Funds in the context of service charge are the annual collection of sums to meet future costs and in so doing equalise annual expenditure through time.
A variety of terms are used but those most commonly recognised are sinking, reserve or depreciation funds, the latter being least common.
The common definitions, promoted by RICS, are that sinking funds are to meet the costs of wasting assets, reserve funds the cost of cyclical or recurring expenditure, and depreciation, in common with normal accounting terminology, is the recovery of an original cost over the life of the asset.
These definitions are not universally understood, or applied, and the various case law judgements that exist sometimes appear to conflict but must always be referenced to precise lease terms.
Lease drafting often further compounds the subject as definitions are unclear or simply lacking in detail and as the practical implications are not understood.
Professional judgement is a variable that can only be applied consistently with knowledge, effective lease drafting, and correct application.
This article is too short to explore all of the issues. However, the key points that arise often are:
- Lack of precise lease terms, or definition.
- Leases that loosely refer to provisions for future expenditure.
- The lack of guidance on the terms of PPM’s or lifecycles.
- Cost and replacement projections become less accurate over longer terms.
- Sometimes funds are collected arbitrarily in the absence of any technical basis.
- PPM and lifecycle content should be examined and validated annually and not simply incorporated into budgets.
- Funds should be held in trust for the benefit of occupiers and distinct from the landlords’ other rents.
- Incorrect accounting could create a corporation tax exposure.
- Who “owns” the accumulated fund such that if it is not fully expended at lease expiry (break-option or surrender) it is clear who benefits.
- How are excess collections dealt with where sums have been collected for specific work but not fully utilised or in the case of redevelopment, how is the balance applied.
- There are a host of accounting considerations but importantly funds and service charge caps do not sit well together. They should be avoided. Funds are not accumulated to enable a landlord to avoid exposure to costs above tenants’ caps, and yet this happens.
- Whilst projections may be based on the replacement of key assets, this does not avoid the correct technical assessment of repair versus replacement (about which there is much case law) relative to the residual term of leases. This is potentially an issue of recovery and/or apportionment.
Notwithstanding these issues, and this is not an exhaustive list, funds can in principle be a good idea. 20, perhaps 30 years ago, funds were avoided even when permitted by leases. But, of course, leases then were much longer, and as the lease landscape has changed, the average lease length compressed (with break-options), spikes in service charge costs within shorter lease terms becomes an issue for all parties.
Unfortunately, there are very few examples of funds being managed and accounted for correctly. Conversely, there are numerous examples of funds being misunderstood, administered incorrectly, and used for purposes for which they were not intended including, on some occasions, to mitigate landlords’ exposure to costs above service charge caps given that there is a fundamental conflict between funds and caps when contained in the same lease. Until RICS prescribe mandatory requirements and guidance, and commercial leases contain provisions that effectively ensure the correct management and use of funds, it is difficult to advocate their use.
You may also be interested in: An Introduction to Service Charges – Am I paying the correct proportion of the service charge?
