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Upkeep Factor
Hello,
This is meant more for Presidents or Treasurers; however, Owners would be greatly informed by learning more about Annual Budgets and the mechanisms.
Firstly, I’d like to outline our current funding model within Alberta. We have an Operating account and a Reserve Fund.
The Operating account is used for monthly cash flow and it’s difficult to find any financial institutions that offer a rate of return for capital held. Meaning a “healthy” operating account of 3 months of contributions is depreciated through inflation. It’s my opinion that we keep the operating cash account as low as short-term fiscally responsible.
The Reserve fund account is governed by the Act and restricts the use of capital for the benefits or improvements or special assessments. Meaning, if you’re fully funded or over funded, that capital can only be spent to maintain the assets appearance and sqft. This limits the “value add” that a corporation can provide to the owners. In addition to that it’s in the best interest for owners that the Reserve capital be invested under the Condominium Property Regulation “Schedule 2”. I encourage you all to investigate that through a 3rd party manager and avoid requiring GIC renewals from board members. That would reduce responsibility and prevent any loss of return for owners when the board struggles to become engaged.
Secondly, I’d like to introduce to everyone a factor that has not been defined (to my limited knowledge).
Upkeep factor.
To attain this, we’ll need the average sale price of a unit, for example 2 homes sold during the last 3 years, one at $300,000, and the other $200,000.
The average sale price is $250,000.00.
This Globe and Mail article about maintenance costs on a detached home, says 2%-4% of the homes value can be spent on upkeep of the home. (My apologies as this article requires a subscription)
2%-4% is a highly maintained asset, in my opinion 4% is high…
This article from The Balance suggests a 1% rule.
Corporations may fall below 1% and you can determine your Upkeep factor easily.
1% of $250,000.00 is $2,500.00
Next, we need the Annual Contribution to the Reserve Fund.
If all units have a similar unit factor or sqft, go ahead and divide Annual Contribution by the units on the property. If your property has multiple tiers of units, this may require separately accounting for each and then averaging that again. For this example, we’ll be using the same sqft for every unit.
Let’s say we have 40 units, and the annual contribution is $60,000.00, divide. The unit contribution annually would be $1,500.00
Now take the unit annual contribution of $1,500.00 divided by the average 1%, $2,500.00. We have an upkeep factor of 0.6%.
We can now say our corporation contributes 0.6% of the average asset value to the Reserve Fund.
Now the Annual Budget Upkeep.
It’s common to have many line items on the Annual Budget that fall into the upkeep factor and for those you’ll need to better define each line… Insurance in not Upkeep, however Lawncare/snow maintenance and management fees are. You’ll need to determine a full amount and preform the same calculation above by dividing it into units. Our example will be $65,000.00 in Annual Budget Upkeep line items.
65,000 divided by 40 = 1,625 divided by 2,500 = 0.65%
We now know we contribute 0.65% of our Asset Value to the Annual Budget for Upkeep.
Finally, the Corporation Upkeep Factor is 0.6 + 0.65 = 1.25%
1.25% May sound great but this hardly equates to the real impact of Corporation woes. Large scale emergencies may put your Reserve Fund into peril at any moment. Again, overfunding this structure doesn’t add value for modernization or additional sqft. Funding for that is not structured and is the puzzle piece missing in the Condominium sector.
We should be striving for 1% in both Reserve and the Operating. Now 1% in Operating would mean overpaying for our manager or maintenance however, it would be far more prudent to set the additional funds above the 2-3 month holding, into a GIC ladder within the Operating.
You could then offset the Annual Budget with the investment return and use the Capital Amount to hedge against future Special Assessments. Leading to a far better future funding approach for Corporations that benefits Owners today, and tomorrow.
Thank you very much for your time and I encourage further discussion, criticism, and feedback. I also apologize for any grammatical errors.
Furthermore, I have begun detailing examples of this structure, with multiple compounding provisions, over the long-term and know that the owners have an appetite for any sound planning.
The next step is developing policies that not only encourage portfolio growth but protect this structure like the Reserve Fund governing policies.
If properly structured, we could use this tool to effectively reduce and permanently eliminate contributions…
Neil
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3 Replies
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Great explanation of a concept many Condo Corporations don’t consider. I suppose one could also play around with inflation in this calculation as well to provide yet an additional factor to an exercise primarily being used to counter inflation in the first place. You could provide it over the time remaining in the current reserve fund study. Especially these days even though an inflationary factor should have been used in a Corporation’s Reserve Fund Study it probably has no relationship to what it was when the study was commissioned compared to what it is currently.
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Precisely!
Basically, this structure would mimic the Reserve fundamentals. Where the Corporation would be required to have a new Plan or Study every 5 years with cashflow provisions. Except instead of Architects and Engineers it’s Consultants and Actuaries.
Interesting thing about inflation within the Corporation Annual Budget is that inflation doesn’t quite affect each line, unless all Agreements are signed with a 3% increase. Many times, the Directors may change and thus look to change out contractors too. The real loss is when you don’t invest the capital and lose purchase power to inflation.
I’ve created a future horizon for our Annual Budget that introduces provisions to raise the Upkeep Factor over a course of 10 years, 8 if we the chose aggressive option. Taking a Benchmark return of 3% – 4.5% (current Schedule 2 margins) of the excess funds, you end up nominally above what the future inflated contribution fees would be provided you never took these steps 15 years earlier…
What’s also interesting is a “Windfall” provision. This is where instead of compounding the interest earned the Corporation receives a windfall of 25%, 50%, 75%, etc. of the interest earned from the portfolio annually. This is not allowed through the Reserve Fund but what it could provide through the Operating is an easement of the annual budget crunch. You could have a windfall projection every 2, or 3, or 5 years, where the percentage is added to the Budget Surplus, thus maintaining a healthy Operating and providing additional funds for benefits or improvements.
Over the course of 15 years, you end up nearly in the same contribution position, except with a portfolio that’s structured to offset contributions. Now, you may have had funding issues from Reserve or special projects considered a betterment? So, this is where the Actuary Reports would help keep you on track. You could have a “Project” provision where you add real asset value through a tennis court or a detached building addition that can serve as rental income… The options are endless once you prepare to fund appropriately.
It’s a hard sell for those later in their life cycle because its value doesn’t compound for decades however, you still own a share of that portfolio structure and that should have a direct impact on the property asset. Especially if it’s well managed!
Honestly, this is not for Corporations that wish to maintain the lowest fee possible. This is for boards that have young owners who plan on holding their asset for +15 years. Reserves should be above 60% and the Owners should all agree contribution increases are better than Special Assessments. Anyone renting or leasing their units will likely pushback.
Realistically though nobody is saying, just wait 20 years and we’ll lower the contributions or maintain the rate… We’re just waiting for… Someone else to handle it? There’s no tool to ease rising contributions.
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Posted on Behalf of Terry Brooker:
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Neil
A great article for financial analysis and discussion.
I feel this approach is one of many analysis that could be applied to condo financings. But there are a tremendous range of condo with very different financial metrics.
Starting with the Reserve Fund, the 1% metric may be appropriate, but I rely very heavily on the Reserve report and the associated plan. Certainly it is necessary for the Board to review the report beyond simply accepting the bottom line. A large scale emergency should not happen in isolation, but should only occur as a result of a major acceleration in the timing of the expenditure. So it is necessary to understand the risk of that event versus the current balance in the Reserve Fund (ie are there sufficient funds to cover a major event occurring much sooner than expected).
And with the operating fund, I agree that any surplus should be invested in a GIC ladder, rather than accept the minimal interest paid on most bank accounts. But again, depending on the nature of the condo, the general 1% metric may or may not be appropriate, although certainly worth calculating where you stand against that metric.
You are certainly correct that most condo accounting does not incorporate funds for special new projects. I have seen a large condo that puts their annual operating surplus into a special capital fund for additions and improvements (as set out in the bylaws). However, the Board needs to be very careful how this is spent. The benefit of a special assessment for improvements, is the necessity for the owners’ approval of the project and the expenditure.
But thank you for this thoughtful article, and I certainly hope it prompts other ideas and suggestions.
I now need to do the Upkeep Factor calculations for my condos !!
Terry Brooker
