Replacement reserves

Replacement reserves are a savings account for a building. Roofs, mechanical systems, elevators, parking surfaces, windows, and appliances all wear out on predictable schedules, and replacing them costs far more than a year's ordinary maintenance. Rather than treat those replacements as surprises, owners and lenders set aside a fixed amount per unit per year so the money is there when the roof fails.

Lenders usually require reserves as a condition of a permanent loan, often holding the funds in an account they control and releasing them for approved capital work. The reserve contribution is treated as an operating expense for underwriting purposes, which means it reduces the net operating income used to size the loan and to value the building.

Reserves matter for rent because a building has to earn them. Assume a reserve contribution of $300 per unit per year on a 100-unit building: that is $30,000 of annual expense that rent must cover, about $26 per unit per month after the vacancy adjustment. The number is small next to debt service, but it is one of the reasons rent on a new building includes more than the cost of building it. A building that skips reserves is not cheaper; it is deferring a cost that will arrive later, often as a rent increase or a decline in condition.