Investors attracted to low service charges at some Dubai residential towers are now facing huge bills to replace ill-maintained assets, or risk potentially dangerous hazards for tenants
Thousands of Dubai apartment owners are facing costly repair bills after failing to adequately contribute to maintenance and long-term reserve funds.
Since the introduction of freehold property law in Dubai in 2002, hundreds of towers have been built and investors from more than 150 countries (according to the Dubai Land Department) have poured billions of dollars every year into the emirate’s real estate market.
They have received higher rental yields and capital appreciation, but many owners have taken a lackadaisical attitude towards long-term maintenance issues, often because they are unlikely to hold on to their investment for more than ten years.
But as the buildings are aging, owners are facing the consequences of failing to prepare for inevitable upgrades. The shortage of reserve funds means owners are compelled to fork out large lump sums of money to replace big ticket items such as lifts, facade cladding and air-conditioning units.
Failing to fix them risks serious safety hazards for occupiers, diminishing building value and even hampering unit sales in the secondary market, lawyers say.
Well-run buildings prevent such potentially disastrous issues by creating compulsory reserve funds, used to cover the costs of significant repairs, as well as annual maintenance funds.
“A special service charge levy will put a strain on the personal finances of the owners and therefore the setting aside of funds for such eventualities over a longer period is preferable,” Al Tamimi and Company’s head of real estate Jeremy Scott tells Arabian Business.
“The community manager may have to approach the owners with a special service charge levy to make up the shortfall if there is an urgent requirement to replace equipment and no funds are set aside for this purpose.”
A top level executive with a Dubai-based strata management company, on conditions of anonymity, admits that though many developments have been collecting reserve fund charges the amount is currently under the spotlight as the collection rates may not be sufficient to meet future asset replacement needs.
“This will come to light when the forecast is completed. If there is a variance between perceived balance and actuals based on the study, then a decision must be made how to gradually increase the collection rate without impacting substantially on the overall service charge collection rate.”
Under Dubai law, community managers appointed to run multi-owner residential buildings must set up two types of funds: a general fund used to pay for day-to-day maintenance costs; and a reserve fund (sinking fund), meant to cover capital investment, such as replacing assets in common areas (equipment, building facades, air-conditioning units, elevators).
The owners associations must prepare an annual budget, with the general fund covering 12 months, and the reserve fund set for a minimum of ten years. These calculations are based on an independent, third-party reserve study of the costs of renewing or replacing the standard elements.
The independent study typically forecasts expected expenditure over about 60 years and then breaks it down to ten- or 20-year installments. The forecasts are updated every three years to account for changes in maintenance practice, inflation and account expenditure.
In August, Dubai-based master developer Nakheel notified property owners in Discovery Gardens that it had initiated an independent study to evaluate the health of its reserve fund in the residential community. The notice was accompanied by a separate report by property consultancy Cavendish Maxwell, which said it had found a “considerable” deficit between the level of reserve funds required against the current size of the fund and annual contributions made by owners at an undisclosed residential tower or community in Dubai.
The report did not specify buildings that were facing a shortfall.
Cavendish Maxwell’s report says non-payment of service charges, incorrect use of funds for general items or payments towards rectification of building defects caused by sub-standard contractors are some of the reasons to blame for the shortfall.
It also criticised the developers for initially setting low service charges as “bait” to attract off-plan property buyers.
“This short-sighted economy can have disastrous consequences for a building in the future. If funds are not available to replace key building assets such as chillers, water tanks or fire pumps in the future, owners may face a ‘special levy’ in the form of a large lump sum to pay. If this cannot be paid by some owners and if the building around your property is falling apart, this will have an extremely detrimental effect on your property value,” the report says.
Dubai’s Real Estate Regulatory Agency (RERA) senior director of real estate relations, Mohammed Bin Hammad, says the law requires owner associations to allocate a specific amount from all investors into a reserve fund, which is calculated along with the annual service charges.
But the Dubai Land Department says there are only 451 registered owners associations, despite as many as 2,000 freehold buildings.
JLL MENA director for property asset management services Graham Howat says a well-managed, jointly-owned properties with reputable owner association managers should have sufficient funds put aside to deal with most predictable planned maintenance and equipment replacement needs.
“We have heard, anecdotally only, of some properties which do not have reserve funds established or figures based on rough estimates only. There is a real possibility that in the earlier years of Dubai’s residential property market, there have been properties without reserve funds but the work being done by RERA over recent years to encourage all owner association managers to plan for future maintenance needs has reduced this risk considerably.”
Owners associations do not follow a standard formula for calculation, as each building has its unique characteristics with capital expenditure on critical assets depending on the maintenance regime in place.
Middle East Real Estate Inspection Association (MEREIA) vice-president for legal affairs Majdel Musa reveals many owner associations and developers simply put aside 2 percent of the service charges as a reserve.
For example, if an owners association sets service fees at AED12 per square feet, then only AED00.24 (which may be rounded up) will go into the reserve fund.
As a rule of thumb, the strata management company official says, collections should be at least 10 percent of total service charge collections in the initial five to ten years for an adequate reserve fund balance to accumulate.
“However, if this is not followed, the development may find this rate increasing dramatically after ten years once capital expenditure starts to emerge.”
Chestertons head of research and advisory Dima Isshak says the reserve fund cost, included in the service charge budget, should range between AED0.50 and AED2.50 per square feet depending on factors such as the age of the building and equipment.
Phidar Advisory managing director Jesse Downs estimates reserve fund allocations range from AED0.10 to AED4 per square feet, or between less than 1 percent and almost 30 percent of the total service fee.
“On average, about 9 percent of the total service fee goes to a reserve fund in Dubai. There are also a handful of buildings and projects without a reported reserve fund allocation, which is concerning,” Downs says.
Al Tamimi & Company’s Scott adds whether such funds are sufficient will depend on the accuracy of the reserve fund studies.
“Also, there have been instances in the past where developers or community managers have experienced cash flow difficulties due to owners defaulting on their service charge obligations. Although this should not happen, the temptation in such circumstances may be to dip into the reserve fund as a means of bridging such cash flow issues.”
Musa admits most owners associations don’t have adequate reserve funds for future expenses and repairs.
“The many hundreds of buildings built during the real estate boom will be due for major repairs and renovations within the next five to ten years. What happens if there is not enough money in the reserves to complete this work? How will the shortage be covered? How will this affect the property value?” she asks.
“For example, if the building’s central air-conditioning chiller breaks down and must be replaced, and the owner association realises that it doesn’t have the money in reserves, it must then implement a ‘special service charge’. Each owner will have to pay the amount the association has calculated (which could easily be in the thousands). Otherwise, there will be no air-conditioning.”
Scott explains: “Historically RERA wanted to see a minimum amount set aside for the reserve fund in an annual budget, but more recently it has been enforcing ‘best practice’ which in this instance requires funds to be set aside under the requirements established in a professional reserve fund studies. Such studies avoid setting aside too much or too little funds to meet the eventualities.”
JLL’s Howat says unit owners will receive a “very large” one-off invoice at the time significant maintenance or equipment replacement projects are carried out, which will be over and above their usual service charge liabilities.
“The buildings systems will deteriorate over time, causing increased inconvenience to the residents, if no or insufficient monies have been set aside — and these will be the owners at the time of the work being carried out and not owners who have sold earlier.
“So when contemplating buying a second-hand apartment it is a sensible exercise to ask the owner association manager if there is a reserve fund established, that the money is held separately from the usual service charge budget and it is enough to cover major repair costs to the common areas of the block.”
Isshak adds falling short of reserves when required will have the potential to not only cause cash flow issues for apartment owners but will also lead to service interruption for occupiers.
Musa says there will be significant repercussions if owners associations and developers do not start taking corrective action for this reserve fund issue.
Lack of maintenance of the common areas will result in a building that is run-down, decreasing the value of the property. Lack of repair and maintenance for fire alarm systems, elevator equipment, air-conditioning systems and balconies, will result in safety hazards that could lead to injury or death.
“Insurance companies would be hesitant to issue a policy for the building, and lenders would be unlikely to mortgage the property. Attracting investors and tenants to such a property will be difficult. Imagine this scenario playing out in hundreds of buildings at the same time. It would not be good for the real estate market,” says Musa.
For now, property owners are happy with their attractive rental yields and capital appreciation. Time will only tell if that bait remains.