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Replacement Reserves

Step-by-Step Guide to Understanding Replacement Reserves in Commercial Real Estate (CRE)

Last Updated March 17, 2024

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Replacement Reserves

How Do Replacement Reserves Work?

The replacement reserves are the funds set aside to repair or replace short-lived parts of a real estate property.

In commercial real estate (CRE), the necessity to replace or repair a property’s structural components is an inherent part of the property leasing business model.

Replacement reserves are funds put aside in anticipation of the near-term requirement arising for the periodic replacement of building components.

For instance, some of the more common building components and building materials in need of repair include the property’s roofing and HVAC system, among various others.

Therefore, commercial property owners set a certain amount of funds aside—the concept of replacement reserves, or “capital reserves”—to prepare for such instances to mitigate the risk of periodic “wear and tear”.

However, replacement reserves exclude routine repairs and maintenance requests from tenants, such as no hot water coming out of the faucet or the air conditioning not cooling.

Why? The issue causing the water to not produce heat or the A/C system to not function as intended often stems from external factors, where the solution to fix the problem is out of the direct control of the property owner.

Therefore, replacement reserves correspond to irregular, unexpected capital expenditures (Capex) of a property, rather than routine operating expenses that are relatively predictable in occurrence.

Further, the tenants of a building might not be the only ones facing issues, as others in the same (or an adjacent) location are likely encountering similar concerns, or perhaps even worse.

Those sorts of issues will normally fix themselves over time, contrary to truly urgent matters in need of immediate attention, such as the ceiling in an office leaking from a pipe burst.


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Why Do Replacement Reserves Matter?

The replacement reserves matter in commercial real estate (CRE) for a multitude of reasons, namely:

  1. Property Maintenance → The replacement reserves function akin to a “buffer” for unexpected events. By properly maintaining the property, the occupancy rate should improve while the rental income rises, contributing toward a higher property valuation.
  2. Property Performance Stabilization → The replacement reserves are also necessary to ensure there are no material disruptions to the generation of cash flow by the property.

In short, the occurrence of unexpected events – both from internal and external factors – are nearly impossible to predict ahead of time.

But as part of managing risk, implementing the proper measures, like capital reserves, can reduce the potential downside in incurred losses.

What Factors Determine the Replacement Reserves?

The appropriate amount of funds to set aside as replacement reserves is entirely dependent on the surrounding circumstances.

  • Property Conditions → Based on historical data and a recent property inspection, the current state of the property (and risks) can be estimated and quantified.
  • Lender Requirements → Most commercial lenders will require a replacement reserve, placed in an escrow account over the borrowing term, to ensure there is minimal disruption, even if sudden capex needs were to emerge.

Should Replacement Reserves Be Included in NOI?

One frequent question is, “Should replacement reserves be included in net operating income (NOI)?”

In short, the conventional answer is to exclude replacement reserves in the calculation of the NOI metric.

However, the context must be taken into consideration here, or more specifically, from whose perspective the metric is being measured.

  • Commercial Real Estate Investors → CRE investors seldom include replacement reserves in the calculation of NOI in a pro forma model, namely for the sake of comparability.
  • Commercial Lenders → Commercial lenders are more risk-averse and prioritize protecting the risk of incurring a capital loss. Therefore, lenders often include the replacement reserves in the NOI calculation – which yields a more conservative value.
  • Property Sellers → The reason for sellers to exclude replacement reserves should be intuitive (i.e. to maximize the sale price).

If the “Reserves for Replacement” expense were inserted above the net operating income (NOI) line item, the NOI of the property would be much lower – albeit, the cash flow metric remains the same in either case.

The net operating income (NOI), by definition, is the operating profitability of a property, calculated as the sum of its rental and ancillary income minus direct operating expenses.

Net Operating Income (NOI) = (Rental Income + Ancillary Income) Direct Property Expenses

The direct operating expenses comprise the recurring costs incurred from the day-to-day operations of a property, such as property taxes, property insurance, and maintenance costs.

That said, placing the replacement reserves account into that category would be a stretch.

Considering the NOI is the numerator in the cap rate metric – the implied return on a real estate property investment based on its risk profile – the estimated property value would be lower from the inclusion of replacement reserves in the NOI metric.

Cap Rate = Stabilized Net Operating Income (NOI) ÷ Property Value

Since the primary use-case of the cap rate among real estate investors is to compare the risk-return profile of a potential rental property investment to comparable opportunities, the replacement reserve can distort such a market analysis.

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Replacement Reserves Formula

The formula to calculate the replacement reserves on a per square foot basis is as follows.

Replacement Reserves (PSF) = Replacement Reserves ÷ Total Square Footage

While there are a handful of different methods to calculate the replacement reserves of a property, the metric is most often denoted on a per unit or per square foot basis.

The replacement reserves of a property, expressed on a per square footage (PSF) basis, serve as a precedent for historical comparisons and comps analysis.

Replacement Reserves Calculator

We’ll now move on to a modeling exercise, which you can access by filling out the form below.


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Replacement Reserves Calculation Example

Suppose we’re tasked with calculating the net operating income (NOI), implied property value, and debt service coverage ratio (DSCR) for a commercial property.

For illustrative purposes, we’ll calculate each metric under two different scenarios, where the only distinction is the placement of the replacement reserves.

  1. Case A → “Above the Line”
  2. Case B → “Below the Line”

Therefore, Case A can be thought of as the lender model, while Case B is the pro forma model of the investor.

The initial assumptions regarding the underlying property investment are as follows.

  • Gross Potential Rent (GPR) = $2.5 million
  • Vacancy and Credit Losses (5% of GPR) = ($125k)
  • Ancillary Income = $225k

Given those figures, we can compute the effective gross income (EGI), which comes out to approximately $2.4 million.

  • Effective Gross Income (EGI) = $2.5 million – $125k = $2.375 million

From the effective gross income (EGI), we’ll add the ancillary income – i.e. the non-rental income earned on the side from sources, such as charging tenants fees for amenities.

The gross operating income (GOI) is $2.6 million, from which we’ll deduct the direct operating expenses.

  • Gross Operating Income (GOI) = $2.375 million + $225k = $2.6 million

The assumptions regarding the property’s operating expenses are as follows.

  • Property Taxes = ($600k)
  • Management Fee = ($400k)
  • Maintenance Cost = ($300k)
  • Property Insurance = ($200k)

The replacement reserves will be assumed to be $100k, which we’ll include in Case A, but not Case B, to compare the difference.

  • Replacement Reserves = ($100k)

Under Case A, the net operating income (NOI) of the property comes out to $1 million.

Property Value = Stabilized NOI ÷ Market Cap Rate

On the other hand, the net operating income (NOI) of the property under Case B is $1.1 million – with the $100k difference being the replacement reserves.

  • NOI, Case A = $1 million
  • NOI, Case B = $1.1 million

The implied property value will be estimated using the direct capitalization method, where we’ll divide the stabilized NOI by the market cap rate, which we’ll assume is 5%.

  • Market Cap Rate (%) = 5.0%

Under Case A, the implied property value is $20 million, whereas for Case B, the implied property value is $22 million.

Thus, the treatment of the replacement reserves – a mere $100k expense – contributed toward a difference in property valuation of $2 million.

In the final section of our exercise, we’ll calculate the debt service coverage ratio (DSCR), one of the core credit metrics used by lenders in loan sizing.

Debt Service Coverage Ratio (DSCR) = Net Operating Income (NOI) ÷ Annual Debt Service

The norm for the minimum DSCR is 1.25x in commercial real estate, so we’ll assume that to be the “hurdle rate” to be eligible to receive the requested loan amount.

  • Commercial Loan Size = $12 million
  • Annual Interest Rate (%) = 6.0%
  • Loan Term = 30 Years

Using the PMT function in Excel, we can determine the annual debt service, and then the DSCR.

= Net Operating Income (NOI) /-PMT (Annual Interest Rate, Loan Term, Loan Size)

In conclusion, the DSCR is 1.15x under Case A and 1.26x under Case B, reflecting the impact of the replacement reserve – since the minimum DSCR required by the lender is met only in Case B.

Replacement Reserves Calculator

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