The importance of sinking funds in real estate assets
January 18, 2023
This bodes the question - what is a sinking fund?
The RICS Service Charge Commercial Code 2018 states that a sinking fund is ‘‘a fund formed by periodically setting aside money for the replacement of a wasting asset (for example, major items of plant and equipment, such as heating and air-conditioning plant, lifts, etc.). It is usually intended that a sinking fund will be set up and collected over the whole life of the wasting asset.
Therefore, a sinking fund is in essence a replacement fund. The landlord or Owners Association (OA) builds up a fund to pay for repair and replacement of major items of plant and equipment.
The difference between a sinking fund and reserve funds?
Sinking funds on the surface do not appear vastly different to reserve funds. Essentially however, the sinking fund differs from the reserve fund as a mean of collecting funds for specific future replacement or repair costs that occur during the designed life of a property. An example of this is using the sinking fund for periodic maintenance such as lift replacements or fire alarm upgrades that are needed periodically instead of having to pay large sums as and when major repairs are needed. In essence, this is a sort of insurance where the smaller regular payments are made to pay of future large cost
What are the key advantages of a sinking fund?
The main advantage of a sinking fund being collected as part of a service charge is that the expenses for repairs are identified in advance and are pre-planned, rather than a call for a large amount in one go, which may come as a shock to owners - some of whom may not have the funds to pay.
Having a fund in place ensures that the cost of major, but infrequent, repairs are paid for equally by all generations of residents, rather than leaving large expenses to be footed by future occupants. This means that you will avoid having to pay large bills when work does need to be carried out, as there will already be funds in place.
Critically, the fund will also help to maintain the value of your home, as prospective purchasers will be sure to check the adequacy of the sinking fund before buying. A 10-year old apartment building with no or minimal sinking fund in place will be less attractive than a 10-year old apartment building with healthy fund provisions to cover upcoming large expenses.
How should a sinking fund be calculated?
When calculating the amount to be provisioned (set aside), the property owners are required to take into account the potential replacement costs of certain items, which will need to be replaced or repaired during the designed life of the building, and the average length of time that passes before each type of repair. Some major parts of a building may not require replacement while others, such as AC equipment, may need to be replaced a number of times over 40-plus years.
By way of an example, a management company should consider the cost of replacing a door entry system of a property, as well as the average amount of time before such a repair is usually required. This should then be calculated into a yearly figure and this figure will form part of the total yearly charge that each resident has to pay towards the sinking fund. Other examples of typical repairs and replacements that are taken into account and for which sinking funds are used include drainage, communal lighting, footpaths and certain access roads. Certain repairs which are considered minor are paid for by the service charge. Naturally, such calculations can never be precise and assumptions will need to be made, however if all the different scenarios are taken into consideration, a sinking fund can mitigate the risk of incurring large costs on a property.
A cyclical maintenance report done by a qualified surveyor or professional will determine the type of works required on the block and over what time period. This can help ascertain time scales and rough costs for future works, so appropriate contribution amounts can be calculated.
Director, Property Management