The Hidden Risks of Reserve Fund Planning

As condos mature and reach the age where infrastructure replacements are necessary, many condo owners experience the discomfort of reserve fund planning. Even those who adhere strictly to their reserve fund study recommendations discover there is a significant difference between what is on the page, and the actual cost. This has been compounded by years of low interest, and owners have not had the benefit of earning interest on their reserves.

Reserve fund requirements often get pushed aside by the reality day-to-day issues that arise when administering the condo’s affairs. Rising operating costs and preemptive planning take a back seat while bylaw infractions, parking issues, neighbour disputes and pet droppings take precedence. While all these things are not unimportant, overall stewardship of a condo’s financial future is the board’s primary responsibility. 

Risk management, a concept usually associated with insurance, can just as easily be applied to reserve fund planning. For most aging condos, years of trying to delay fee increases have taken their toll on reserve funds. There are many contributing factors, but perhaps the most pervasive is the average owner’s focus on trying to keep condo fees as low as possible – at all costs. It is human nature to deal with the realities in front of us and leave future concerns for the future owners. Those future owners are strangers after all that you haven’t even met yet – who cares about them. Well, that future owner just might be you. Fortunately, this is not the way condos are structured.

There is an overarching principle of fairness that should govern condos. Condos should be governed consistently, with the distribution of benefits and burdens dived equally over all owners during the entire lifetime of the building. This means that every owner has an obligation to pay their share of the cost of replacing aging infrastructure, today, regardless of the age of the property. Just because it is new, doesn’t mean you should maintain artificially low budgets – this is unfair to future owners. Just because the building is old and you’re on deaths doorstep, doesn’t mean you should maintain an artificially low budget either. Owners, tomorrow and tomorrow, need to be protected from having to fund the full replacement costs out of pocket when big projects come up. In a perfect world, reserve contributions remain consistent, increases naturally, gradually, and yearly to account for inflation, throughout the life of a property. Write that in stone, and never change it – your condo will be much better off.

The strategy of maintaining low condo fees at the expense of funding the reserve defies this principle of fairness. Artificially low budgets are essentially stealing from future owners. As many new owners of aging condos are finding that means punishing special levies regardless of how long they have owned their condo.

The myth that market value is based on low condo fees has persisted in the minds of condo owners since condos were devised. If low condo fees are what drives buyers, those same price sensitive buyers are being lured into situation they are completely unprepared for. The consequence is usually a special levy to fund necessary capital replacements – this certainly doesn’t make price sensitive buyers happy, and these recurring stories ruin the reputation of condominiums for everyone.

The market, or resale value of a condo is dictated by market forces, just like any other type of real estate. Market value is a metric based primarily on the supply and demand of real estate. Condo fees factor in along considerations of monthly budget, like utilities and debt payments. Market value is also driven by location, condo fees are at best an after thought. Ultimately a buyer selects a condo based on their own personal priorities or even just the emotions a particular property evokes. The mandatory fees, like taxes, don’t determine whether you participate in a market – as much as how much you want to live there.

One of the unique characteristics of a condo is the distinction between market value and equity. When a special levy is imposed on owners to correct a buildup of deficits over the years, it has a very real, direct, and immediate impact on an owner’s equity in their condo. Protecting equity is what a prudent board should focus on.

When a special levy is announced there is inevitable confusion about why sufficient money hadn’t been set aside over the years. The owners who have lobbied for low condo fees and the suppression of increases usually don’t see the irony in how this strategy has led directly to the situation in which they now find themselves. Even a new board, who inherited a deficient reserve fund from earlier boards, tends to adopt the same strategy and put off addressing the problem. It takes real courage and foresight to understand what’s happening and correct this. If not, the problem reaches the critical mass on its own anyway and the owners face – the dreaded special levy.

One of the challenges in governing a condo is explaining this pattern to owners. For some reason, the problem is only acknowledged in hindsight. Setting money aside in small, affordable increments is so obvious – after the fact. Strategic financial planning helps offset the devastating impact of large special levies. Owners need to understand that continuing to put off fee increases will compound the problem and ultimately everyone will bear the cost. 

Helping owners break down annual budgets so they are more easily understood would be a step in the right direction. Condo budgets usually only show the total of all the fees received from owners and the total cost of all operating expenses and reserve contributions. These large numbers, year over year, after many budget trials reliably predict the stable outcome of what is known as “sticker shock”. It’s time for more creative thinking. Illustrate the value received from the monthly fees. It is more relevant to an owner, at budget time, to show their monthly portion for common insurance stated simply in a per unit price, of say – $150 – instead of sharing a total annual premium of $150,000 for the entire common insurance policy. Large numbers are pretty much incomprehensible, irrelevant and on the face it of – just upsetting to look at. The same applies to services like landscaping and snow removal – break them all down into fees per unit so everyone can do the math intuitively. If the benefits of co-ownership are easily calculated, relative comparisons between condo living and detached home living can be made and understood. Then you can move on to the all-important buy in for long term planning, making healthy reserve funds part of the conversation and easier to implement.

As an aside, looking at relative comparisons, the cost of owning a house compared to a condo, some may argue that condos are more expensive to live in than houses. The cost of utilities, insurance and maintenance of a condo and a house reveals that there is still economy of scale when owners share the cost of these expenses.

Understanding of the principle of fairness and the risks associated with ignoring reserve fund requirements goes a long way toward convincing most condo owners realistic fees based on reasonable operational and reserve fund costs are better than budgets based on wishful thinking. There is no magic formula to solve this conundrum, but one thing is very certain: if owners continue to ignore long-term needs using short-term strategies, there is considerable risk that a special levy could take a serious toll on their equity. The current strategies are unsustainable and new ways of thinking about condo finances need to be explored.