Reserves are an allowance for the replacement of short-lived components. Short lived components are those components of a building that do not require annual replacement but wear out before the end of the building's useful life and must be replaced periodically.
Appliances, furnaces, carpeting, roofing, etc. require a reserve allowance. A reserve is an amount that is set aside (supposedly) to make sure that there are sufficient funds to replace short-lived items. Occasionally, a mortgagee will require a reserve account as a condition for making a loan.
Reserves typically include:
|•||Exterior paint (interior paint is usually considered maintenance)|
|•||Root covering, gutters and downspouts|
|•||Heating and Air Conditioning|
|•||Electrical and plumbing fixtures|
Since these items do not require annual replacement, they are often not considered an expense of operation. An appraiser must consider these as annual expenses in reconstructing the operating income statement.
Since short-lived components have a life expectancy of more than one year, the appraiser must "annualize" the cost of replacement. Since the capitalization rate used to convert the income stream into a value estimate is an annual rate, the income and expenses must also be expressed in an annually.
Owners and managers rarely create an actual reserve account the replacement so the appraiser must create hypothetical reserves. The hypothetical reserves are nothing more than the "annualization" of the replacement costs of the short-lived components.