Reserve Funds and Reserve Fund Studies

July, 13 2023 Published by South Alberta Chapter - By Walter Wakula

Investing the Reserve Fund – Part 2

From the Summer 2023 issue of the CCI South Alberta CCI Review

Part 1 of my article “Investing the Reserve Fund” was published in the Spring edition of this CCI Review newsletter. This article covered an introduction to the reserve fund and investing the money in it, the Condominium Property Act (CPA) legislative backdrop which regulates reserve fund investments and the importance of, and some suggested content for, a condo corporation (Corporation) investment policy. I now follow up that article with Part 2 of “Investing the Reserve Fund” covering investment objectives and strategies and how, practically, to implement your investment policy.

Investment Objectives

In Part 1 I had stressed the need for a condo Board to draft and approve an investment policy and strategy before setting up a reserve fund investment portfolio. Also, your reserve fund investment portfolio should strive to achieve a number of objectives that balance safety of the investment against its rate of return requirement. One such objective, and an important one, is for the rate of return of the portfolio to exceed the rate of inflation. Another objective may be to manage the funds wisely or to diversify the portfolio in some way or even to focus on environmental, social and governance focused investments. I will focus on the objective of returns exceeding inflation.

If the rate of return of the reserve fund portfolio does not exceed the rate of inflation then the value of the money in the reserve fund will decline in real terms. However, the costs of repairs and capital replacements that the reserve fund must fund have, during the past few decades, exceeded the economy-wide rate of inflation, or Consumer Price Index (CPI), which is the widest and most used measure of inflation. Because of this the reserve fund rate of return must be quite a bit greater than the CPI to keep pace with the escalating cost of repairing and replacing equipment and other assets the Corporation is responsible for maintaining. In other words, equipment etc. cost inflation is quite a bit higher than CPI inflation.

If the reserve fund costs increased at the CPI rate of inflation then investing in guaranteed investment certificates (GICs) would generally provide a large enough rate of return to cover this inflation and cover the risk of investing in GICs. This is because the structure of interest rates in the Canadian economy normally provide for rates of return which are greater than CPI inflation. However, recent experience has shown that GIC interest rates are not high enough to cover reserve fund cost escalation. This results in an erosion in the real value of the reserve fund over time and this erosion can be as much as 2 percent a year. This erosion in value over 10 years means you may be as much as 20 percent short of being able to pay for the replacement of a piece of equipment. To compensate for this erosion in the real value of the reserve fund a portion of the reserve fund should be invested in stocks, bonds and/or preferred shares to help boost the return of the reserve fund. 

However, to boost these returns the Corporation must incur a higher level of risk through stock and bond investments and this must be an acceptable level of risk. These investments have, over a long period of time, earned higher returns than GICs but these higher returns are an average of higher such returns during part of past business cycles, and zero to negative returns during part of past business cycles. Though riskier, the stocks, preferred shares and bonds permitted under the CPA are limited to the highest quality such securities trading in the markets. For example, common stocks and preferred shares must have solid earnings and dividend paying track records which span many years. Because of this only the securities of the highest quality banks, utilities, conglomerates and similar companies are permitted investments under the CPA. Similarly, only the highest credit quality bonds are permitted as investments under the CPA. If the Owners or Board of the Corporation wish to invest in less risky stocks and bonds than those permitted by the CPA, the Owners may introduce restrictions with an investment Bylaw or Boards through the Board investment policy.

Investment Policy and Strategy

If the Board is investing the reserve fund only in GICs then it is wise to retain an investment advisor who can provide advice for investment of these GICs and who can execute investment transactions, handle the maturities of these investments, act as a repository for the actual GIC instruments and provide a monthly report of the GICs in the portfolio. If the Corporation will be investing in stocks, bonds and/or preferred shares the Board should go one step further and retain an independent investment manager or an investment management firm that manages one or more pooled investment funds.

Hiring such a manager or firm is necessary because a Board typically does not have the skills to manage the investment portfolio. Also, this is to avoid the Board being convinced by an outspoken or aggressive director saying that he can make a killing in the market with bitcoin or some other risky, ‘flavour-of-the-month’ investment opportunity. Most importantly, the Board needs to retain an investment professional because investing the reserve fund can be a daunting exercise which includes analyzing the corporations or governments issuing the securities, evaluating the state of the markets and deciding where and for how long to invest. For example, at the time of writing, interest rates have been rising and stock markets are on the verge of declining because of a pending recession. Shorter term interest rates are higher than longer term interest rates with what is called an inverse yield curve and it is not known when these interest rates will revert to a normal positively sloped yield curve. Rising longer term interest rates have reduced the value of bonds and preferred shares and could reduce these values further. Several large banks in the US and in Europe have just failed and/or been forced to consolidate with other banks to enable them to survive.

The investment manager can be either a fund manager that has one or more pooled investment funds that are compliant with CPA regulations or a fund manager that acts independently to design a custom portfolio for the Board. The latter manager will be more expensive than the former and this greater cost is only typically economic with larger investment portfolios with several millions of dollars to manage. Choosing the investment advisor and/or the manager should be handled with a request for proposal from three or four firms which should include one proposal from the investment group or the wealth management arm of your banker, if it has one.

To summarize, one investment policy should be to hire an investment fund manager for the long term portion of the portfolio and a fund administrator or advisor for the shorter GIC portion of the portfolio.

Long Term Cash Forecast

The Reserve Fund Plan provides, among other things, a 30 year forecast of the cash and investment balances that are expected for the reserve fund. Before you can develop an investment strategy the very first thing you must know is how much cash you will have to invest and for how long. This will determine the types of investments that you can place and for what terms to maturity be they stocks, bonds, GICs or other securities.

The following rather busy graph [1] is for a hypothetical but typical reserve fund plan for a Corporation with over 200 residential units. The reserve fund balance (cash plus investments) is forecast to increase from $3.0 million at year 0 to $5.0 million in year 10, decline for a few years back to $3.0 million in year 13 and then increase to $6 million in year 20 of the plan. The fund balance then decreases from $6 million to $1.5 million in year 26, reduces again to $1.0 million in year 29 and finally increases to $2.7 million in the last year of the plan.

Next I will look at an investment strategy based on the above cash forecast. The strategy may be to invest the maximum allocations permitted by the CPA in the riskier asset classes. Because of the shape of the Reserve Fund Balance graph I have divided this initial $3 million cash pool into three Investment Tranches. An investment tranche is a division or a portion of a pool of cash each with a type or a combination of securities in it. Each tranche shown in the graph will contain the categories of investments that are permitted investments by the CPA.

The CPA provides a list of approved investments for the reserve fund and restricts the percentage of the reserve fund that can be invested in each major category of investment. Common share investment may not exceed 15% of the reserve fund portfolio and the value of bonds, debentures and preferred shares cannot exceed 35% of the portfolio. That leaves 50% or more of the portfolio for GICs and similar less risky securities. I have thus divided the $3 million pool of cash into the three Investment Tranches shown in the following table and these correspond to the Investment Trancjes shown in the above graph:

None of this allocation to the maximum percentages should be attempted without the professional advice of an investment manager. The reason for this is because the valuations for these asset classes will be different at different points in the business cycle, the economic cycle, interest rate cycle and/or the stock or bond market cycle. In other words, these security classes will be more or less expensive depending on where we are in these various cycles and the securities in these classes will be individually undervalued or overvalued. As mentioned earlier, all this is beyond the skill set of virtually any condo director and must be undertaken with professional investment advice.

Going back to our example, we would want the longest term securities to be in our Investment Tranche 1 where the funds will not be needed for 29 years. We are able to invest up to $450,000 in these securities. Common stocks are considered the longest term securities because they never expire (though they may be delisted, merged with another corporation or suffer bankruptcy and disappear) so we could invest $450,000 in a portfolio of high quality common stocks or a fund that contains only the common stocks that qualify as investments. Investment Tranche 2 has $1,050,000 of capacity and has a maximum term of 26 years. This can be invested in preferred shares (mostly no maturity dates) and in bonds with maturities as long as 26 years. The investment manager will provide advice on the mix of preferreds and bonds based on the many variables discussed earlier. Note that even otherwise safe government bonds should be kept to maturity because they can go down significantly in value if interest rates increase and/or their credit ratings are reduced.

Investment Tranche 3 has $1,500,000 with a maximum term of 11 years. This tranche would be reserved for investment in GICs with a maximum term of 5 years with a separate strategy for this GIC portfolio. The GIC and other investment tranches can be added to in future years as the additional $2 million in excess cash comes into the portfolio over the next 10 years of the plan.

Conclusion

In this Part 2 of “Investing the Reserve Fund” I have covered investment objectives, policies and strategies and how, practically, to implement your investment policy. This includes establishing investment tranches for your reserve fund plan based on CPA approved asset allocations for common stocks, preferred shares, bonds and GICs. I have also covered some of the complexities of investing in these financial markets and have explained the need for retaining an investment professional to guide the Board through the development of an investment portfolio. In the Fall Edition of this CCI Review newsletter I will publish Part 3 of “investing the Reserve Fund”. This will focus specifically on developing a GIC investment strategy and portfolio and will go into detail on the simple but powerful laddered GIC investment strategy.


By Walter Wakula, BComm, MBA, ICD.D
President, Foothills Global Capital Group Inc.

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