Sounds like a university math problem, but it isn’t. Math problems have answers. Reserve fund studies are subject to numerous assumptions beyond anyone’s reasonable control. One such assumption made by far too many reserve fund planners (one that has been for many years) is that the cost of work and expenses from reserve should change at a percentage rate equal to the rate of change that the annual contributions to reserve do. The available evidence illustrates that correlation simply does not happen often enough to justify being used in, or forming the basis of, 30-year or longer cash flow plans.
In Ontario, the Condominium Act and Regulations require condominium Boards to develop a plan for future funding that is sufficient for the anticipated major repair and replacement costs over a period of at least 30 years on a positive cash flow basis. Remember that even though 30 years may sound like a long time, for buildings it is really just a fraction of their likely, and expected, service life. Essentially, the opening balance plus the annual contributions and interest earnings minus the predicted expenses, every year, must be greater than zero. The minimum closing balance for most Corporations is no less than $500 per unit and many corporations establish policies for even higher minimum closing balances. One very interesting policy – that may find its way into the regulations – is that the minimum closing balance in any year of a plan should be no less than, say, 20% of the maximum predicted expenditures in the plan.
In 1991, the Canadian Government and Bank of Canada established an objective to deliberately control inflation to about 2% annually and near the centre of a 1% to 3% target range. Similarly since then, and in the interest of stable, predictable, and affordable common expenses fees, of which reserve contributions make up a third to half, many Boards try to get the common expense fees to only increase at the widely reported rate of the consumer price index (CPI). The CPI is a measure used to broadly track the retail price changes of a basket of goods of approximately 600 items related to food, housing, transportation, furniture, clothing, and recreation. Most condominium professionals agree that plans for future funding that have annual contributions at rates that are in line with CPI are probably sound plans. That may even become the legal definition of an adequate reserve fund plan for future funding one day, in the context of reserve fund planning.
But, reserve funds are meant to be used for the sole purposes of paying for the anticipated major repair and replacement costs of the Common Elements and assets of the Corporation. Paying for the studies too is a valid reserve fund expense. Estimating the cost of performing construction work in an occupied building bears very little correlation to the changing costs of broccoli, mortgages, fuel, sofas, t-shirts, and concert tickets. What does it track closely to? Perhaps, not surprisingly, construction work at occupied properties changes with the cost of building construction, which we have been tracking as the expenditure price index (EPI). Those changes appear to be mostly labour related.
In the summary table, the past 25 years of CPI and EPI are listed (1991 to 2015 both inclusive). When the EPI was less than the CPI a downward pointing arrow in a cool-blue background is indicated, whereas when the EPI is equal to or greater than the CPI an upward pointing arrow in a red-hot background is indicated.
Herein lies the rub of reserve fund planning: in the past 25 years, the future value of money going out of reserve has changed at rates greater than inflation 18 times out of 25, over 70% of the time. It has only been less than CPI annually seven times in: 1991, 1992, 1993, 2009, 2010, 2013, and 2014. All of those negative adjustments are related to periods of extreme events, including:
- In the early 90’s combined Canadian and US recessions with long recoveries
- In 2009/10 the US sub-prime mortgage fiasco and its fallout
- The 2013/14 global debt crisis
When EPI is lower than CPI, it averages about -0.2% compared to CPI in those same years at 1.9%. However, when EPI is equal to or greater than CPI, it averages 3.9% compared to CPI in those same years at, no surprise here, 2.0% (the deliberate inflation control target). Therefore, 16 of the last 25 years, EPI is usually greater than CPI by about 2% or more. Only twice in the last 25 years has EPI been equal to CPI and only 7 out of the last 25 years, which has been related to three extraordinary financial events, that EPI was less than CPI.
If your plan is predicated on EPI matching CPI, or construction at occupied properties being like vegetable crops, you know it will be wrong 23 out of 25 times. As past experience has shown, if it assumes, quite correctly, that EPI is roughly 2.0% greater than CPI, then you can be more confident that the expenses are more accurately projected.
Consequently, the cumulative growth of expenses from reserve will always reach a point of being greater than the balances built up and contributions made over time. Regular updates will continue to reveal that in most cases, contributions need to be increased at a rate greater-than-inflation to overcome the next updated window of expenses. The greater-than-inflation time-period should be reasonable, not so short that it causes distress in the community, and in any event not more than ten years in our opinion. That timeframe allows the completion of several tri-annual updates to either support the rationale or identify revisions needed. We also believe that it will be necessary to make prolonged funding adjustments gradually to overcome the proposed longer minimum duration cash flow tables (probably 45 years) that the new Act and Regulations in Ontario are likely to implement.