Sinking and Reserve Funds – how best to save for a rainy day
Most managing agents will know that it is best practice to keep funds aside for a rainy day but how many are aware of the formalities necessary to properly account for such funds?
Long leases regularly used to provide for sinking funds but since the introduction of shorter leases and difficulties with how such funds are taxed and administered, there has been a decline in their use.
Landlords do, however, still need to accumulate adequate funds from tenants for the more expensive works which will need to be carried out to a building over its lifetime and smoothing out the costs year to year.
At a recent conference where RPC partnered Revo to host agents from across the retail sector, David Johnston of RPC, Avis Sayer of Service Charge Analytics and Peter Forrester, Chairman of the RICS Service Charge Working Group, discussed how important it is for agents to know how such funds should be dealt with, in order to avoid disputes between landlords and tenants.
Sometimes a distinction is drawn between a sinking fund and a reserve fund based on the anticipated lifetime of the fund.
Sinking funds often set aside money for the replacement of particular wasting assets over the longer term (e.g. heating and air-conditioning plant and equipment, lifts, etc.) whereas reserve funds often provide for the more general cost of maintenance and upkeep such as external cleaning and redecorations likely to re-occur every 5 years or so.
Bearing in mind that longer duration, it is often better for sinking funds to be held on behalf of the tenants from time to time. On the other hand, a reserve fund is more likely to be spent during the terms of a single lease and therefore could be considered as belonging to the tenant for the time being, being repaid to the contributing tenant if it remains unspent by the end of the term.
It is important to remember that no fund can lawfully be held if the lease does not specifically provide for it. The RICS guidance note on sinking funds, reserve funds and depreciation charges authored by Peter Forrester suggests what the lease provisions ought to cover, namely:
• who the money properly belongs to;
• the purpose for which the fund is being accumulated and its timescale; and
• what will happen to it at the end of the lease.
The panel discussed the benefits of itemising areas of expenditure and then spending only on those things. The general consensus was that properly managed funds should be specific, ring fence expenditure and not allow too much or too little to accumulate.
Audience members were interested to know what could happen to the funds at the end of the lease and the panel discussed lease drafting which could provide for funds:
• being paid back to the tenants who contributed if unspent at the end of the term;
• being paid back to previous tenants if the building is demolished or;
• remaining within the fund until it is needed.
All of the above should be the subject of negotiation between the parties when lease provisions are being drafted.
A key message throughout the day was that service charge provisions should not place a tenant in any worse position than if it were taking a lease on full repairing and insuring terms and many disputes could be avoided if this principle was adhered to.