What would you do if one of your buildings suffers damage that’s not covered by insurance? Are you putting enough money aside to pay to replace or repair the tennis courts, the swimming pool, the club house, or other amenities?
On the flip side, is it possible you’re putting too much aside for reserves? And do you even know how reserve funds are supposed to be used?
Here we discuss possible uses for your reserve account so that you have guidance on how to spend these funds.
Know What Your Reserves Are For
Board members are often not clear on the true purpose of a reserve fund. “The proper use of a reserve fund is very confusing, especially for members new to the board who aren’t familiar with the protocols and legal requirements,” says Debra A. Warren, principal of Cinnabar Consulting in San Rafael, Calif., which provides training and employee development services to community association management firms and training and strategic planning sessions for association board members. “The proper use of reserves isn’t to maintain the common elements but to repair and replace them. ‘Repair’ and ‘maintain’ are words that people use interchangeably until they’re familiar with the difference. Also, reserves are clearly not intended to add something new to your association.”
A reserve fund is also sometimes called a replacement fund, explains Harry Styron, an attorney at Styron & Shilling in Branson, Mo., who’s drafted covenants for more than 100 subdivisions and more than 40 condominiums. “It’s intended to avoid special assessments,” he says, “which are very politically unpopular for board members.”
The proper use and funding of reserves is becoming a more prominent issue for associations. “As Fannie Mae, Freddie Mac, and the Federal Housing Administration are tightening their underwriting guidelines for loans, they’re very concerned about reserves,” explains Styron. “They have a minimum requirement that an association’s annual budget include something like a 10 percent reserve contribution. And in many instances, they’ll require independent reserve studies.”
While those federal agencies, which purchase or guarantee mortgage loans, have begun to demand more information about reserves, it’s not clear the effect their efforts will have on lending for community association units. “We don’t know if they’ll enforce reserve guidelines yet,” says Styron. “We’re just now seeing questionnaires that cover reserve balances from lenders using Fannie Mae and Freddie Mac for insurance.”
Underfunding is a Huge Problem
“I was a member of an association that had low reserves but owned a clubhouse, a boat landing, docks, and swimming pools,” says Jeff Vinzani, an attorney at Nexsen Pruet LLC in Charleston, S.C., who represents associations. “It had $50,000 in reserves, and I said, ‘You’ve got to be kidding!’”
Vinzani was able to convince board members that they needed to boost the association’s reserves. “They ended up raising the dues and got the capital reserve fund over $300,000—and they were able to fix the clubhouse.”
Vinzani has also seen associations that had bulging reserves and used the funds for new projects—which isn’t what reserves are for. “Other associations have had a chunk of money in their reserves and started doing pet projects,” he recalls, “in one case because the president wanted to build a fence.”
The lesson? “You need to be looking at your association’s actual capital and the buildings and amenities the association owns, have some idea of what it costs to repair those buildings, and then budget for that,” says Vinzani. “If something happens and the pool pump goes out, you can make an exception on occasion and use the reserve fund. But a reserve fund shouldn’t go to pet projects or something new and not contemplated before. And if you’ve budgeted with a specific project in mind for the reserve account and don’t use all the funds, you should carry them forward. You shouldn’t use the reserve fund for some pet project or a party.”
Though it’s possible for reserves to be misused for pet projects, it’s much more common for them to be underfunded. “There can be a concern about assessing too much for reserves because of the impact that will have on the amount of the overall assessments and how that relates to the marketability of individual units,” says Warren. “But I haven’t seen too much reserves leading to unnecessary repairs. Very rarely have I seen a community that has too much in reserves.”
Determining the Right Reserve Level
That’s been Styron’s experience, too. “I’ve never found a situation where there’s too much in reserves,” he says. “It’s generally woefully short, and the challenge is how over time to build up the reserve to a point where it’s properly funded. The arithmetic behind reserve calculations is fairly conventional—it’s a discounted cash flow analysis.”
First, evaluate how much life all the major capital systems in the association have left and how much they’re likely to cost when they wear out. Then calculate how much money the association has to set aside each year to cover the replacement of those items when they do wear out by taking the estimated replacement cost and dividing it by the number of years it’s estimated to last. That number is the amount you should reserve each year.
You may even need to perform a reserve study. “Unless you have a very small association with little common property, a reserve study shouldn’t be done by amateurs,” says Styron. “In addition, the board can’t defend itself unless it’s hired someone with credentials who’s independent to do the reserve study.”
There are national companies and reserve consultants that perform reserve studies, explains Styron. Some engineering firms can also handle reserve studies. “The cost varies tremendously with the size and complexity of the property,” he adds. “It would be difficult to find someone to do a reserve study for a 20-unit building for less than $1,000, and it could even go up to $5,000 for a complicated property with hundreds of units. For associations that are small in size with not a lot of common property, some of the do-it-yourself software can be pretty good, too, and it’s not very expensive. Once a reserve study is done, it shouldn’t take a lot to update it every few years. Things like decks and railings don’t have to be measured again.”
Can you just ask your accountant how much of a reserve you need? “I don’t know why accountants would feel like they had the expertise to evaluate the physical condition of structures,” says Styron. “I’d be suspicious of an accountant who says he can do a reserve study unless he had additional training.”
Once you know the proper amount for your reserves, create a plan to build it up. “With so much financial distress in condo and homeowners associations because of foreclosures and people being unemployed, it’s very hard to do anything aggressive in most of the cases I’ve seen,” says Styron. “So you may have to start small but increase over time. Maybe set a target of 5-10 years, at which point the reserve balance might be adequate. You don’t have to do it all at once, but there’s no better time to start than now.”