Attachment 2-1: Capital Needs: Saving for a Rainy Day
Capital planning for affordable rental housing can be summed up simply: stuff wears out. Importantly, however, the rate at which the various building systems wear out is well known and replacement costs also are well known. As a result, it is possible to estimate how much money will be needed to cover replacements, year by year, as the property ages. This analysis is called capital needs assessment or capital planning. Exhibit 2-14 provides a simple capital needs assessment in the form of a spreadsheet.
Exhibit 2-14: Sample Capital Needs Assessment Sample (only five years shown)
Actual capital needs assessments typically evaluate building systems over a 20-year period. Twenty years is used because most major systems require at least one replacement during that time frame. The column labeled “Now” may also be labeled “Rehab” or “Year 0” or “Required Repairs.” It indicates replacements that are needed because the inspector found (for example) a furnace that was not working and was old enough to require replacement.
The Refrigerators line indicates one replacement in the first year, then two replacements per year for years 2-5 (at $500 per refrigerator). The Furnaces line indicates one immediate replacement, then 5 per year for years 1-5 (at $2,500 each). The Parking Lot Resurfacing line indicates no needs until year 5.
The Total line tells the owner and PJ how much money will need to come from Replacement Reserve withdrawals, future cash flow, future refinancing, and possibly future subsidies, in order to maintain the proposed project. The cost of replacing capital items is not reflected in the operating expense underwriting or budget of the property.
Typical Timing of Capital Needs for New Construction Projects
Below, Exhibit 2-15 illustrates the annual capital needs, per unit, that a newly constructed property might expect to incur over its first sixty years.
The capital needs are virtually nonexistent in the first five years, small in years 6-10, and then increase steadily over the next 20 years, with a peak in years 21-30 when a number of major building systems (typically, roofs, siding, windows, and parking lots) require major repair or replacement.
Exhibit 2-15: Average Annual Capital Needs Per Unit (constant dollars)
Lessons on Replacement Reserves in Affordable Housing
Traditionally in the apartment business, Replacement Reserve deposit requirements have been created by lenders, specifically for market-rate apartments. Because most first mortgage loans for market-rate apartments must be refinanced every seven to twelve years, and because market-rate apartments are expected to generate annual increases in NOI, lenders typically have required relatively small Replacement Reserve deposits in combination with relatively large requirements for repairs at the time of financing or refinancing. Because of the relatively short period between refinancings, market-rate apartment lenders also typically did not require the Replacement Reserve deposits to increase for inflation.
Affordable housing underwriters adopted these Replacement Reserve practices from the lenders of market-rate apartments, only to find that these practices did not translate well into affordable apartments. In particular, these problems became apparent as the first wave of affordable apartments aged:
- Rents did not rise as quickly in rent-restricted developments as they did in market-rate apartments. Therefore, NOI did not rise as quickly.
- Many early affordable apartments had significantly greater operating expenses than owners and funding agencies expected. As a result, affordable apartments generally did not have the same financial ability to refinance as market-rate apartments.
- First mortgage loans on affordable housing developments generally did not require refinancing, and were designed to be self-amortizing (that is, after the final payment during the mortgage term, the remaining balance would be zero).
- Many first mortgage loans were designed not to be refinanced. In fact, many first mortgage loans for affordable apartments contained the key affordability provisions and accordingly contained prohibitions on prepayment.
- As a result, many affordable apartments could not refinance even if doing so would be sensible from a purely financial standpoint.
- Following market-rate apartment practice, first mortgage loans did not require inflation adjustments to the Replacement Reserve deposit.
The result is that affordable housing owners and funding agencies have found themselves invested in properties that face increasing capital needs as properties age, with small Replacement Reserve balances, small ongoing Replacement Reserve deposits, only modest cash flow, and often regulatory prohibitions on refinancing.
Funding agencies made two primary responses to this set of problems:
- Second mortgage programs and grant programs, for needed repairs
- Decisions to structure new properties so that this would not happen again. These decisions involved requirements and guidelines to ensure:
- Larger initial Replacement Reserve deposits
- Increased monthly deposits to cover inflation
- More attention to the sustainable underwriting principles discussed in this publication.
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