Understanding Replacement Reserves in Commercial Real Estate

The topic of replacement reserves is often confusing for commercial real estate professionals. How much should be set aside for replacement reserves? Should replacement reserves be included in net operating income? How do replacement reserves impact cap rates and value? In this article we’re going to take a closer look at reserves for replacement, clear up the confusion, and also tackle some common misconceptions.

What are Replacement Reserves?

First of all, what are replacement reserves? Replacement Reserves are funds set aside that provide for the periodic replacement of building components that wear out more rapidly than the building itself and therefore must be replaced during the building’s economic life (short lived items).

These components typically include the replacement of the roof, heating, ventilation, and air conditioning (HVAC) systems, parking lot resurfacing, etc. Note that replacement reserves do not include minor repairs and maintenance such as broken doorknobs or lightbulbs. These minor expenses are considered routine operating expenses, not irregular capital expenditures.

How much should be set aside for replacement reserves? As always, it depends. Typically a commercial property will be inspected by a general contractor prior to acquistion. This will give you a good indication about what will need to be replaced over the intended holding period and allow you to work backwards into an appropriate replacement reserve amount. Additionally, many lenders will also require a replacement reserve to be set aside, usually in escrow, to cover major capital expenditures over the term of the loan.

Should Replacement Reserves be Included in NOI?

Conventional wisdom says no, replacement reserves should not be included in the NOI calculation. This is what’s taught in many commercial real estate textbooks and even the highly respected CCIM courses. However, just because something is popular doesn’t make it right. As always, the decision to include, or exclude, reserves for replacement from NOI largely depends on the context.

One thing to keep in mind is that many sellers and listing brokers will intentionally exclude replacement reserves from their proformas in order to boost NOI, and thus improve valuation. Buyers, on the other hand, are typically much more conservative when creating a proforma. Recognizing this tension can be helpful prior to entering into any negotiations. Additionally, lenders will almost always include a reserves for replacement figure in their NOI calculations when determining the maximum loan amount. This makes sense from their perspective because lenders want to minimize risk and ensure the property’s cash flow is sufficient to repay the loan. Maintaining an adequate reserve for replacement gives a lender more comfort that a property can support the loan without relying on any capital injections or guarantor support.

Where context becomes particularly important is in understanding how market based cap rates are calculated. You want to ensure you’re comparing apples to apples. For example, it’s common for appraisers to value a property using a market-driven cap rate based on comparable properties in the relevant submarket. However, if the market driven cap rate you are applying to a stabilized NOI is derived from properties with reserves already netted out, then this obviously wouldn’t make sense to apply this cap rate to an NOI without reserves included. Let’s take a quick example to illustrate the difference:

replacement reserves included in NOI

As shown in the above simple proforma, replacement reserves are included in the NOI calculation. As such, the calculated net operating income is $750,000 and the resulting valuation based on an 8% cap rate is $9,375,000. Now, let’s take a look at what happens when we exclude replacement reserves from NOI:

NOI without replacement reserves
As you can see, the resulting valuation is $10,000,000, which is an improvement of $625,000. This is certainly a significant difference in value that should not be ignored. Keep this in mind when working with seller provided proformas. Also, when reviewing third-party appraisals, this is usually a good item to take a closer look at.

Ultimately, the practice of capitalizing NOI without including any ongoing expenditures required to maintain market based rents isn’t wise. These ongoing capital expenditures may include reserves for replacement, and even tenant improvement and leasing commissions required to keep the property occupied. Sophisticated investor’s will of course understand this and most certainly take it into account when determining value. As Warren Buffett famously asked:

 Does management think the tooth fairy pays for capital expenditures?   -Warren Buffet

Although Warren Buffet was referring to the misuse of Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), the same concept certainly applies to NOI and commercial real estate. Why would you determine value without taking into account all required expenditures to keep the property occupied and otherwise competitive?

Conclusion

Replacement reserves are an important line item in any commercial real estate proforma. Capital expenditures are necessary for maintaining a competitive and fully occupied property. Yet, many people gloss over the reserves for replacement line item and often exclude it completely from the NOI calculation. As shown above this can have a significant impact on a property’s valuation and as such it should not be ignored. Whether you include replacement reserves in NOI or not is largely based on context, but in either case your choice should be based on sound reasoning.

  • Prince Kapoor

    Yeah replacement is really necessary for the commercial estate stuff.

    http://www.manglamgroup.com/flats-in-jaipur/

  • Jerry

    You are absolutely correct. The only major issue is how detailed to you get with the reserves. Certainly major replacements, roof, HVAC, parking lot, etc. should be included. The more complicated issue is the discount rate used to calculate the reserves and the determination of the future cost of the replacement. Most would suggest that the investor’s rate is appropriate. However, that rate may be adjusted to reflect the uncertainty associated with the future value of the replacement. Contrary to prevailing wisdom, the more uncertain the future replacement cost, the lower the discount should be. (This actually makes sense. A lower discount rate increases the amount needed for the reserve.)

    • Rob

      Great observations. Usually a “finance rate” or “safe rate” is used, which is essentially a risk free rate. That way, you don’t put the capital at risk today since you want to make sure you have it in the future.

  • DennisMay

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  • Yomi Omotoso

    Interesting topic. The context matters as you pionted out. However, how you replacement reserve is treated dep

    • Juan Carlos

      You are incorrect and your assumptions are not supportable.

      • Yomi

        Please enlighten me

        • Jeremiah

          Yomi,
          I tend to agree with you. Financing at the end of the day is the tail that wags the dog. We underwrite properties from the buyer’s perspective which in turn is going to be largely dependent on the lender’s perspective. If the seller has a pie in the sky number on what they perceive the value to be and are misplacing capital reserves below the line to hit their numbers, the buyer and lender aren’t necessarily going to view it the same way and the deal could up not being traditionally financeable which eliminates a huge pool of prospective buyers. We deal exclusively in multifamily so on short term leases with lots of turnover costs, we put capital reserves above the line which is the industry norm. From my understanding, it is more common to put capital reserves below the line for retail and office properties.

  • Michael

    Your blog on replacement reserve was very informative as or all of your blogs. I have been reading your blogs for sometime know and my commercial real estate knowledge is forever increasing. I am beginning to understand why some place the replacement reserve above the line and others place it below the line. Therefore, am I correct in assuming the placement of the reserve replacement depends on what side of the transaction one is on?

    • Rob

      Yes, it largely depends on context as well as your intended purpose.

  • David Monroe

    Replacement reserves should never be included in the NOI. The way something gets treated, operational, interest, reserves, is all determined by accounting functions and how their treated in the tax world.

    Reserves are held for larger items, as you mentioned in the article, such as roof replacement, parking lot repaving, and HVAC replacement. All of these items are Capital Expenses and therefore can depreciated and are not taxed as an operating expense.

    Reserves are typically an amount held in escrow, usually provided at acquisition, and are not increased over time, only replaced if used. Therefore reserves should never be included in the NOI.

    A property can operate without reserves, just like it can operate without a loan, and we don’t put our mortgage interest in the NOI, nor should you put replacement reserves in the NOI.

    In the sale of a property, reserves are only considered by the lender, based on condition of the property and the strength of the buyer, and the buyer so they can calculate annual cash flow and cash on cash returns. The seller, nor the property, cares if the lender is requiring the buyer to have replacement reserves.

    • Toussaint

      Shouldn’t the buyer care if he/she is required to put up more equity when the lender withholds proceeds due to their inclusion of the replacement reserve? It would seem the buyer should care because the additional equity would result in a lower leveraged return.

      • David Monroe

        Of course the buyer should care. My comment was the seller doesn’t care what the lender is requiring the buyer to put up for reserves.

  • Javad Neakta

    With all due respect to all, I would add the replacement reserve in the NOI simply because that money is available to be spent once needed. A mortgage is a cost solely to an investor and is not a part of NOI.

  • bigjayva

    I agree with this article. The only thing that matters is how the lender looks at it. Real estate is bought with leverage. Period.