Tin Buckets and Cash Flow

When thinking about glamorous real estate deals, mental images of ribbon cuttings at the foot of sparkling new towers while flashbulbs illuminate freshly manicured mansions often come to mind. It’s the sexy side of the business, one in which the desire for a dazzling show matches the desire for a sizeable return on investment in the future. These not-so-common unveilings are aimed at the front pages and centre spreads of glossy magazines, but how often do they actually happen?

When it comes to planning for real estate investment, the scenarios noted above are not the everyday situations facing investors, asset managers and property managers. While it’s the dream of many to execute glamorous deals, reality is more about air conditioning fan belts, pavement cracks in a parking lot, peeling paint and regular water droplets diving from a ceiling into an awaiting bucket. All of this falls into the umbrella of property maintenance, the unsexy but compulsory side of real estate investment.

Discussing property maintenance can be about as appealing as waiting for a fresh coat of paint to dry, but remember, that new paint is an important part of increasing or maintaining the value in a property. Therefore, planning for property maintenance and how to properly finance it is a key to real estate success.

Capital Reserves

When it comes to property maintenance, capital reserves are a common point of discussion among investors and managers. It often generates plenty of back and forth dialogue about how to approach this fund, which is viewed by some as essential and others as a nuisance. There is no sweet science when approaching reserves, and it’s generally dependent on an individual or group of investors. Whether it’s viewed as a rainy day fund or part of the greater investment, capital reserves are an important consideration and one that should be a key element of the equation.

Having reserves for property maintenance is often mandatory when applying for mortgage loans, however, maintaining reserve capital is a good practice even when it is not required. Like personal financial planning, it’s prudent to be prepared for the unexpected. And like personal financial planning, there’s not necessarily a standard amount that should be in reserve (two months of living expenses, as an example), although there are regulations with strata corporations. Having a reserve is important so that there isn’t a scramble for funds to deal with an urgent issue.

These reserves can either be held in investors’ private accounts, in designated operating accounts or, in many cases, held in escrow by the mortgage lender. It can be used to cover a wide variety of cash flow shortfalls or expenses that arise with property maintenance, as well as vacancy, replacement of major appliances, loan payments and legal costs. The requirements of mortgage lenders frequently change depending on the market and the details revolving around a particular project. Normally, reserve requirements can range between three to six months of operating expenses per property. While some investors feel this is outrageously expensive, others agree that it is just common sense.

Idle vs. Liquid Reserves

The big issue for most investors is keeping this amount of cash liquid and parked on the sidelines. This is especially true when expanding a portfolio. It is crucial to have access to fast cash in a crunch, but too much idle capital can drag down overall portfolio returns.

Some alternatives may include keeping the bulk of these funds in interest-bearing or investment accounts, which can be accessed relatively quickly. Others may find it more beneficial to use a substantial line of credit to cover immediate short-term expenses.

Substantial planning is required in relation to property maintenance so you are able to plan for cash flow. Have a contractor or engineer thoroughly review the property to determine whether specific components will need full replacement or steady maintenance over a period of time. If property maintenance can prevent an unexpected failure, there is room to budget for a replacement or overhaul at a later date. As it is in any business, one of the golden rules in real estate is prevention is almost always the most cost-effective option.

Tolerance Levels

Depending on the type of property, there will be different levels of tolerance regarding property maintenance, which can dictate the amount of funds placed in a reserve. Those living in a residential property will have the lowest tolerance for any repairs and maintenance since it’s their home and disruptions in daily life are not met with much patience. For example, malfunctioning elevators are a great way to annoy tenants.

Tenants in office and retail properties are next on the ladder of tolerance, but depending on the level of public traffic throughout their space, the threshold may not be much higher. Here, it’s the potential disruption to business operations that will frustrate tenants. Heating units going out in the winter will not only exasperate employees, but keep clients and customers away.

Industrial or commercial properties with limited public interaction will have the highest level of tolerance in relation to property maintenance. They may be patient with putting off the repair of a leaky roof and placing a bucket below it until the scheduled maintenance date, as long as it keeps operational costs lower.

All of this is to suggest that appropriate property maintenance and having available reserves to act on repairs or fixes in a timely manner is part of a sound retention strategy. Generally, all parties want operations costs as low as possible, but that desire needs to be balanced with the considerations of whether the disruptions are affecting the personal and business lives of the tenants.

There can be a point when it’s not worth it to continue with the property maintenance strategies and tactics that are being employed, but it’s not an overnight occurrence. Thinking about highest and best use, there may be a period when tenants will leave for another place – albeit not all at once – because those properties may be better suited, including the property maintenance. At that point it may be time to consider other options for the property.

One of the looming controversial questions is: should capital reserves be recognized as a deduction from net operating income when valuing properties? It’s the tail wagging the dog here. If it’s a soft market, a buyer may suggest providing a five per cent capital reserve to get a discounted price. When appraisers look at net income, they want to be conservative and always deduct the capital reserve at three to five per cent. Answering this question is dependent on a number of factors and one that will be up for debate with a number of market considerations in play.


 

Richard Crenian is the founder and president of ReDev Properties, a Canadian owned and operated commercial real estate asset management company. Founded in 2001, ReDev Properties has grown using a long-term approach and now manages over 25 commercial properties, primarily in Western Canada. He can be reached at www.redevgroup.com

 

 

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