Reserve fund vs sinking fund: Exploring the differences
Many commercial leases will contain a provision for the tenant to pay a service charge and this will often include a contribution towards a reserve fund or sinking fund.
However, the terms “sinking fund” and “reserve fund” are often used interchangeably and it is not always easy to identify what the difference is between these two types of funds.
It is however important for all parties to understand the difference between a sinking fund and a reserve fund. This will have an impact on how the tenant contributes towards the fund and the landlord and/or management company must be accountable to the tenant in respect of how it apportions, budgets and accounts for the service charge.
Sinking Fund
The Royal Institution of Chartered Surveyors have defined sinking funds as ‘a fund formed by periodically setting aside money for the repair or replacement of a wasting asset’. A wasted asset is any asset with a predictable lifetime, not exceeding 50 years. Such assets include (but are not limited to) lifts, roofing, heating and air conditioning plant and equipment. Therefore essentially, a sinking fund is generally used to set aside money for the repair or replacement of specific wasted assets over the longer term.
The main advantage of a sinking fund being collected as part of the service charge is that the expenses for repairs and replacement of wasted assets are pre-planned. This minimises the risk of a tenant being unexpectedly required to make a lump sum payment at the point works are needed, which would not be desirable, especially for those who may not have funds available to pay.
On the other hand, a disadvantage of a sinking fund being collected is that some properties do not require any major repairs or replacement of a wasted asset during the term of the lease. This raises disputes over whether the sinking fund is being used correctly or whether the balance is repayable on the termination of the lease.
Reserve Fund
The Royal Institution of Chartered Surveyors have defined reserve funds as ‘a fund formed to meet anticipated future costs of maintenance and upkeep to avoid fluctuations in the amount of service charge payable each year’. For example, payments made towards a reserve fund can help with the maintenance of the periodic cleaning and redecoration of the common parts of the building. A reserve fund will accrue over a period of time until funds are required to cover large items of unforeseen expenditure or a shortfall in the service charge income. Therefore, unlike a sinking fund which is intended to cover specific costs that occur occasionally, the main purpose of a reserve fund is to help the landlord or management company cover irregular and expensive works that the service charge budget could not account for in a financial year.
Are Funds Repayable to the Tenant on Termination of the Lease?
Neither sinking funds, nor reserve funds are refundable to the outgoing tenant at the termination of a lease. As a result, the tenant cannot reclaim their unused contribution towards the sinking fund or reserve fund. However, ultimately having a sinking fund or reserve fund has long term benefits for tenants and protects them from suddenly having to pay for large unforeseen expenses.
If you need legal advice on service charge, commercial leases or any real estate matters, contact our specialist property lawyers.
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