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:
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:
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.
Yeah replacement is really necessary for the commercial estate stuff.
http://www.manglamgroup.com/flats-in-jaipur/
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.)
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.
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Interesting topic. The context matters as you pionted out. However, how you replacement reserve is treated dep
You are incorrect and your assumptions are not supportable.
Please enlighten me
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.
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?
Yes, it largely depends on context as well as your intended purpose.
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.
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.
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.
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.
I agree with this article. The only thing that matters is how the lender looks at it. Real estate is bought with leverage. Period.
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?
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?
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!
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…
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
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.
Is there a rough guide on the
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?
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.
I certainly think that replacement reserve contributions should be treated as an expense in NOI. In fact, the big difference between EBITA and NOI is that NOI is after reserves, whereas NOI is after. But, my question, when you are capitalizing income to get cap value, is how are the accumulated reserves treated in terms of value. Especially with assets like hotels, that must do periodic rehabs (say, every 7-8 years) to maintain ability to charge mkt rates and retain mkt share, a hotel entity should be saving up for each anticipated rehab so no borrowing is required. The question becomes…let’s say in comparing two hotels that rehab every 8 years, if it is now 4 years on since the last rehab…how do we adjust the value of the two hotels (not just of the RE, but also the entire operating business entities) if, say, once of the entities has put away no reserves, whereas the other has banked the recommended amount in the 4 years since the last rehab. My thought is that the value must be adjusted for the amount of deferred maint that must be ameliorated within the 1st year after purchase AND for the amount of reserves that shuld be banked to make total reserves what they should be had the property been owned all along.