Replacement reserves are a budget line item used by commercial property underwriters to address periodic maintenance on systems that wear out faster than the building itself. These are necessary upgrades, such as roofing repairs, heating and ventilation… not mere cosmetic changes. Although replacement reserves are essential to ensure continued operation of the building and thus prevent disruptions in revenue, not all real estate investors include replacement reserves in their net operating income calculations (although most commercial property lenders and appraisers generally do).
The result of excluding replacement reserves from net operating income calculations is to boost the building's valuation and thus offer the appearance of lower risk to a potential lender of a mortgage or loan product. Although replacement reserves may be essential at some point during the life of the building, and therefore potentially the life of the loan product, it is impossible to tell when the expense will be incurred.
Commercial real estate brokers therefore normally do not include replacement reserves in net operating income.
In regard to commercial property investing and underwriting, replacement reserves serve as an important budget line item. Most of the time, lenders not only require that replacement reserves be set aside in escrow but often require specific minimums that must be met in order to cover potential major capital expenditures over the term of the loan. In a sense, lenders view replacement reserves as a form of risk mitigation — acting as a sort of financial safety net to ensure the uninterrupted operation of the asset, and by extension, prevent any harmful disruptions in revenue that could potentially hinder repayment of the debt.