Compounding Matters

For most, superannuation really only gathers relevance in the later stages of life. This makes sense, as the goal is now in view and preparations to build the funds become the primary focus as the picture of what retirement might actually look like becomes clearer.

For those fortunate enough to have built a substantial amount during their lives, this is a happy period and brings with it the comfort that their lifestyle will be preserved (or increased) once they finish work and move into the next phase of life. For many, this is also a time of regret that they didn’t start earlier or make more effort to contribute more to their retirement savings or focus on how it was invested.

Owners Corp, Sinking or Strata funds can be looked at similarly, but thankfully with a much higher level of clarity over what is required at the other end. The increasing requirement for buildings to have a 10-year plan (now mandatory in many states for specific sized buildings) has meant that much of the ambiguity found in personal retirement plans can be removed, and more defined costings and timelines can be established.

So with the periodical and significant costs of replacing substantial components of a building now clearly defined, the ‘financial plan’ of a building is thankfully a lot easier to compose. There is an existing amount and a reasonably good idea of the end amount required, so all that is left is the pathway there.

Essentially this all now boils down to two major components, contributions to the strata (strata levies) and the rate of return available to compound the accumulating funds.

Compounding Matters for Australian Strata and Sinking Fund Investment

Albert Einstein reportedly said it. “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”

In the frame of long term investment, there is no more crucial aspect to understand.

For most Australian buildings’ strata funds, the rose-tinted glasses of previous years can be worn with honesty. Term deposits, the default and most secure investment vehicle for these funds over the last few decades, have proven useful with interest rates providing a reasonable return, and little thought has been required in managing these holdings. As the adage goes, ‘if it ain’t broke, don’t fix it.’ For many financial controllers, the task at hand was simply rolling over the term deposits and perhaps a precursory check of better rates at another institution.

The ways of before, unfortunately, are proving now to be inappropriate going forward. As global central banks (including Australia) are consigned to relaxed monetary policy, leading to sub 1% rates of return on traditional options like the term deposit, more effort is now going to be required to ensure that the financial goals of the savings can still be met.

The difference between a prior and current term deposit and cash rates is significant on long term savings. As illustrated in the table below, a mere 2.5% drop in average returns has an alarming impact on the final result, meaning that the only lever left to pull is increasing the strata levies on each lot holder to cover the shortfall.

As a basic example, consider a 5 lot apartment building with $100,000 in their strata / capital works fund and current annual strata levies of $2,500 each year, rising 4% per year. There is an estimated expenditure of $300,000 at year 10 ($365,698 including 2% inflation).

Using historical term deposit returns (4.5% pa.), this would be fine. The savings plan would roughly meet the expenditure requirements, but what if that return fell to 2%?

Starting Balance – $100,000

Required Expenditure – $300,000 at year 10

Adjusted for inflation (2%) – $365,698 required at year 10

Current annual strata levy – $2,500 per lot

Number of lots – 5

Scenario: Strata Fund balance at year 10:

Levy growth at 4%, Investment growth at 4.5% (reaches goal) $363,794.42

Levy growth at 4%, Investment growth at 2% $306,949.28

Difference (56,845.13)

Levy growth at 9.3%, Investment growth at 2% $364,409.56

Final annual levy amount at 9.3% compounding, per lot $6,083.33

The result is that the annual levy will need to be increased at a rate of 9.3% per annum (rising 243%, nearly two and half times, over the 10 years) to make up for the missing investment return shortfall, or the deficit (nearly $59,000) will need to be borrowed and repaid once the work is done.

Seeking a higher return rate on the invested capital is much more preferable to annual levy rises of nearly 10% being borne by lot holders.

But where to find a reasonable return rate that still offers sufficient protection from the perils of modern markets and can provide confidence to all lot owners that their hard-earned contributions can be reliably invested and accessed when they need it?

A new solution to a new problem

This is the reason we started Strata Guardian. We understand the importance of seeking higher returns to minimize the need for tough decisions like raising (and re-raising) annual strata levies to keep a building’s strata fund on track to help meet its goals.

We do this by managing a portfolio of high-quality, reputable exchange-traded funds that are always on market and accessible by our investors with the express purpose of achieving higher than term deposit returns without taking on too much risk.