The announcement of special residency visas by the U.A.E. Cabinet in 2018 for expatriate retirees wishing to remain in the country after working age created a discussion and debate around how much money one needs to retire and live comfortably in the Emirates past working age.
Perhaps more importantly, this debate has brought cost planning and saving into the limelight, as people consider how best to save for retirement.
This mindset is not too dissimilar to the one that should be adopted within the discipline of asset management, with obvious parallels to be drawn between saving for personal retirement and saving for asset replacement.
In the case of personal retirement, a date is identified and funds are saved or invested to allow that date to become the effective date of retirement, whereby the individual enjoys the income or capital to allow them to give up work. The vehicle used to achieve this is usually some kind of pension fund, where regular contributions are made and the money held earns a tax efficient return over the course of the fund.
This is where the more prevalent mindset of saving for personal retirement can be adopted to explain the principle of one of the most effective tools used within property and asset management: the sinking fund.
Sinking funds are used within property and asset management by owners or property managers to set aside money for when building equipment or fabric elements require replacement to ensure the continued provision of services. Usually contributions are made annually according to a sinking fund budget.
These contributions are often part of a service, estate or community charge relating to assets within that community and both owners and occupiers will contribute to the fund. Funds should always be used to replace assets as and when such replacements fall due, and not used to upgrade, renovate or facilitate improvements that would otherwise require capital investment.
Equating sinking funds to pension funds for buildings brings some clarity in observing the importance of saving for asset replacements and the importance of the way in which these savings are made for both owner and occupiers. The crucial difference being that if an individual does not achieve the required savings to allow retirement, they may need to work a little longer, whereas built assets may not have this flexibility. While the date of retirement and the money required to retire on a personal level will be individually subjective, the date of asset replacement and money required to replace that asset should be less so. Within the discipline of asset management, the cost of replacement when assets reach the end of their lifecycle is a relatively fixed date based on manufacturer’s guidelines, recognised performance criteria, local operating conditions and the level of maintenance applied over the course of the asset’s operation. The cost of replacement at that point will be estimated based on factors including how far in the future the asset replacement date is and the forecast applicable inflation rate each year up to that point in time.
Risk mitigation
The risks of not having sufficient funds in place at the end of a built asset’s life expectancy are significant. From an operational perspective, delays in replacing assets at the point of failure could have an impact on building function and occupation depending on the criticality of the assets being replaced. The operation of assets beyond their expected life cycle, successfully or not, is widely seen in the Middle East. Although not uncommon in any part of the world the reasons for doing so differ from one location to another. Emerging and developing markets are more likely to experience this due to a lack of planning or relative inexperience in understanding the balance between obtaining maximum value from an asset against mitigating the risk associated with its failure.
Should equipment essential for the intended uninterrupted use of the building fail, the direct costs of repairing this equipment will be accompanied by the less tangible but still significant costs such as reputational damage, loss of occupier confidence and in extreme cases potential claims for negligence. Examples of high-profile asset failures in the region are not hard to find. Each year in the UAE the onset of summer sees numerous reports of building occupiers suffering from air conditioning failures as equipment that has either not been maintained properly or has simply reached the end of its design life begins to fail. From a cost perspective, raising funds to pay for asset replacements as and when they fall due could involve additional capital contributions from owners, particularly if multiple occupiers are liable for such costs and payment recoverability becomes an issue.
Regular contributions to the fund not only help to ease the commercial impact of the cost of asset replacements when they fall due but allow for the more equitable recovery of these costs during the course the asset’s life cycle. The greater the number of stakeholders, the greater the importance of obtaining regular contributions. This is particularly important in multi-let office or residential buildings, which in the UAE can involve hundreds of individuals paying into a single estate service charge to allow for a building’s services to function.
By including a sinking fund contribution within the service charge, funds are raised for asset replacements over a period of time rather than at the point of need. This not only mitigates the risk of unrecoverable expenditure, but also ensures that all the occupiers and owners that have benefitted from the use of the asset in question have contributed an equitable amount to its eventual replacement.
Sinking Funds
A building block in effective asset management
Asset management practice applies to the entire life cycle of a development and as part of effective asset management practice sinking funds provide a useful tool during the management/operational phase. Recognising the integrated approach to asset management, we see life cycle cost analysis in the design stage and accurate asset register compilation at handover as critical contributors to an effective sinking fund.
Commercial sense
The commercial impact of not operating a sinking fund is effectively having to ‘find’ large amounts of money for immediate use on asset replacements as and when they fall due. Even if life cycle cost analysis is used to determine asset replacement dates and inform a planned preventative maintenance schedule, the requirement for funds will be an issue that any property owner needs to carefully manage. A typical life cycle cost analysis profile will include spikes in projected expenditure in years when asset replacements are due. These spikes can be replaced with a more consistent line of sinking fund contributions year-on-year that remove the need for significant, irregular fund-raising (much like a pension fund). Depending on the quality of the life cycle cost analysis, the adequacy of the sinking fund will be tested when funds are due, but should always alleviate the burden of unforeseen capital expenditure.
As a property market matures, the normalisation of sinking funds within asset management practice so that they become expected, rather than nascent, helps underpin both transactional confidence and market value away from pure ‘supply and demand’ economics. Quality of supply, to which asset management plays a fundamental part, has become a focus where the current stock includes many recent developments and built assets less than 10 years old. It is in these markets, particularly in the United Arab Emirates where development has been significant in the last 10-15 years, where the first cycle of significant asset replacements is approaching and building maintenance is as important as it has ever been. An effective plan for these replacements will help to maintain the commercial value of property, both in terms of capital value, rental value and ability to lease.
Legislative drivers
It comes as no surprise that the operation of a sinking fund when managing property is considered as best practice and critical to effective asset management. The U.A.E. already recognises this in Dubai, with the Real Estate Regulatory Authority (RERA) requiring Owner Associations (and therefore their appointed agents) to show sinking fund contributions in service charge budgets with the contributions based on a study of the assets the fund intends to cover under RERA Direction for Association Constitution (Part 8). Internationally, the Royal Institution of Chartered Surveyors (RICS) outlines guidance on the operation of sinking funds and recommends the operation of such funds as part of good estate management practice within their information paper Sinking Funds, Reserve Funds and Depreciation Charges (2nd Edition) and their Service Charge Code of Practice (4th Edition).
RICS has a number of overarching principles that help to create market confidence through the operation of best practice and transparency in service charge administration.
The mindset of retirement planning for the individual now needs to be applied to the built environment in the U.A.E. at the federal level for both a commercial and operational perspective. The wide-adoption of sinking funds through either commercial awareness or legislative requirement will help to underpin confidence property markets that are currently experiencing several challenges. Within the wider region, this aspect of asset management will come into focus as the property market matures.
Key Benefits of Sinking Funds
The main benefits of operating a sinking fund and thereby planning for asset replacements as part of an effective asset management strategy are:
- Mitigate risk of unforeseen capital expenditure
- Increase recovery of funds to pay for asset replacement
- Reduce delays in asset replacement
- Reduce disruption to property occupiers
- Maintain confidence in property
- Underpins property value
The Process of a Sinking Fund Calculation
Usually conducted in coordination with life cycle cost analysis, which will provide asset replacement dates and forecast cost of asset replacements, a sinking fund calculation will involve examination of asset data and consideration of economic indicators to establish an annual contribution that needs to be made to a sinking fund to allow for funds to be available at the time of asset replacement in future.
It comes as no surprise that the operation of a sinking fund when managing property is considered as best practice and a critical to effective asset management. The U.A.E. already recognises this in Dubai, with the Real Estate Regulatory Authority (RERA) requiring Owner Associations (and therefore their appointed agents) to show sinking fund contributions in service charge budgets. As a property market matures, the normalisation of sinking funds within asset management practice so that they become expected, rather than nascent, helps underpin both transactional confidence and market value.