Reserve Funds

Reserve Fund

The theory

Before discussing reserve funds, here are some extracts from the RICs Code 3rd edition:

The intention of a reserve fund is to spread the costs of ‘use and occupation’ as evenly as possible throughout the life of the lease to prevent penalising leaseholders who happen to be in occupation at a particular moment when major expenditure occurs…”

“It is, therefore, considered good practice to hold reserve funds where the leases permit….”

“{The managing agent} should also recommend your clients to have a costed, long-term maintenance plan that reflects stock condition information and projected income streams. This should be made available to all leaseholders on request and any potential purchasers upon resale. (7.5)

Meanwhile, the ICAEW Tech 03/11 guidance contains examples of service charge accounts and says this as a footnote (3):

The term used for transfers to reserves will need to reflect the provisions of the lease to ensure that it is allowed as relevant expenditure. Where there are several reserve funds, the transfer or payment should be shown separately for each fund either on the face of the income and expenditure account or in the notes. The terminology will need to be consistent with the lease in order for the item to be treated as relevant (allowable) expenditure for service charge purposes.

The ideal is crystal clear and readily understood. However, as leaseholders often come to know, the leasehold caper does not operate on ideals. The RICS code reveals a sting in the tail:-

If after the termination of any lease there are no longer any contributing leaseholders, any trust fund shall be dissolved and any assets comprised in the fund immediately before dissolution shall, if the payee is the landlord, be retained by them for their own use and benefit, and in any other case, be transferred to the landlord by the payee.”

Once paid in, reserve contributions are never refunded.

The reality

Given the significant sums that might be involved, the ideal expressed in the RICs code that the: “intention of a reserve fund is to spread the costs of ‘use and occupation’ as evenly as possible throughout the life of the lease,” deservedly sends shivers through leaseholders, or ought to do so.

The problem with reserve funds projected for the whole life of the lease is fivefold:-

1) Contrary to the RICs code, there is in practice no “ensuring monies are available” no matter how much leaseholders pay into reserves;

2) Leaseholders’ interests are usually more short term than the life of the lease;

3) Freeholders and managing agents may change numerous times during the life of a lease;

4) There is a high probability for long term reserves being exploited or misused.

5) Come the day reserve funds are needed, guess what, no funds.

Funny story

I bought my leasehold flat when our estate was about fifteen years old (almost twenty years ago now). My surveyor recorded that the exterior of the building showed no sign of redecoration since the estate was built. The lease did not set any specific refurb cycle, just “as and when” the landlord saw fit.

In my first flush of ownership I sent off a copy of my surveyor report to the agent and politely enquired what plans they had for exterior painting, mentioning that my exterior wood was showing signs of rot. I got no response.

A few years later I received a letter. Our new agent said that, in their “professional opinion”, we needed a reserve fund for among others things exterior redecoration. I thought things were on the up, so happily paid the extra.

A few more years went by, still no exterior works. I could see my door frame was now rotting and decided I’d better dig out the rot, cure the wood, refill and repaint. Meanwhile, I noticed in annual accounts that we had nil in the deposit account, but each year a surplus sat in the Income & Expenditure account, despite the lease not allowing any carried-over surplus. There was no mention of a reserve fund.

More years passed and I noticed how the surplus evaporated because the agent used it as an ‘advance loan’ for annual costs, and did not revise the annual service charge. This might sound OK but consider that new owners were benefiting from my paying in advance before they purchased.

Then one day a new managing agent took over and spent the remaining ‘surplus’ on a sudden hike in agent fees. A few more years passed and this agent stopped issuing annual accounts. Finally a whole bunch of flats went to tribunal to complain, among other things, about long term misuse of reserves. The LVT effectively told us to stop being petulant. They did not seem to see the grievance that those of us who had paid for years in advance had subsidised newer flats. I imagine the folks who run these tribunals are not leaseholders.

So how should a reserve fund work?

The first bitter fact leaseholders have to swallow is that the theory of a reserve fund makes sound sense. The tragedy is that reserve funds are managed by managing agents. If leaseholders could manage to take over control of their own service charge accounts, suddenly the ideal of a reserve fund can make perfect sense.

One method for assessing a reserve fund is to create cyclical targets based on current estimates for specific works, and then index the estimates for estimated inflation until the work is needed.

Annual contributions are calculated using a pro-rated formula. There is no need to wait the full cycle for a particular work, as expenditure from the fund should average out across cycles.

This becomes the Long Term Maintenance Plan (LTMP) from which the annual reserve fund contribution is calculated. Managing agents will offer to create one of these for about £500.

Before we exercised RTM, one of our numerous managing agents issued an LTMP. It looked OK on face value if rather complex for the pensioner flats to understand. It came without further explanation. The fund looked dangerously high. Turned out the agents had assumed everything that could go wrong would go wrong, included the need to replace all the roofs. This one item alone would have –by the end of the lease–accumulated £400,000 in just one ‘pot’. Remember the RICs code as to what happens to any funds left at the end?

When we acquired RTM we came up with a more modest compromise plan. We operated on the assumption that some, but not all, the roofs would need replacing over a certain cycle. We did the same with all the other major ticket jobs that could arise. If one pot was ever filled without need arising, we projected we would build a pot for something else. The goal was to aim for a positive cash flow as far as this can ever be achieved but without building eye watering amounts that could go to the freeholder.

The maths

The first step is to read the lease and list all the non-annual costs that could arise. There is nothing mysterious here. The average freehold home owner knows intuitively that their roof might need repairing etc. Whereas they might not feel compelled to save towards such events (if only because when they sell the buyer does not expect to be handed a ‘reserve fund’) in leasehold the principle is fair enough that leaseholders who just happen to live in the block when the drains need digging up shouldn’t be expected to shoulder the costs.

Once a list of cost heads is prepared, the next step is to get current estimates. Again there is no mystery here. Homeowners up and down the country get quotes or estimates every day. Nowadays there are websites such as http://quotationcheck.com/visitor-sitemap/ that will run quotes on almost anything. If you want to apply belt and braces you could pay a professional surveyor to do a dilapidation and condition survey with estimates and priorities.

Once you have the estimates you decide a cycle in which to collect the total for that pot, say seven years. Some things might have a longer cycle, such as rewiring a communal hall or resurfacing a car park.

Next you decide an inflation index, say 2.5%. You could squeeze the maximum out of contributions but the higher the cost the less likely the willingness to agree to a reserve fund. Now you can run the numbers.

Example: Exterior refurbishment fund

  • Estimates are sought at today’s prices. An example current year figure of £4000 is used here.

  • The £4000 current estimate is indexed for inflation over the period of the planned fund. Inflation-indexing is not a fixed science as building and decorating costs can remain static.

  • Here, the example estimate of £4000 is indexed at 2.5% over seven years:- £4000, £4100, £4203, £4308, £4415, £4526 and £4639.

  • In year one, the amount to collect is £4000 ÷ 7 yrs = £571.

  • In year two, the amount to collect is (£4100 – £571) ÷ 6 yrs = £588 etc.

  • At the end of the seventh year, the total reserve fund is available to be used. Or work may be phased to start earlier, as long as the first phase costs have been reached.

  • The exercise is repeated for each ‘pot’ and all the sums for year one are totalled, and likewise year two etc. The result can be rounded to create a sensible figure.

Here are a number of example ‘pots’ added together:

Reserve Fund

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