Replacement Reserves
Also called: Reserves for replacement, CapEx reserve, RUM
Replacement reserves are an annual per-unit allowance set aside for the periodic replacement of major building components such as roofs, HVAC systems, and appliances, deducted as an operating expense by most lenders.
Reserves exist because capital items fail on a long cycle but consume cash on a short one. Charging a level annual amount smooths that lumpiness and prevents a property from appearing more profitable than it is simply because the roof has not failed yet.
Accounting treatment is inconsistent and it matters. Sellers typically present net operating income before reserves, since excluding them raises NOI and therefore value. Lenders almost always underwrite them as an operating expense. When comparing two NOI figures, confirm both sit on the same side of this line.
Rules of thumb
- Agency lenders commonly underwrite $250 to $300 per unit per year, with older properties assessed higher.
- Reserves are separate from the value-add renovation budget. One funds ongoing component replacement, the other funds the business plan.
Calculate replacement reserves
Related terms
- Net Operating Income (NOI)
Net operating income is a property's effective gross income minus all operating expenses, excluding debt service, capital expenditures, depreciation, and income taxes.
- Operating Expense Ratio (OER)
The operating expense ratio is total operating expenses divided by effective gross income, expressed as a percentage, and it measures what share of collected revenue is consumed by running the property.
- Capital Expenditures (CapEx)
Capital expenditures are investments in a property that extend its useful life, improve it, or reposition it, and they sit below the net operating income line rather than being treated as operating expenses.