More landlords are adopting reserve funds, also known as Sinking Funds, in their management practices to attend to future capital expenses and major repairs. These may be established for items such as Heating, Ventilation, Air Conditioning (HVAC) system replacements and major roof, envelope or parking lot repairs. Effectively the sinking or reserve fund is money collected from the tenants and set aside for these future requirements so the landlord is not out of pocket in the funding of those at that time. This is separate and distinct from a capital fund an investor may fund from the property profit.
However, unwary investors often miss the transfer of these sinking or reserve funds from the vendor to the purchaser as part of the property sale transaction and the closing adjustments. It is certainly incumbent on the purchaser to determine if the vendor has these types of funds during the due diligence process and to ensure that they are including in the closing adjustments.
Several issues can arise if the transfer of these funds is missed. The most important one is the financial risk assumed by the purchaser when it comes time to complete the replacement or repair. Many times the lease will exclude the amortization of items covered by the sinking fund, since the fund represents a form of prepayment toward those costs. This will mean the new landlord may not be able to recover these costs, directly affecting the property Net Operating Income and the overall property value. Failing this type of exclusion wording in the lease, tenants would still object to any form of amortization or recapture of the expense without accounting for their past contributions to the reserve fund. Aside from the financial impact, the landlord may be faced with a tenant relation problem too.
A second issue is that the missed transfer may become a legacy problem when the purchaser subsequently sells the property. The new purchaser will not want to inherit the issues we are discussing in this article.
The purchaser must determine what fund, or funds, exist and the current balance of each fund (at closing) to be transferred. This, in itself, can seem like a job for Sherlock Holmes, depending on how the funds were collected and accounted for in the landlord’s books. To compound the issue, many purchase and sale agreements are negotiated to limit the time frame of the financial statements to be provided by the vendor (such as three or five years). It is for this reason we counsel clients to have a separate line item in the list of due diligence production documents for sinking and reserve funds that is not time limited. It calls out the need to disclose all of these funds.
In addition, purchasers should be aware of the many different types of reserve funds another landlord may establish. For example, the landlord may have created a reserve fund for a pending insurance claim deductible or litigation expectation. It pays to seek out all potential funds by inquiring with the vendor and scouring the lease for any wording that could allow the landlord to establish these funds.
It is also important when examining the leases in due diligence to note if and when the funds may have started or ended. In some (albeit rare) cases, a landlord may have stopped using a sinking fund and now excludes fund payments in their current leases. But, if a tenant has been in the property over a number of terms and lease editions, you may uncover a dormant fund contribution. It is important to determine what became of a dormant fund; otherwise, at the very least, the purchaser could have a tenant relation issue on their hands in the future.
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