What are reserves, and why do associations need to have them? In order to answer these questions, and provide other important details on this topic, we spoke with Todd M. Walter, P.E., PRA, RS, Vice President of Engineering at Reserve Advisors, LLC, a company specializing in reserve studies, serving clients in all 50 states and in 35 countries worldwide.
“Reserves are funds that are collected by the association from the homeowners on a monthly, quarterly, or annual basis, and set aside into a reserve account for the purpose of replacing the common elements of the association as they wear out,” said Walter. The reserve amounts are most commonly included as part of the co-owner’s regular association fee. The elements the funds are set aside for include those undertaken as large capital projects, such as roof and siding replacements or pavement replacements. Although it is ideal for associations to have sufficient reserves for items such as these as they are needed, that is not always possible. In instances where reserves fall short, associations are faced with three undesirable options: 1) impose a special assessment on the co-owners; 2) borrow funds for the capital project from a bank, or 3) postpone projects.
Of course, it would be impossible for anyone to randomly decide the proper amount to hold aside in reserves. Many factors must be examined, including the age and condition of each common element the community association is responsible for, maintenance practices, interest earned on the reserve funds, as well as adjusting for inflation to the time each of those would need to be repaired or replaced. This is where a professional reserve study comes in. Often conducted by engineers, reserve studies offer a detailed analysis of all of these factors, and provide recommended contributions the association can depend on to ensure adequate reserves will be there when the association needs them.
Reserve studies have evolved over the years to where they are available in various forms of sophistication, ranging from simplistic forecasts with limited support to comprehensive studies that provide advice that can save associations money. Today, one can obtain a professional reserve study that contains cloud-based software that enables boards and managers to have a dynamic, “living” reserve study, that they can easily update as each actual capital project is completed and allows them to conduct unlimited “what if” scenarios.
Prior to starting the reserve study, the association should provide the reserve professional with copies of the community’s governing documents — the declaration, bylaws, CC&Rs, and any other legal instruments that identify what the association is responsible for. “These documents will identify the property components for which the association is responsible for maintaining,” said Walter.
In addition to examining the documents, Walter recommends convening with association leadership to ensure the actual needs of the community are addressed by the reserve study. “Equally, or even more important, our engineers have a thorough discussion with management and/or board members or committee members about each of the common elements and whether they want it included in the reserve study that we’re going to prepare for them,” he said.
There are several good reasons why the reserve professional doesn’t rely exclusively upon what’s in the governing documents. “First and foremost,” said Walter, “we’re not lawyers and governing documents are legal documents. We use them as a starting point to get a general idea of the size and complexity of the common elements.” Also, he said that association documents are often not specific enough to properly determine which common elements are maintained through the association’s reserve account. For that reason, association boards will often consult with legal counsel on the scope of the association’s responsibilities. The association board of directors might treat the maintenance and replacement of certain common elements through the association’s operating budget and not the reserve budget. “I’ll give you a simple example — mailbox stations. While a mailbox station might be considered a significant item worthy of inclusion in the reserve budget for a small association of ten units, the replacement of mailbox stations might fall under the operating budget as maintenance in an association comprised of hundreds of homes as it’s, relatively speaking, a very small item to them,” he said.
While the association is responsible for maintaining the common elements, there is latitude for the board to choose how they maintain the elements, and from which budget, reserve or operating, they take funds to repair or replace. So for these reasons, a discussion with association leadership is key.
Walter explained that a reserve study is made up of two parts, as defined by Community Associations Institute (CAI) and the Association of Professional Reserve Analysts (APRA) — the physical analysis and the financial analysis of the common elements.
The physical analysis is comprised of three things. First is the component inventory, which is an identification of the common elements and their quantities, such as square feet, square yards, number of street lights, etc. Second, a condition assessment is performed, which is an evaluation of the current condition of each component, based on the observation of the engineer performing the reserve study. Last is the life and valuation estimate. This is where the reserve professional’s engineering team determines the useful life, the remaining useful life — or better stated, how much longer the component will last before it has to be replaced — and what is the repair or replacement cost of each component.
The financial analysis has two components. First is an analysis of the fund status. This looks at the current amount of money in the association’s reserve fund at the time the engineer conducts the reserve study. It will be noted on the study as of a specific date, often the beginning of the fiscal year for the association. “This is a starting point for the engineer as he or she conducts the financial analysis portion of the reserve study,” said Walter.
Second is the funding plan. “This is the plan that identifies the unit or homeowners’ reserve contributions that go into the reserve account to offset the anticipated future capital expenses and pays for those capital projects as they become necessary,” he said. The funding plan extends a minimum of 20 years into the future, and, more commonly, is developed as a 30-year forecast.
Aside from having the information in the reserve study itself, there are other benefits associated with having a professional reserve study performed.
One benefit is that the reserve study can point out potential problems the association and board doesn’t know about. “You’d be surprised how often maintenance issues are overlooked,” said Walter. The reserve professional could also find possible unbudgeted or over budgeted items. “We like to look at the entire operating budget, which includes the reserve budget,” he said. There are two reasons for doing this. One is to make sure that all of the property is accounted for and nothing was omitted from both budgets. The second reason is to ensure that no items were double counted and in both budgets. “When that happens, the association is obviously over-assessing,” he said.
Another major benefit of a reserve study, when followed by the association, is that it will eliminate, or certainly greatly reduce, the possibility of special assessments. “Picture yourself as part of a young couple who recently bought a condominium trying to make ends meet and getting a surprise special assessment bill in the mail from the association saying that you have to come up with $4,000 in the next six months for a re-roofing project that wasn’t planned for,” said Walter. Reserve studies make it easier for homeowners to manage their personal long-term financial planning by ensuring stable association fees, with only minimal and predictable increases.
Preservation of the market value of units or homes in the community is another benefit of having and following a proper reserve study. “This is a big one because peoples’ single largest investment is usually their home. A reserve study will help maintain the property in good condition, which helps strengthen the market values of the homes,” said Walter.
The reserve study provides benefits to the board as well as homeowners. Since one of the board’s primary responsibilities is to maintain and protect the common property of the association, a reserve study helps them fulfill that fiduciary duty. The reserve study can also help board members reduce claims of fiscal mismanagement by homeowners. “And having that long-term plan saves boards countless hours and meetings. The reserve study gives the board that long-term financial master plan that they need to prepare for both the short-term and long-term,” said Walter.
For the community association manager, the reserve study helps prepare the community for capital projects. “They need to know when capital projects are coming down the pike so they can go out to bid and help the board in understanding the bids,” said Walter. It is also a great tool when planning the next year’s budget. The information in the reserve study will help free up the manager to focus on their many other property management functions.
While some states have legal requirements regarding reserve studies, many still do not. “For instance, California requires that associations hire a professional reserve study firm to provide a full reserve study with site inspection every three years, and an annual update in the years that a full reserve study was not provided,” said Walter. Virginia requires a professional reserve study every five years. According to Walter, other states that have statutes that involve either funding reserves, establishing reserve accounts, or rules relating specifically to reserve studies include: Minnesota, Michigan, Ohio, Hawaii, Washington, Nevada, and others. “The key thing that we’ve found over the years is that the number of states that are enacting legislation is growing. There is clearly a trend toward more legislation, not less,” he said.
Recognizing the terrible consequences from associations having to levy special assessments, Ohio law for both condominium and homeowners’ associations generally requires that association boards either: 1) provide for “reserve” funds in the association’s budget so as to avoid special assessments, or 2) obtain a majority vote annually of the ownership to waive the reserves.
As the language of the laws indicates, the intent of the legislature was to require boards to include reserve funding within their regular budgets. The language expressly states that the reserves “shall” be adequate to cover replacement costs “without the necessity of special assessments.” The law in Ohio intends to lessen, if not alleviate altogether, the practice of boards’ levying special, and often unexpected, assessments on owners.
Where special assessments are levied in the future, they will no longer be unexpected. The law requires boards to adopt and amend budgets for reserves unless the unit owners vote to waive the requirement. Special assessments will not be a surprise to unit owners who have voted each year to operate with “under-funded” reserve accounts. A majority of the ownership’s voting power is necessary to waive the fully funded reserve requirement, and the vote for waiver must be taken each year. Accordingly, absent a vote to waive the reserve requirements, Ohio law generally requires boards to include reserves in their budgets to avoid the necessity of a special assessment.
How does a board know how much money is enough to repair or replace a major item? To ascertain these numbers, a board should seriously consider hiring an outside firm to perform a “reserve study.” While Ohio law does not specifically require a reserve study, it is virtually impossible to have the owners intelligently vote on waiving reserves if the owners are not told how much they are waiving. Once the Board has obtained and is following the reserve study, the association’s reserves are being adequately funded, special assessments will not be necessary and the board has complied with the law.
Compliance with the law means avoiding liability. The easiest way for the board to avoid liability is to obtain a professional reserve study; immediately share the results of the reserve study with all owners and either: 1) adopt a budget that is in accordance with the reserve study recommendations or 2) obtain a majority vote of the ownership waiving the reserves requirement for that particular year.
Walter recommended that a full reserve study, which includes a site inspection and condition assessment, should be conducted as soon as possible after transition from the developer. “Then it should be updated with a site inspection at least every three years and certainly no later than every five years,” he said. Another good time to have an update is after major changes to the property, such as following a large capital project. “However, it is very important for the board and management to review the reserve study every year. Many boards use the study throughout the year,” he said.
The initial reserve studies themselves can take anywhere from two weeks to three months upon authorization from the association, depending on several factors. “Weather conditions can slow down the development of a reserve study. We sometimes experience delayed inspections in the Midwest and Northeast due to extended bad weather,” said Walter. The engineer needs to be able to see the roofs and pavement in order to assess their conditions, so if there is snow and ice on these surfaces that isn’t melting, that would cause a delay. Also, the scheduling time varies for different companies, so associations should ask potential reserve professionals about their time-frames and schedules.
Walter said that the reserve study should be used as a guide for future planning. “No one can predict with complete accuracy when capital replacements will be necessary. Weather conditions, for example, can alter what the reserve study provider projected several years earlier,” said Walter. Even so, the reserve study is going to give the association the best chance of properly planning and funding their reserves.
To further insulate the community from the possibility of special assessments or needing a bank loan, Walter recommended the reserve professional consider a cushion when developing the funding plan so there is money available in the event that a capital repair or replacement takes place sooner than initially projected in the reserve study. Another safeguard against the unexpected is to have frequent updates conducted on the reserve study. “The initial study is a snapshot in time, and common elements don’t wear out overnight. Things change over time, like the inflation rate, interest earned on funds, etc. Every few years the study needs a fresh update to prevent the need for special assessments,” he said.
Walter said that a good reserve study provider should ask questions about the objectives of the board and association before completing the reserve study. “We like to learn about what I call the ‘culture’ of the association. Some like to just maintain their properties while others take an active interest and want to maintain the association in ways that one might consider over-the-top, but others don’t,” he said. He gave an example of redecorating the clubhouse. “One association may want to do this every five years, because the members prefer to see it being kept as fresh as possible, while another association might redecorate every 20 years. Neither is right or wrong, it’s what I call the ‘culture’ of the association,” he said.
Association board members have several roles in the reserve study process, and one of those roles is to communicate to the provider not only the list of common elements that should be included in the reserve study, but these types of desires for the association to maintain its individual personality.
Asphalt seal coating is an example of one type of item that is frequently overlooked by associations. “Sometimes it’s in the reserve account because of asphalt replacement, other times it’s in the association’s operating budget, and some of the time it’s not anywhere to be found,” said Walter. When it’s time to do it, the association will struggle to find the funds to do it, or take the money from the reserve account even though it wasn’t part of the reserve budget.
For the most part, the reserve funds should be kept in their own separate account. Statutes regarding this are different in each state, and the laws are frequently changing, so associations should ask their accounting and legal professionals about this. “It’s really a legal question, and I’ll defer to the attorneys,” said Walter. However, he pointed out an example of how Florida specifies the funds be kept. “In Florida, state law requires that reserves can only be used for their intended purpose unless approved in advance by a vote of the members,” he said. Other states allow using reserve money for other expenses, but specify the funds must be paid back to the reserve account within a strict time frame. Another factor in deciding how to keep and use reserves is the strategy the reserve study provider used to fund the reserve account. “One method, known as the cash flow method or pooling method, pools all of the future replacement costs into a pool. That pool of funds is used to conduct the replacements in the order that they come due,” said Walter.
While Ohio law does not specifically require a separate account for reserves, this is clearly a best business practice and boards should operate accordingly so that reserve funds and operating funds are kept separately.
Walter said there really is no such thing as leftover reserves. A reserve account is a dynamic thing. It is constantly changing, money goes into it (reserve contributions) and money is drawn from it (paying for capital projects) on a regular basis. “And remember, the association never completely wears out, so the purpose of and need for the reserve account never comes to an end,” he explained.
At some point, if a reserve account has been overfunded over a period of time, the board could then reduce the regular common fees assessed to the owners. However, associations should beware of and avoid overfunding the account. “The negative aspect of overfunding is that the current owners are paying more than their fair share into the reserve account. This means that, as the current owners are paying too much, the future boards will reduce the amount of reserve assessments and the future owners will pay less into the reserve account because today’s owners are paying for part of the future necessary contribution,” said Walter. So, in essence, when you overfund, the current owners are paying toward a future fee reduction that, if they move, they will never be able to enjoy. And, additionally, owners who purchase later in this timeline will not be contributing the same level of funding toward the reserve account as current owners.
“Regular reserve study updates will help keep the association on track,” said Walter. These should be conducted every three years to avoid overfunding, or possibly worse, underfunding. Reserve study updates account for changes in the inflation rate of materials and labor, interest rate changes on the reserve funds and accelerating or delaying capital projects as compared to the original reserve plan estimates. “All of these events contribute to the calculation of an appropriate level of reserve funding,” he said.
According to Walter, the prices vary on reserve studies, and there is even software that associations can purchase to do simplified, but not very reliable, reserve studies. However, cost should not be the main factor in choosing a reserve study provider. He also does not recommend relying on do-it-yourself software for this important service. Walter said to look at the choice of which provider to use from a board member’s perspective. “What do I, as a board member, want out of that study? I want the kind of reserve study that will help me fulfill my fiduciary responsibility, protect the investment of the association members in their homes, provide our board with advice and recommendations that would save the homeowners money over the long run and educate us so that we can be more effective board members while maintaining a community where the members look forward to coming home every night,” he said. For the most part, board members are neighbors in the communities they serve, and they should treat the decision about how to pursue maintaining proper reserves in terms of how it would affect their neighbors and themselves.
What is typically included in the cost of a reserve study? CAI and the APRA have strict guidelines as to the minimum components of what should be included in the reserve study. “National standards were developed in the mid 1990s by a small committee of national reserve study providers, ewhich included the founders of Reserve Advisors,” said Walter. One can expect, at a minimum, a component inventory of each common element, a physical inspection and measurement of each common element, a determination of the normal useful life of each, the remaining life (how long before replacement is necessary), a status of the reserve fund at the time of the reserve study, and a funding plan that determines the amount of annual reserve contributions necessary to offset the anticipated expenditures for replacement over at least the next 20 years. “That’s the minimum,” he said.
Walter said that reserve studies have changed in many ways over the past few decades. He explained, “We’ve seen a lot, en a lot of changes over the years. In the early days, we found that most people who were doing reserve studies were property managers or board members because there wasn’t a reserve study industry yet. Property components were just beginning to wear out and associations clearly weren’t prepared for that. They’d take projections from contractors and guesstimate the future replacement costs in very unscientific ways. We’d see accountants trying to get their arms around the question of how to fund for replacements. People were using different terminology in different parts of the country. Some were providing engineering inspection reports that were invasive in nature, providing more information than a board would ever need to plan for the future. Others were providing common element replacement forecasts without any kind of funding plan, which didn’t really help when it came time to budget. They still called these reserve studies, even though half of what we expect from reserve studies today wasn’t even included.”
Walter said in the mid-1990s, CAI invited a handful of reserve study providers to meet and develop national reserve study standards and consistent terminology so boards and managers would have a basis from which to compare providers and have reasonable expectations of what they were buying. “Along with that came the Reserve Specialist designation program that required providers to provide their reserve studies in accordance with these standards. The purpose of the national standards was to provide boards with a standard reserve study that served as a budgeting tool,” he said.
Going forward, Walter sees the industry expanding. “In addition to more states enacting legislation to ensure that associations are protecting their members’ investments in their homes, the new generation of managers and boards are reshaping the way they use reserve studies. A demand for information in real-time is driving the industry towards delivering additional tools that allow for interactive planning. Associations today want to be able to evaluate alternate replacement options and be able to determine how individual replacement projects affect their long-term budget. Cloud-based software solutions, and to some extent, Excel spreadsheets, answer these types of questions and allow for greater collaboration in a team environment. The result – making more informed decisions that enhance their community’s long-term health,” said Walter.
There are four general funding strategies for association reserve accounts: baseline funding, threshold funding, full funding and statutory funding. Aside from statutory funding, the remaining three strategies are all about how much risk the association will be taking in funding their reserve account. Statutory funding is what associations need to have in reserves in order to comply with their state statutes. The other strategies would be at the association’s discretion. Baseline funding looks at the future expenditures and their timing, and calculates future reserve contributions such that the reserve account balance will reach $0 as the lowest point over the life of the analysis, anywhere from 20 to 30 years out into the future. “This approach is the highest risk for the association to assume because it will get down to a $0 balance at some point,” said Walter. The threshold funding strategy is calculated like the baseline approach, with one very big difference — this plan never takes the reserve account balance down to $0. The reserve professional builds a cushion into the reserve account so that in the event that some capital expenditures are necessary sooner than projected in the association’s reserve study, the association will have the available funds to cover those costs without having to conduct a special assessment or take out a bank loan. The last strategy, full funding, also known as the component method, is the least risky of the strategies, but there’s a big tradeoff. “It’s also the most costly,” said Walter. “What happens here is that each common element is looked at and funded individually. In other words, the association will begin fully funding for items that won’t be replaced for up to 20 years.” Walter gave the example of the association’s roofs. “Let’s say they’ll need to be replaced in 20 years at a cost of $200,000. In this example the association collects $10,000 per year and sets it aside. The money builds up over time and isn’t used for 20 years. Now repeat this process with each of the association’s common elements and before long, you’re collecting a lot of money that won’t be used for long periods of time,” he said. This is the safest for the association, but is also significantly more costly than other strategies.
Walter explained cash flow analysis as a method of calculating the appropriate level of reserve funding. It’s also known as the pooling method. In short, using one of the cash flow methods, the reserve professional aggregates all of the future capital expenditures or project costs and “pools” them into one group. He then looks at those future capital expenditures as they come due and funds the reserves with consistent annual contributions into the reserve account with the objective that the reserve account will never fall into a deficit position or below a set minimum amount.