Understanding reserve fund & service charges from the leaseholders

Payment of service charges is a standard requirement of a lease for flats and apartments.  Leaseholders who are members of the freehold company hold shares that are transferable to a new leaseholder after the sale of the flat. Leaseholders who buy a flat with a share of freehold have to deal with two types of legal relationships. One is between the company and the shareholder arising from the share in the freehold company that owns the block, the other is between a landlord and tenant arising from the lease. Payment of leaseholder's service charges and reserve funds rely on these two legal relationships. A good lease will have a clause in it allowing the freeholder, of the freehold management company that bought the freehold to collect a reserve fund as part of the normal service charge collection. But some leases don't!

What to do if your lease does not allow you to collect a reserve fund

In such a situation because of the Morshed Mansions Ltd v Leon Di Marco 2014, EWCA Civ 96 a Residents Management Company, Freehold Management Company, and Right to Manage Company of which leaseholders are member’s shareholders may collect fund reserves from any leaseholder who is a member of such company. The leaseholder cannot refuse the demand for reserve funds, as company members cannot take shelter from Section 18 of the Landlord and Tenants Act of 1985, which sets out, alongside the lease, what, is permitted service charge.

Section 18 Landlord & Tenant Act 1985 states of service charge and relevant costs.

• In the following provisions of this Act service charge means an amount payable by a tenant of a dwelling as part of or besides the rent
• which is payable, directly or indirectly, for services, repairs, maintenance improvements or insurance or the landlord's costs of management, and
• The whole or part of which varies or may vary according to the relevant costs.
• The relevant costs are the costs or estimated costs incurred or to be incurred by or on behalf of the landlord, or a superior landlord, in connection with the matters for which the service charge is payable.
• For this purpose
• Costs include overheads, and
• Costs are relevant costs about a service charge whether they are incurred, or to be incurred, in the period for which the service charge is payable or in an earlier or later period.

What are the pitfalls of not collecting a reserve fund alongside the service charges?

Whilst a Residents Management Company, Freehold Management Company and Right to Manage Company has no legal obligation to demand a reserve fund it is widely accepted that the principles of good estate and service charge management need a reserve fund to be built up. Without a reserve fund, it is hard to get projects like re-roofing or external decorations off the ground. Without a reserve fund, you have to demand all the money you need in the year you are going to do work. Most likely not every leaseholder in the block of flats be able to afford a big lump sum payment, but also the Garside and Anson v RFYC and Maunder Taylor case in 2011, the Upper Tribunal determined whether or not it is reasonable to take into account the financial position of residential lessees before spending money on major works and held it was a consideration.

The difference between service charge and fund reserve explained

Most leaseholders receive a demand for reserve or sinking funds alongside service charges. You may not understand the difference between these service charges and reserve funds because of the ambiguity of the lease and the jargon in it. You may ask what is the purpose of a reserve fund when you are paying service charges. Reserve or sinking funds are collected both to support unexpected large expenditures, like replacing a lift or roof, and to build up a pot of money to fund larger cyclical projects such as redecorations. Typically, a reserve fund will collect say years 1, 2, 3, 4, and 5, so that in the 5th year sufficient funds have accumulated to meet the 5 yearly external decorations requirement written into the lease.

Most leases also provide that reserve funds can be used to meet unforeseen expenses or major repairs - this will depend on how widely the reserve fund clause is written. The landlord, landlord company, or Managing Agent should calculate the reserve funds to be collected from individual leaseholders by using financial modeling and assessing the likely future works required and the likely cost.

Leaseholders benefit by paying the reserve fund over time because they will not have to make unexpected payments for emergency repairs or suddenly find all their share of the money in the year works are carried out. And where the landlord is a Residents Management Company, Freehold Management Company and Right to Manage Company and one or more leaseholders cannot raise the required money all in one year, then other leaseholders face the real prospect of having to loan money and pay more to cover the shortfall of non-payers.  Otherwise, the work won't get done.

So, how do you estimate what the reserve fund collection should be?

Managing agents design a long-term maintenance plan with help from a building surveyor who periodically will prepare a CapEx or Capital Expenditure plan. This five or ten-year plan considers the type of work and the amount of funds necessary to execute the works. The desired outcome is that the reserve fund collections spread the unforeseen costs, covering the length of the lease.  

Collecting a reserve fund avoids penalizing the leaseholder in the event of sudden major expenditure. Albeit as most leases don't have a 'contingency clause, the reality is that if you don't have a reserve fund and an unforeseen contingency event happens then if you are a Residents Management Company, Freehold Management Company, and Right to Manage Company you will have to find or raise the money from those able to pay voluntarily or bill the required money from those who are shareholders or members of the company. 

Industry experts want the reserve funds to become compulsory. However, some, wealthy leaseholders often argue they should hold what they would otherwise pay into a reserve fund themselves, as they will get a higher return on their money.  That said, most people live day to day and it can put the building (or the directors of any Residents Management Company, Freehold Management Company, and Right to Manage Company) at risk if funds are not put aside.

What is the difference between service charges and reserve funds?

Regular expenses like the day-to-day costs of electricity, cleaning, insurance, the cost of employing a managing agent, service charge accountant, and ground maintenance are what most people think of as service charges. Service charge differs from a reserve fund, as a reserve fund acts like a piggy bank to save funds, over time. Funds reserves help spread the major costs of replacement, development, and repairs evenly. These can cover major expenses throughout the life of the property.

Knowing the amount of reserve funds and service charges before purchasing a property is always helpful. The amount of monthly service charges and reserve funds will depend on the individual property type, age, and when things like roof renewal, external and internal. Decorations and lift replacement were undertaken. Understanding the basis of calculation for determining the amount of reserve funds is also important - a prudent buyer should ask not only about the level of current service charge collection but also what reserve funds are in the reserve fund and what works are anticipated when and should check that a formal reserve fund is in place. Checking about major works and their timing alongside what reserve funds are held is crucial before buying a leasehold property.

Collection of reserve funds

The lease must have provisions for the collection of reserve funds for such funds to be collectible. A Residents Management Company, Freehold Management Company and Right to Manage Company cannot ask leaseholders to contribute towards the sinking funds if the lease does not allow it. Most lease agreements mention reserve funds without providing clarity on the amount. Leaseholders are free to approach the first-tier tribunal if the amount is unreasonable.