at your bank or your lender requires the funds to be held in escrow, as is the case with HUD multifamily loans, having a sufficient operating reserve will ensure you have the necessary funds to tackle capital expenditures as they crop up without needing to add to your existing debt service.
How can you use replacement reserves?
Overall, your replacement reserve fund is meant to be used to help you replace any items that have a shorter life span than the building itself. This fund should help ensure the building stays in good shape as it ages and reduce the possibility of deferred maintenance.
You should plan for your replacement reserves fund to be put toward tasks such as:
- Putting on a new roof.
- Replacing an old HVAC system.
- Repairing communal plumbing.
- Replacing windows or exterior masonry.
- Repaving sidewalks, driveways, and parking lots.
- Overhauling elevator systems.
- Repainting common areas and replacing flooring.
- Upgrading the building's smoke alarms and sprinkler system.
- Making accessibility upgrades.
Routine maintenance costs, including unit turnover costs, are not usually included in this line item -- those costs should be considered part of your traditional operating expenses. In addition, you don't need to budget for any upkeep that's the responsibility of the unit owner or tenant.
How to plan for replacement reserves in your budget
While you definitely need to plan for replacement reserves in any budgeting or financial analysis you do for a property, there's some debate on where to put the line item. Between real estate investors, there's often an argument about whether a reserve component should be included in your net operating income (NOI) calculations.
For the most part, conventional wisdom maintains an item of capital expenditure is not an operating expense. As a result, your reserve component should not be included in your NOI. Instead, it might be a better idea to include this figure in your calculations for your cash flow. In this case, an equation for accounting for your cash flow might look like this:
Net operating income - replacement reserve - existing debt service = Cash flow
As you're budgeting, if you'd like to have a better idea of how much to allocate for a replacement reserve, one option is to conduct a replacement reserve study. As the name suggests, a reserve study is a long-term budgeting tool used to examine the current health of your reserve fund and create a funding plan to ensure these major expenditures occur when needed and the funding distribution is equitable.
The Millionacres bottom line
Whether you're budgeting for replacement reserves because they're a requirement of your loan or you're simply doing so because it will help you create a more accurate annual budget for this fiscal year, you're doing the right thing. Replacement reserves are a key component of ensuring your investment will stand the test of time.
To that end, make sure to use this as your guide to how to handle these periodic capital expenditures. Armed with this knowledge, you should be able to ensure you have enough cash on hand to fund any necessary reserve costs going forward.