Hi Bonnie
It’s Paul from Lannock Strata Finance. The simple answer to “20% of what?” is “20% of the total capital works would come from the sinking fund”.
The real value is in understanding the reasoning behind this. Using a sinking fund to fund 20% of the works means that you would be using borrowed funds to supply the other 80%. Why is this good? The answer is all about risk and return.
We know from finance theory that equity is expensive and borrowing is cheap. But the problem with borrowing is that it increases financial risk. 100% equity (ie, 100% sinking fund) is the least risky but the most expensive option. Change that to 1% borrowing and 99% sinking fund and cost goes down and risk goes up. The trick is to find the optimal amount, the best ratio of borrowing to equity.
There are so many practical examples where we land on 80% borrowing and 20% equity – for example, buying a house is usually 80% borrowing and 20% deposit (equity). And large sophisticated finance structures such as leveraged leases which provide the funding for ports, ships, pipelines etc almost always come out at 80% borrowing and 20% equity.
You’ve probably heard us at Lannock say that there is no one size fits all in strata – there’s no single funding solution that is right for every body corporate because each situation (and every owner) is different. That’s worth repeating – no one size fits all because every property and every owner is different.
This means that in some cases it will be all borrowing, no sinking fund. In some others, all sinking fund and no borrowing. Mostly, it is a combination of the two that will produce the optimal mix of reduced cost without too much risk.
However, if in theory you just had to have a single rule for all strata, it would be to set the sinking fund of 20% of the anticipated major capital works. 100% sinking fund will be the most expensive option and is clearly inappropriate.
Sorry for such a long reply but I trust this helps.
Paul Morton
CEO, Lannock Strata Finance