Reserves for Replacements - Discussion

[Ricky LaFleur]

Here's my thoughts: In my area, most of the cap rate data available (by brokers, investors, or even RealtyRate) is developed with no reserves being taken, which produces a lower capitalization rate. So, I've moved away from attempting to estimate them while extracting NOI from sales, as I believe I can more reasonably rely upon investor survey, broker interviews, etc, to inform my reconciliation of cap rate data. I think, as noted in the forum post below, the reserves can be quite complex to accurately develop as well, especially in sales with limited information available. My justification for this, besides doing what the market already appears to be doing here, is that it might actually produce a more accurate cap rate on a consistent basis, even though prudent ownership would reason that reserves would be necessary. Obviously, however you approach it, one should be consistent in applying the same method to sales and subject, and if so, I'm not certain that the results produced will vary much... although I might be happily persuaded otherwise, if someone can demonstrate so.

Interested to see what others currently practice in their areas: Do you include reserves for replacement in your income pro-forma (for subject and sales) or do you not? Do you for some property types and not others? Do you include only short-lived items?

Here's an interesting post from a while back on it. Sure wish the people who contributed to posts like these in the past would visit the forum again.

Reserves For Replacement

I was discussing reserves with a fellow appraiser and it got me thinking that this may not be something that we all view consistently. In TARE, it acknowledges some market variations, which could explain why reserves may not always be analyzed in the same manner, but I wanted to get your...

appraisersforum.com

 

[George Hatch]

I watch what my comps are doing.

 

[Overimprovement]

From a commercial lending perspective, it also varies. If we are financing the construction (24 month) then a 5 year balloon on a new multi-family project, we do not require them in the underwriting, and usually don't see them in the proforma from the client either. That makes sense, its brand new construction, usually class A as well, though we do some class B new construction. A refi on an existing 20 year project? Yep, gonna include whether the appraiser does or not. I think this matters since most buyers will work their financing cost into whatever model they have to arrive at a price they are willing to pay. Another big variable is management fee.

 

[Terrel L. Shields]

Do you include reserves for replacement in your income pro-forma (for subject and sales) or do you not? Do you for some property types and not others? Do you include only short-lived items?

I allow recapture based on remaining life (4% for 25 REL as an example) - a sort of sinking fund thingy...and, I allow recapture of short-term items but key is regardless how you apply it the "Purity of Application" principle. Apply the same mode in both the comps and subject. And I am likely to treat say a poultry farm differently than I would a motel or assisted living property.

 

[Gobears81]

If you are relying on local brokers' data, the cap rates are often extremely high, but they almost never include management, reserves...and probably a few other expenses that are actually incurred. I will usually report the source of the cap rate, but if it is a small apartment as an example, I will present the gross income multipliers and what kind of expense ratio that cap rate would imply. That way, we can correlate the 20% expense ratio indicated by the broker's cap rate to our 40% ratio.

NNN leases are perhaps the most simplistic cap rates to calculate, so naturally, us appraisers often overcomplicate it (myself included). I'll typically present the cap rate in unadjusted (i.e. rents/ sale price) and adjusted formats to allow for like-kind comparison, so that items such as reserves are consistently applied.

I do still include reserves in pretty much all of my appraisals. We could spend quite a bit of time on support to build-up our reserves, but it will probably not arrive at a level consistent with what the market uses (if they include any reserves), so I usually cite surveys for support. Making sure that cap rates include similar deductions is of greater concern at this point.