It may sound like a nit-picking detail: Where and how do you account for “reserves for replacement” when you try to value – and evaluate – a potential income-property investment? Isn’t this something your accountant sorts out when it’s time to do your tax return? Not really, and how you choose to handle it may have a meaningful impact on your investment decision-making process.
What are “Reserves for Replacement?”
Nothing lasts forever. While that observation may seem to be better suited to a discourse in philosophy, it also has practical application in regard to your property. Think HVAC system, roof, paving, elevator, etc. The question is simply when, not if, these and similar items will wear out.
A prudent investor may wish to put money away for the eventual rainy day (again, the roof comes to mind) when he or she will have to incur a significant capital expense. That investor may plan to move a certain amount of the property’s cash flow into a reserve account each year. Also, a lender may require the buyer of a property to fund a reserve account at the time of acquisition, particularly if there is an obvious need for capital improvements in the near future.
Such an account may go by a variety of names, the most common being “reserves for replacement,” “funded reserves,” or “capex (i.e., capital expenditures) reserves.”
Where do “Reserves for Replacement” Fit into Your Property Analysis?
This apparently simple concept gets tricky when we raise the question, “Where do we put these reserves in our property’s financial analysis?” More specifically, should these reserves be a part of the Net Operating Income calculation, or do they belong below the NOI line? Let’s take a look at examples of these two scenarios.
Now let’s move the reserves above the NOI line.
The math here is pretty basic. Clearly, the NOI is lower in the second case because we are subtracting an extra item. Notice that the cash flow stays the same because the reserves are above the cash flow line in both cases.
Which Approach is Correct?
There is, for want of a better term, a standard approach to the handling capital reserves, although it may not be the preferred choice in every situation.
That approach, which you will find in most real estate finance texts (including mine), in the CCIM courses on commercial real estate, and in our Real Estate Investment Analysis software, is to put the reserves below the NOI – in other words, not to treat reserves as having any effect on the Net Operating Income.
This makes sense, I believe, for a number of reasons. First, NOI by definition is equal to revenue minus operating expenses, and it would be a stretch to classify reserves as an operating expense. Operating expenses are costs incurred in the day-to-day operation of a property, costs such as property taxes, insurance, and maintenance. Reserves don’t fit that description, and in fact would not be treated as a deductible expense on your taxes.
Perhaps even more telling is the fact that we expect the money spent on an expense to leave our possession and be delivered to a third party who is providing some product or service. Funds placed in reserve are not money spent, but rather funds taken out of one pocket and put into another. It is still our money, unspent.
What Difference Does It Make?
Why do we care about the NOI at all? One reason is that it is common to apply a capitalization rate to the NOI in order to estimate the property’s value at a given point in time. The formula is familiar to most investors:
Value = Net Operating Income / Cap Rate
Let’s assume that we’re going to use a 7% market capitalization rate and apply it to the NOI. If reserves are below the NOI line, as in the first example above, then this is what we get:
Value = 55,000 / 0.07
Value = 785,712
Now let’s move the reserves above the NOI line, as in the second example.
Value = 45,000 / 0.07
Value = 642,855
With this presumably non-standard approach, we have a lower NOI, and when we capitalize it at the same 7% our estimate of value drops to $642,855. Changing how we account for these reserves has reduced our estimate of value by a significant amount, $142,857.
Is Correct Always Right?
I invite you now to go out and get an appraisal on a piece of commercial property. Examine it, and there is a very good chance you will find the property’s NOI has been reduced by a reserves-for-replacement allowance. Haven’t these people read my books?
The reality, of course, is that diminishing the NOI by an allowance for reserves is a more conservative approach to valuation. Given the financial meltdown of 2008 and its connection to real estate lending, it is not at all surprising that lenders and appraisers prefer an abundance of caution. Constraining the NOI not only has the potential to reduce valuation, but also makes it more difficult to satisfy a lender’s required Debt Coverage Ratio. Recall the formula:
Debt Coverage Ratio = Net Operating Income / Annual Debt Service
In the first case, with a NOI of $55,000, the DCR would equal 1.41. In the second, it would equal 1.15. If the lender required a DCR no less than 1.25 (a fairly common benchmark), the property would qualify in the first case, but not in the second.
It is worth keeping in mind that the estimate of value that is achieved by capitalizing the NOI depends, of course, on the cap rate that is used. Typically it is the so-called “market cap rate,” i.e., the rate at which similar properties in the same market have sold. It is essential to know the source of this cap rate data. Has it been based on NOIs that incorporate an allowance for reserves, or on the more standard approach, where the NOI is independent of reserves?
Obviously, there has to be consistency. If one chooses to reduce the NOI by the reserves, then one must use a market cap rate that is based on that same approach. If the source of market cap rate data is the community of brokers handling commercial transactions, then the odds are strong that the NOI used to build that market data did not incorporate reserves. It is likely that the brokers were trained to put reserves below the NOI line; in addition, they would have little incentive to look for ways to diminish the NOI and hence the estimate of market value.
The Bottom Line – One Investor’s Opinion
What I have described as the standard approach – where reserves are not a part of NOI – has stood for a very long time, and I would be loath to discard it. Doing so would seem to unravel the basic concept that Net Operating Income equals revenue net of operating expenses. It would also leave unanswered the question of what happens to the money placed in reserves. If it wasn’t spent then it still belongs to us, so how do we account for it?
At the same time, it would be foolish to ignore the reality that capital expenditures are likely to occur in the future, whether for improvements, replacement of equipment, or leasing costs.
For investors, perhaps the resolution is to recognize that, unlike an appraiser, we are not strictly concerned with nailing down a market valuation at a single point in time. Our interests extend beyond the closing and so perhaps we should broaden our field of vision. We should be more focused on the long term, the entire expected holding period of our investment – how will it perform, and does the price we pay justify the overall return we achieve?
Rather than a simple cap rate calculation, we may be better served by a Discounted Cash Flow analysis, where we can view that longer term, taking into account our financing costs, our funding of reserves, our utilization of those funds when needed, and the eventual recovery of unused reserves upon sale of the property.
In short, as investors, we may want not just to ask, “What is the market value today, based on capitalized NOI?” but rather, “What price makes sense in order to achieve the kind of return over time that we’re seeking?”
How do you treat reserves when you evaluate an income-property investment?
—-Frank Gallinelli
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Copyright 2014, Frank Gallinelli and RealData® Inc. All Rights Reserved
When I get info on a commercial property, I always have to run my own NOI because I always see them do them differently, even from appraiser to appraiser. It’s a hassle, but I try to look at it as an opportunity to use their information against them to negotiate a better price due to their valuation. If someone includes reserves, but without a cap, then essentially your saving money every year and growing it, but one you hit a certain amount, you should be able to handle everything on your property. for example. If the most expensive repair on my property is 30k and I decide 40k is my cap in case more than one thing happens at a time, then I’m not going to pull out any more for reserves after I hit my cap. It’s the same idea of insurance companies running a pool of money and not expecting everyone to get sick all at the same time.
In the appraisal arena, different properties have different market perceptions from an investor’s standpoint. A “mom and pop” investor will typically not utilize a reserves account because of owning smaller properties, and fix/repair items on an as-needed basis. More experienced and investor savvy participants will include this cost in their pro formas. We normally look to the market and ascertain what the overall trend is for a particular property type. With this being said, normally if a reserves expense is not included in the analysis, employing a slightly higher cap is used to account for the increased risk.
Philip — You make excellent points here. Indeed, “mom and pop” investors typically do not consider future one-off costs when building a pro forma — just as they will typically make not an allowance for property management expense because they plan to manage personally. Your suggestion to use a slightly higher cap rate to account for the higher risk is particularly elegant because it avoids entirely any argument as to whether reserves should be above or below the NOI line.
One sidebar note: For an investor who has no track record and is making an initial presentation to a lender, there can be some benefit to including an allowance for reserves in that presentation, either ongoing or simply funded upfront. Quite simply, it can demonstrate that, inexperience notwithstanding, the investor recognizes the need to anticipate future costs that are not part of the day-to-day operation.
Mr. Gallinelli,
Excellent academic article! Thank you. While I completely agree with your overview, there is a factor that seems to be absent from consideration, and it is a big one. From my own experience as a retail real estate broker and investor, MANY savvy investors do not follow the convention you suggest, and instead include CapEx Reserves in Operating Expenses. To me this is a particularly abhorrent practice, but it is hard to criticize profit-seeking investors. The lease types I almost always deal with are of the Net to NNN variety. In placing CapEx Reserves as a line-item within Operating Expenses, property owners are able to charge tenants for these reserves, and more often than you might think, these owners get away with it. Generally, such tenants are not of the national credit tenant ilk, but that depends on the attractiveness of the center. Excellent real estate can enable owners to get away with a lot with tenants. The point of all of this, is that when such practice is employed, (typical) market cap rates can indeed be applied to the NOI (assuming an appropriate allowance for vacancy) to arrive at a higher value for ownership. Also, lenders and appraisers, where tenants pay for these reserves, do not punish the NOI by raising it account for CapEx Reserves because they are in fact, tenant funded. Neither do investors interested in purchasing such properties. I just wanted to bring this matter to light knowing how prevalent it seems to be where I conduct my business.
Frank,
Greatly appreciate the article and advice. What do you think about using Home Warrantys? It has the same “rainy day” effect as the reserves approach.
I have found them to be a good safety net with decent ROI. For example I had to replace a boiler recently and the policy reimbursed me $2500 of the $5000 expenditure. The cost is on average $600 per year. I can send you a list of what all is included. I would be very interested to hear your expert opinion.
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