CONDOCENTRIC: RESERVE FUNDS - Investments

The new Condominium Act created a number of changes in Reserve Fund management. There have also been changes in legislation governing Trust Fund management (including reserve funds), which provide further guidance to Boards. The information below integrates and summarizes these “guidelines”.

Roles & Responsibilities

Board members are responsible for the management of the reserve fund. They set its goals and objectives and monitor its performance in accordance with the Condominium Act and the Trustees Act. They may rely on the advice of professional advisors including: investment advisors, accountants, engineers, lawyers and property managers in making their decisions. I strongly recommend they do so. Making decisions without professional advice, when a prudent person would seek an expert opinion, or ignoring such advice, may leave the Board members liable for losses or costs arising from their decisions.

Property managers provide practical guidance for Boards, recommend professionals for specific needs and assist in all aspects of managing the property. Auditors review the projections to ensure they will provide adequate funding for the corporation’s needs and comply with the law, as part of their normal audit duties. Engineers provide quantity, cost and useful life estimates for common elements and summarize this information in cash flow projections, using inflation and interest income assumptions. A financial advisor can assist Boards in fine tuning engineers’ projections to ensure inflation and interest income assumptions are appropriate for the condominium.

Boards should review their funding and investment plans annually as part of their budgeting process. Such a review should include a moving three to five year plan for reserve fund expenditures and investments. It will provide a tool for the board to anticipate and manage changes in the cost or timing of work on their common elements in between reserve fund studies as well as insure funding is in place for both the short term and long term needs of the condominium.

Investment Objectives

Investment objectives can be stated in a number of ways. For example: a desired level of return over a given time period, ie: average 4.5% over a ten year period or to exceed inflation by an average of 2.5% over a ten year period. It should be kept in mind that there will be frequent periods when much or all of the reserve fund will be required to fund repairs and will not be available for investment. With a $2,000,000 repair bill due next year a condo may have all of its reserve fund earning only 2%.

I recommend that Boards err on the side of caution for two reasons. First, it is better to exceed expectations than to come up short. Second, there is a significant amount of uncertainty in the amount and timing of expenditures, which if earlier or greater than planned, will reduce potential investment income.

Decision Criteria / Prudent Investor Rule

The Board, as a manager of trust funds, is required to consider a list of seven criteria when setting investment policy and making investment decisions.

1. economy: Does it have an impact or not? Should expenditures be made now or later to take advantage of cost savings or avoid high costs during a boom period? What impact will those decisions have on cash requirements and investment opportunities?
2. inflation/deflation: In my view this is the most important consideration for the Board. Boards need to consider a long term inflation rate rather than the current rate and review their inflation assumptions annually. Estimating too low initially will mean not enough funds are being collected for the long term. The exception to this will occur in a period of high inflation where short term rates will be too high for the long term but may be needed short term to keep up with short term expenditures.
3. tax: Condominiums are lucky. They are not required to pay tax on reserve fund income (unless they are a commercial, income generating property). This provides owners a tax sheltered vehicle to save for future repair and maintenance costs. No other home owner enjoys this benefit!
4. individual investments vs portfolio: Board members should be aware of the benefits of diversification even in a fixed income portfolio. The goal should be to establish a series of investment maturity dates to provide funds when needed. They should avoid overly long maturities to maintain an adequate level of liquidity for cost overruns or expenses coming due before expected or planned and to avoid having all investments maturing in a period of low interest rates.
5. total return: Condominiums should be holding investments to maturity whenever possible and not trading or speculating. As a result there will likely only be interest income, rather than capital gains, to consider and the investment objectives will adequately cover this criterion.
6. liquidity/preservation of capital: Legislation restricts condominiums to government issued or guaranteed fixed income investments, so preservation of capital is unlikely to be an issue. As a result the key consideration is liquidity: the ability to convert investments to cash, that is important

Summary

The legislation provides Boards with a great deal of guidance for the management of reserve funds. The legislation also sets out a standard of care, which Directors must meet in order to fulfill their duties. These duties are not onerous and do not require in depth knowledge of engineering, accounting or investment management; however, professional consultants can and should be hired to provide this expertise.

From “Common Elements” Fall 2002

By Russell Bennett, B.E.S., M.B.A.: A financial planner specializing in Condominium Reserve Funds, Russ provides hands on support and reliable advice to condominium directors and property managers.
Tel: 905.415.2440 Fax: 905.415.0706 E-mail: russ.bennett@investorsgroup.com

All of the information contained in this article is of a general nature for informational purposes only, and is not intended to represent the definitive opinion of the firm of Elia Associates on any particular matter. Although every effort is made to ensure that the information contained in this newsletter is accurate and up-to-date, the reader should not act upon it without obtaining appropriate professional advice and assistance.

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