• Skip to main content
  • Skip to primary sidebar
  • Skip to footer

PropertyMetrics

  • Home
  • Blog
  • Products
    • Proforma Software
    • Publisher Software
    • Courses
  • Sign In
    • Software Login
    • Courses Login
  • Contact Us
  • Build a Proforma

Last Updated on January 5, 2016 By Robert Schmidt 24 Comments

Understanding Replacement Reserves in Commercial Real Estate

The topic of replacement reserves is often confusing for commercial real estate professionals. How much should be set aside for replacement reserves? Should replacement reserves be included in net operating income? How do replacement reserves impact cap rates and value? In this article we’re going to take a closer look at reserves for replacement, clear up the confusion, and also tackle some common misconceptions.

What are Replacement Reserves?

First of all, what are replacement reserves? Replacement Reserves are funds set aside that provide for the periodic replacement of building components that wear out more rapidly than the building itself and therefore must be replaced during the building’s economic life (short lived items).

These components typically include the replacement of the roof, heating, ventilation, and air conditioning (HVAC) systems, parking lot resurfacing, etc. Note that replacement reserves do not include minor repairs and maintenance such as broken doorknobs or lightbulbs. These minor expenses are considered routine operating expenses, not irregular capital expenditures.

How much should be set aside for replacement reserves? As always, it depends. Typically a commercial property will be inspected by a general contractor prior to acquistion. This will give you a good indication about what will need to be replaced over the intended holding period and allow you to work backwards into an appropriate replacement reserve amount. Additionally, many lenders will also require a replacement reserve to be set aside, usually in escrow, to cover major capital expenditures over the term of the loan.

Should Replacement Reserves be Included in NOI?

Conventional wisdom says no, replacement reserves should not be included in the NOI calculation. This is what’s taught in many commercial real estate textbooks and even the highly respected CCIM courses. However, just because something is popular doesn’t make it right. As always, the decision to include, or exclude, reserves for replacement from NOI largely depends on the context.

One thing to keep in mind is that many sellers and listing brokers will intentionally exclude replacement reserves from their proformas in order to boost NOI, and thus improve valuation. Buyers, on the other hand, are typically much more conservative when creating a proforma. Recognizing this tension can be helpful prior to entering into any negotiations. Additionally, lenders will almost always include a reserves for replacement figure in their NOI calculations when determining the maximum loan amount. This makes sense from their perspective because lenders want to minimize risk and ensure the property’s cash flow is sufficient to repay the loan. Maintaining an adequate reserve for replacement gives a lender more comfort that a property can support the loan without relying on any capital injections or guarantor support.

Where context becomes particularly important is in understanding how market based cap rates are calculated. You want to ensure you’re comparing apples to apples. For example, it’s common for appraisers to value a property using a market-driven cap rate based on comparable properties in the relevant submarket. However, if the market driven cap rate you are applying to a stabilized NOI is derived from properties with reserves already netted out, then this obviously wouldn’t make sense to apply this cap rate to an NOI without reserves included. Let’s take a quick example to illustrate the difference:

replacement reserves included in NOI

As shown in the above simple proforma, replacement reserves are included in the NOI calculation. As such, the calculated net operating income is $750,000 and the resulting valuation based on an 8% cap rate is $9,375,000. Now, let’s take a look at what happens when we exclude replacement reserves from NOI:

NOI without replacement reserves
As you can see, the resulting valuation is $10,000,000, which is an improvement of $625,000. This is certainly a significant difference in value that should not be ignored. Keep this in mind when working with seller provided proformas. Also, when reviewing third-party appraisals, this is usually a good item to take a closer look at.

Ultimately, the practice of capitalizing NOI without including any ongoing expenditures required to maintain market based rents isn’t wise. These ongoing capital expenditures may include reserves for replacement, and even tenant improvement and leasing commissions required to keep the property occupied. Sophisticated investor’s will of course understand this and most certainly take it into account when determining value. As Warren Buffett famously asked:

 Does management think the tooth fairy pays for capital expenditures?   -Warren Buffet

Although Warren Buffet was referring to the misuse of Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), the same concept certainly applies to NOI and commercial real estate. Why would you determine value without taking into account all required expenditures to keep the property occupied and otherwise competitive?

Conclusion

Replacement reserves are an important line item in any commercial real estate proforma. Capital expenditures are necessary for maintaining a competitive and fully occupied property. Yet, many people gloss over the reserves for replacement line item and often exclude it completely from the NOI calculation. As shown above this can have a significant impact on a property’s valuation and as such it should not be ignored. Whether you include replacement reserves in NOI or not is largely based on context, but in either case your choice should be based on sound reasoning.

Filed Under: Articles

Reader Interactions

Comments

  1. Prince Kapoor says

    August 28, 2014 at 9:27 am

    Yeah replacement is really necessary for the commercial estate stuff.

    http://www.manglamgroup.com/flats-in-jaipur/

    Reply
  2. Jerry says

    September 29, 2014 at 12:17 am

    You are absolutely correct. The only major issue is how detailed to you get with the reserves. Certainly major replacements, roof, HVAC, parking lot, etc. should be included. The more complicated issue is the discount rate used to calculate the reserves and the determination of the future cost of the replacement. Most would suggest that the investor’s rate is appropriate. However, that rate may be adjusted to reflect the uncertainty associated with the future value of the replacement. Contrary to prevailing wisdom, the more uncertain the future replacement cost, the lower the discount should be. (This actually makes sense. A lower discount rate increases the amount needed for the reserve.)

    Reply
    • Rob says

      November 6, 2015 at 9:41 pm

      Great observations. Usually a “finance rate” or “safe rate” is used, which is essentially a risk free rate. That way, you don’t put the capital at risk today since you want to make sure you have it in the future.

      Reply
  3. DennisMay says

    October 14, 2014 at 11:11 am

    That’s really a great blog you’ve shared. Thanks a lot. I’m interested in real estate business and I’m browsing through related blogs and discussions to understand this great industry. Blogs like this helps me in my pursuit for agent’s license.
    Planning to attend next week at Mississauga Convention Centre by Richard Robbins, and I’m expecting it to be beneficial for my career building. This might be helpful for others too, check out: http://www.richardrobbins.com/events/free-seminars

    Reply
  4. Yomi Omotoso says

    December 30, 2014 at 1:21 pm

    Interesting topic. The context matters as you pionted out. However, how you replacement reserve is treated dep

    Reply
    • Juan Carlos says

      January 6, 2015 at 1:29 am

      You are incorrect and your assumptions are not supportable.

      Reply
      • Yomi says

        January 6, 2015 at 3:54 am

        Please enlighten me

        Reply
        • Jeremiah says

          April 14, 2015 at 4:53 pm

          Yomi,
          I tend to agree with you. Financing at the end of the day is the tail that wags the dog. We underwrite properties from the buyer’s perspective which in turn is going to be largely dependent on the lender’s perspective. If the seller has a pie in the sky number on what they perceive the value to be and are misplacing capital reserves below the line to hit their numbers, the buyer and lender aren’t necessarily going to view it the same way and the deal could up not being traditionally financeable which eliminates a huge pool of prospective buyers. We deal exclusively in multifamily so on short term leases with lots of turnover costs, we put capital reserves above the line which is the industry norm. From my understanding, it is more common to put capital reserves below the line for retail and office properties.

          Reply
  5. Michael says

    May 22, 2015 at 3:49 pm

    Your blog on replacement reserve was very informative as or all of your blogs. I have been reading your blogs for sometime know and my commercial real estate knowledge is forever increasing. I am beginning to understand why some place the replacement reserve above the line and others place it below the line. Therefore, am I correct in assuming the placement of the reserve replacement depends on what side of the transaction one is on?

    Reply
    • Rob says

      November 6, 2015 at 9:42 pm

      Yes, it largely depends on context as well as your intended purpose.

      Reply
  6. David Monroe says

    November 11, 2015 at 12:39 pm

    Replacement reserves should never be included in the NOI. The way something gets treated, operational, interest, reserves, is all determined by accounting functions and how their treated in the tax world.

    Reserves are held for larger items, as you mentioned in the article, such as roof replacement, parking lot repaving, and HVAC replacement. All of these items are Capital Expenses and therefore can depreciated and are not taxed as an operating expense.

    Reserves are typically an amount held in escrow, usually provided at acquisition, and are not increased over time, only replaced if used. Therefore reserves should never be included in the NOI.

    A property can operate without reserves, just like it can operate without a loan, and we don’t put our mortgage interest in the NOI, nor should you put replacement reserves in the NOI.

    In the sale of a property, reserves are only considered by the lender, based on condition of the property and the strength of the buyer, and the buyer so they can calculate annual cash flow and cash on cash returns. The seller, nor the property, cares if the lender is requiring the buyer to have replacement reserves.

    Reply
    • Toussaint says

      March 21, 2016 at 2:10 am

      Shouldn’t the buyer care if he/she is required to put up more equity when the lender withholds proceeds due to their inclusion of the replacement reserve? It would seem the buyer should care because the additional equity would result in a lower leveraged return.

      Reply
      • David Monroe says

        March 21, 2016 at 2:45 am

        Of course the buyer should care. My comment was the seller doesn’t care what the lender is requiring the buyer to put up for reserves.

        Reply
  7. Javad Neakta says

    November 23, 2015 at 7:25 pm

    With all due respect to all, I would add the replacement reserve in the NOI simply because that money is available to be spent once needed. A mortgage is a cost solely to an investor and is not a part of NOI.

    Reply
  8. bigjayva says

    October 20, 2016 at 9:18 pm

    I agree with this article. The only thing that matters is how the lender looks at it. Real estate is bought with leverage. Period.

    Reply
  9. Mike says

    February 7, 2017 at 6:23 pm

    When modeling cash flow for a property, I have seen some models where they have replacement reserves above NOI and then CapEx below NOI. Is that not double counting?

    Reply
  10. Inquisitive Turtle says

    February 11, 2017 at 5:44 am

    what happens if the reserve replacement does not get fully used upon the exit year? does the surplus of reserve replacement funds get added back to the total exit price?

    Reply
  11. Larry says

    May 31, 2017 at 2:08 pm

    Isn’t it possible that the short-lived items are already in the expenses? If so, then allowing reserves for replacement will understate the NOI and inflate the cap rate!

    Reply
    • Jaren says

      June 4, 2017 at 1:04 am

      I guess it depends on whether the cost items included in the calculation for reserves for replacement are critical in maintaining a property’s value. Even if such costs are slightly longer-lived and shorter-lived expenses are already included in the NOI, capitalizing replacement costs for these items make sense in capturing the “actual value” to a property owner…

      Reply
      • Larry says

        June 5, 2017 at 3:48 pm

        No doubt that the cost items (floor covering, built-ins & roof covering) are critical for the property in maintaining its value and income stream. What I am pondering is that if the overall rate has a recapture component as part of the rate, and it does, then the appraiser who allows ANOTHER deduction in reserves for replacement is making a demand of the income stream to pay or account for deductions for that item twice! For instance, if a new CRE building with a RCN for the is $20,000 with a total useful life, of, say 20 years. Using a straight line method, the expense for the roof would be $1,000 per year. Depending on whether the appraiser uses a straight line method or uses the sinking fund factor.

        Whatever the overall rate may be, there is within it a rate that demands a percentage of the income stream to cover the cost of the depreciation of the roof. If the RCN of the building is $800,000 and the building capitalization rate is 12%, then there is a rate of 2.5% (20K/800K-.025) for the roof is already within that building rate. With a land to building ratio of 1:5 the weighted rate for the roof is 2.0% (.80 X .025= .02) which would be part of the overall rate divided into the NOI for a value. Should you also calculate a reserve replacement for the roof in the expenses, the appraiser is allowing $2,000 per year for the roof that only needs $1,000 for return of the investment in the roof!

        I know that allowing a reserve for short-lived items has often occurred in income approach for CRE, it isn’t something that should be done if the appraiser is going to accurately use an income approach. At least that is my understanding. Other’s insights are invited and welcomed! Larry.D.Ellis@gmail.com

        Reply
      • Larry says

        June 5, 2017 at 7:13 pm

        I think we are on the same track and are both saying reserves for replacement allowance is Cash Flow as in the overall cap rate the provision for reserves is already included. Hope I didn’t confuse anyone.

        Reply
  12. Tyson says

    June 21, 2017 at 11:01 am

    Is there a rough guide on the

    Reply
  13. Tyson says

    June 21, 2017 at 11:03 am

    Is there a calculation for what level the Replacement Reserves should be per annum or is it simply having a builder complete a building assessment?

    Reply
  14. geraldguterman says

    October 12, 2017 at 5:40 pm

    Larry:

    In my own experience, only a fool would not include necessary replacement reserves and even a greater fool would use a percentage or dollars per unit to determine the amount of annual reserves.

    In fact, only the very stupidest would use NOI to calculate value.

    Only cash flow is appropriate for this calculation. Additionally, reserves mean just that. They are to be held separately for their appropriate use.

    Lastly, the largest group of bank failures in history, occurred in the late 1980’s when mandatory reserves were distributed by sponsors as part of the distributions paid to investors.

    When all of the leases for the huge generation of office buildings built within just a few years of each other came up for renewal, competition “took” those tenants away and the owners did not have the funds for tenant improvements and commissions.

    This problem resulted in high enough vacancies to cause a default in hundreds of commercial (office mainly, then hotels and apartments) buildings and consequently led to the failure of large numbers of savings and loans and eventually, the total destruction of the whole S&L industry.

    Reply

Leave a Reply Cancel reply

Your email address will not be published. Required fields are marked *

Primary Sidebar

What is PropertyMetrics?

PropertyMetrics provides web-based software for commercial real estate analysis and presentation.

Recent Posts

  • How the Development Spread Works
  • Understanding the Texas Ratio
  • Understanding the Construction Draw Schedule
  • How The Double Net Lease Works
  • How to Calculate an Interest Reserve for a Construction Loan

WHAT OTHERS ARE SAYING

"I'm a 30+ year seasoned veteran in shopping center development. PropertyMetrics is an excellent source of information with professional grade software for analysis and presentation. I highly recommend it."
- Frank C. Guess | Barnhart Guess Properties, LLC


"PropertyMetrics is very helpful in my understanding of commercial real estate. The presentation and information provided is astute and always to the point with great clarity. PropertyMetrics is truly appreciated."
-Sheriar Khorsandian, CCIM | Osceola Partners, LLC


"I am very impressed with your product. I have to also compliment your company on clearly explaining valuation concepts to me. To put this into context, I asked my professor in my investment class last week if he knew of a way to value an income property using discounted cash flow analysis. Long story short...you guys are smarter than my professor. THANKS PropertyMetrics! "
-Jonathan Torres | College Student


"I want to compliment PropertyMetrics for providing clear and concise tools for analyzing commercial real estate. As the head of a local Taxpayers Association with a considerable amount of municipal real estate, your data provides me with the information needed to show how much current lease terms cost the town in lost revenue, making my task much easier. Thank you!"
-Jerome Scott | Taxpayers Association of Jamestown


I am a professor at NYU's real estate program and I always tell my students that PropertyMetrics has the best and most easily understood explanations of real estate concepts. Great job!!!"
-J. Weinberg, Adjunct Professor | New York University


"I want you to know how much I appreciate PropertyMetrics. As a 30 year real estate attorney focusing primarily on commercial leasing and purchase and sale of commercial properties, it is extremely helpful to see the principles I have learned and used for so many years explained so clearly."
-Jon K. Ladd | Business and Real Estate Law Group


"I am commercial real estate lender for a large regional bank and I recommend PropertyMetrics to everyone."
-Andrew Levin | Commercial Lender


"Frankly, since I have been getting your emails we have one of the best educated offices in our market!"
-William C. Colucci | Associate Real Estate Broker


"PropertyMetrics is awesome. I actually just went ranting and raving about it to a few other analysts at my company and everyone has been thanking me for referring them!"
-Richard Cadena Jr. | Analyst


"PropertyMetrics is great. Invaluable."
-Peter Knobloch | President/CEO

Footer

My Account

Software Login

Courses Login

Contact Us

Do you have questions, comments, or feedback? Drop us a line and let us know. Get in touch.

Get Our Best Content First

Solutions | Blog | Resources | Contact | Terms | Privacy

Copyright © 2021 PropertyMetrics.com

We use cookies to ensure that we give you the best experience on our website. If you continue to use this site we will assume that you are happy with it.OK