By Larry and Adam Mogelonsky
One of the obligations of moving from a home to a condominium is to take your turn on the board of directors. Don’t let anyone fool you into believing that this is a simple, 10-hours-a-month task. The time investment is significantly higher, and even though there is no financial remuneration, your fellow unit owners will treat you as if you’re a paid servant. Perhaps this situation strikes closer to home for many of you already.
As we’ll examine later on in this article, everything is up for grabs as inflation rolls through various sectors of the economy. This is a critical-yet-still-underappreciated variable for today’s hotel finance.
Condo Reserve Studies
Apart from the day-to-day administration, aptly executed by the property manager, the main responsibility of a condominium BOD is to ensure that there are sufficient funds generated through monthly maintenance fees to keep the building operational. The yin and yang of this exercise is balancing the monthly fees versus the quality of service and maintenance expenses. No one wants to see their fees increased, but at the same time, they want to ensure the property is well-maintained. And importantly, no one wants a special, one-time assessment.
While the specific rules vary by state and country, here in our home province of Ontario, Canada legislation mandates that condominium corporations provide adequate funding for long-term repairs and replacement. This is managed through a reserve fund study – an independently developed forecast of expenditures necessary to maintain the building structures. Produced by engineering specialists, this 50-year plan identifies major building systems as well as their forecasted replacement costs and dates. We don’t doubt the capabilities of your engineering team, but the emphasis is on ‘independent’.
As an example, our building has a roof replacement coming up in just under a decade at a forecasted cost of three million dollars. Rather than have a special assessment when the replacement is due, our owners will pay a much smaller amount each month, setting aside these funds so that when the roof needs a serious overhaul, the funds for this project will be available. As the building is already 20 years old, by the time the roof needs replacement, unit owners will have been paying for some 30 years, the expected life of the asset. Our roof is but one of over a hundred items that are identified in the reserve find study, each with a different dollar value and replacement timeline. Moreover, every few years the replacement study gets updated, reflecting differences between expected and actual life cycles.
Hotel Reserve Studies
Each year, hotel asset managers develop a capital budget outlining what is required for the upcoming year. Capital projects tend to be irregular in nature, resulting in some years being significantly higher in need. Thus, there is a dance of sorts where capital requirements get jockeyed from year to year, often delayed to meet available cash flow from operations or debt service coverage. Most troubling, decisions of this nature are frequently made to fit some hypothetical available capital budget, an extreme need (in other words, it’s already broken), or a legal obligation (mostly related to safety). It can all be haphazard and leave hotel owners exposed to uneven annual returns.
A reserve fund study approach would strongly help to eliminate this issue. Instead of asset managers or general managers – who seldom possess an accredited degree in mechanical engineering – making decisions on capital projects perhaps with the assistance of the maintenance team, a schedule of physical requirements would be available annually with more realistic timelines.
Having a reserve fund study does not force the asset manager to upgrade or replace assets just because they are on the schedule. Rather, it serves as a guideline for budgetary decisions in the present to avoid more drastic measures in the future. In our condominium, we made the decision to move several maintenance items ahead a few years while others have been delayed because their useful life was underestimated.
The Impact of Inflation
Many projected costs of capital asset replacement are still based on the values assessed before average inflation moved from 2% to 7.5% or higher. Right now, the narrative around inflation has been centered around commodities and direct-to-consumer goods, and yet it will snowball through nearly every other industry, as we are starting to see in higher costs of new construction.
The impact here is that your long-term capital expenditure budget may be underfunded, failing to anticipate the inflationary pressures on periodic investments like window replacements, new water systems or bathroom renovations. The most dangerous word from the previous paragraph is ‘average’ because it undermines the erratic variable costs that some materials are encountering as global supply chains ebb and flow. For instance, while the average reported by the news is at around 8%, specific goods may be at 25% or more.
This is cause for alarm and yet more one imperative for commissioning a reserve study for your property. For a condo, having the reserve funds allows us to make highly rational decisions without asking our unitholders for additional capital or, more so for commercial real estate, having to plead to a bank for a loan. It’s all about preparedness so that any unforeseen, one-time expenses don’t stymie your business in a world of hyperinflation.
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Editor’s note: To discuss business challenges or speaking engagements please contact Larry or Adam directly.