Replacement Reserves and Commercial Real Estate Loans

A blog reader asked, "What is a replacement reserve?"

A replacement reserve, in the context of a commercial real estate loan, is similar to a savings account where the funds that are set aside will be used only to replace certain segments of a commercial property that tend to wear out faster than the rest of the commercial property.

The replacement reserve, for example, is used to replace the roof, resurface the parking lot, replace the carpets, and to replace the HVAC unit every ten years or so.  These items wear out every 7 to 15 years, so the commercial property owner has to set aside money every month to replace them.

In real life, very few commercial property owners actually have a special savings account labeled , "Replacement Reserves".  When a commercial real estate lender, however, prepares a pro forma operating statement on a property for underwriting purposes, he will always include a Replacement Reserve line item.

A pro forma operating statement is just a projected budget for the upcoming year.  When a lender underwrites a loan, it simply means the lender analyzes the loan application to see if the borrower can afford to repay him and if the borrower has good credit and sufficient  experience.  A line item is just one item of income or expense in a budget.  Some other examples of line items in a pro forma operating statement might be real estate taxes, insurance, and electricity.

How does a commercial real estate lender or a commercial real estate loan broker compute the replacement reserve?

Each lender will usually have his own formula based on the number of units or the square footage of the property.  For example, on a mobile home park the lender might use $200 per year per mobile home pad.  On multifamily projects, a lender might use $2.50 psf per year.  For CMBS lenders, the rating agencies will dictate the level of required reserves.

If you are a commercial real estate loan broker, here is a very simple rule of thumb.  Use 3% to 5% of the effective gross income of the property as your replacement reserve, depending on the age of the property.  Use 3% if the property is brand new and 5% if the property is older than 30 years.  The effective gross income of a commercial property is the scheduled income after deducting 5% or so for vacancy and collection loss.

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