Replacement Reserves- above or below the line?

[Jeff Beatty]

First some background so you'll know where I'm coming from:
- I've been reviewing multifamily appraisals since 1981, including a stint at Freddie Mac, underwriting of many Fannie DUS loans, to now working for a developer. My only formal appraisal course was 201 ( Income Property)back in 1986 or 87.

So, my question regards the adding of replacement reserves "above the line" when calculating NOI. I never used to see or count it that way, but I'm now seeing it more frequently, but not all the time. Has there been a change in how this is handled. Is it consistent? Is there a guideline somewhere?

I asked this question at a CCIM course and nobody could give me an answer.

Thanks in advance for your help.

 

[Michigan CG]

I am not following the above or below the line...what line? Replacement Reserves are generally an expense item.

 

[Caligirl]

Above the line?

Are you asking if they are deducted from PGI vs. EGI?

 

[Jeff Beatty]

To clarify, we used to always calculate NOI as EGI less Operating Expenses, and not considering Reserves as an Operating Expense. It entered into our calculations (as a lender) in calculating DSCR but didn't affect value.

 

[Caligirl]

I was trained to deduct reserves as an operating expense *especially* for large multi-family complexes. It is typical and expected behavior in my market. Here you might see reserves run anywhere from 2-5%, depending on the size, number of units, condition of property/deferred maintenance, existing reserves, and type of common area amenities (but of course this varies). Looking back at the last three to five years of regular maintenance is a good start in 'projecting forward' an appropriate reserve.

In my market there is an obvious relationship between appropriate reserves, property type and professional management. Ie., comparative analysis of operating statements for smaller, owner-managed, 'student occupied' properties shows a lack of long-term planning and regular maintenance *more often* than do large properties which are operated by professional management companies.

 

[xm4yb7]

It will depend on the property type and the market the property is in. According to Korpacz, 68% of apartments capitalize the income after deducting the replacement reserves but 75% of office properties in Chicago capitalize the income before the replacement reserves.

When we verify information like cap rates and NOI, we always ask if the replacement reserves were deducted before or after capitalization.

 

[Jeff Beatty]

That's what I needed to know. Does Korpacz break that down by market?

 

[xm4yb7]

They break down the office segment by market, everything else is national.

 

[Jeff Beatty]

Thanks. I'll talk our appraiser into putting us in the 32% group unless the Lender insists.

 

[Lost Cause]

My experience is that those doing direct capitalization generally take reserves out before NOI. And those doing DCFs take reserves after NOI, as part of capital expenses. Yes, it is inconsistent, but that is what I am seeing out there.