eserves for replacement, also referred to as a capital reserve, are monies set aside periodically to pay for replacement of short-lived items. For a marina, I’ve found that this is a particularly “sticky wicket” because the “one size fits all” model just doesn’t work.
Reserves as a Line Item
Having reviewed more marina income and expense statements than I’ll ever admit, the only pattern in reserve treatment is that the larger marina holding companies typically show a reserve line item and the rest don’t. So when we speak of “reflecting the market”, what do we mean? It would seem from the above that it depends on what “market” we are referring to. If the market tier a property is in does not take a reserve, we face the paradox of showing one on the financial statement for the client when the market does not do so or not putting a reserve in our projections contrary to what our client wishes.
Fortunately, there is a resolution to this dilemma: the capitalization rate (cap rate). If the cap rate is extracted from the market, it does not include a reserve because the market and market participants do not take a reserve line item when calculating net operating income, so neither do we. To do so would understate net operating income, lower the value conclusion and be contrary to standard appraisal practice. But if the market participants do take a reserve, so should we show a line item in our projections. Given the above statement, we can clarify this to mean that larger, more investment grade marinas should take a reserve if it is part of the comparable cap rate calculation and small and medium-sized marinas should not take it (because they are not part of market extracted cap rates).
No, this is not the end of the issue. What happens when cap rates are not extracted from the market? Then what we see is a cap rate based on the band of investment or mortgage equity technique. Do we take a line item for reserve or not? This is where appraisal theory becomes “fuzzy math” because appraisers do not apply this consistently. I’ve seen situations where sometimes the appraiser takes it and other times they don’t. The examples I speak of are different property types but that does not make a difference in determining the validity of taking an adjustment. In the real world, this is where customer service comes into play. Since it is not fixed in stone, if the client wants it, I don’t see why they should not get it and vice versa. It sounds like a cop-out, but that’s business.
Reserves in the Market
So if a reserve is not included as a line item on a financial statement, does that mean it isn’t considered? Not exactly. The expenses for the item that a reserve would cover are incurred just the same. When a pump-out station needs to be replaced… it needs to be replaced. What marina owners do is incur a higher repairs and maintenance expense for that year. For income tax purposes, writing off the capital improvement the first year lowers the tax liability much faster than spreading it out over an IRS-mandated length of time.
So the simple reality of it is that a reserve that does not consider some or all short-lived items means that the repairs and maintenance expenses is overstated. The difference is timing. Taking that item the first year lowers income and reduces market value the first year as compared to only a slight decrease in market value for many years by spreading it out in the form of a reserve.
This is why we appraisers always try to get at least three years operating statements and compare the repair and maintenance expense over several years. It greatly reduces the chance of overstating repairs and maintenance and penalizing market value, more so for a single year’s projection via direct capitalization than by multiple year projections via a discounted cash flow analysis.
The next part of this two-part series will address what reserves are based on and the dredge reserve.
