Reserve Studies/Funds 101

Many States have enacted laws requiring an Association to perform reserve studies. I was recently put into the position (i.e. last on in line when jobs were handed out) of having to complete a reserve study for my Association where none existed before. Since most of us on this Board are volunteers and probably don't do reserve studies for a living, I thought I would start this topic to share what I went through and encourage others to provide input so anyone else who needs the info will be able to find it.

I apologize that this posting will be long but the subject tends to require it.

First and foremost, there are plenty of firms and self help kits available to perform a reserve study. I didn’t use any of them. If you are interested just Google “how to do a reserve study”.

I did find two excellent resources:

1. From the Foundation for Community Association Research, Reserve Studies/Management. a plain language paper on what is in a reserve study and how to do one.

2. From the State of CA, Reserve Study Guidelines for Homeowners’ Association Budgets.

Typically every household has a checking account for everyday expenses and a savings account for emergencies and future major expenses. Homeowner Associations need the same thing. Homeowner associations call the account for emergencies and future expenses a reserve account, reserve funds or simply, the reserves. Some associations create separate physical bank accounts for the reserves (sometimes an account for each item in a reserve study). Some Associations keep all the funds in one pot but keep the balance of each as separate line items in their books. No matter how your Association account for the funds, separate physical accounts or just line items, it's important that reserves are fully funded to meet expected future repairs/replacements.

Money set aside for unexpected expenses is typically called a contingency fund. A contingency fund for a household would be used to cover expenses if you lost your job, had an unexpected repair to your car, larger than expected utility bill or to patch your roof after a storm. Association contingency funds (also known as operating reserves) are used to pay for expenses above the expected budgeted amount (perhaps for an extra heavy snowfall or tree removal after a storm) and to cover any shortages between assessment payments. Contingencies are not the same thing as expected repairs/replacements of capital components.

The amount that should be set aside for contingencies varies between each Association just as it would between each household. However, it is commonly recommend that homeowner associations should have an amount equal to 1/12 of the total annual assessments as a minimum for contingencies.

A reserve study is used to identify the expected maintenance and replacement costs of an Associations capital components and to determine how much money should be collected and saved each year to pay for it. For me, this was a simple process that just took about a year to complete:

Steps:

1. Define what your capital components are

Typically these include; roads, sidewalks, playground equipment, bus stop, entrance sign, roofs, etc. Basically anything the Association is responsible for.

2. For each component, identify what has to be done and how often

As an example, your deck might need to be replaced every 20 years but will have to be power-washed and resealed every 5 years.

3. Identify the costs involved for each item identified in step 2

Example: A cost of a replacement deck might be $10,000 and the cost of resealing may be $500

4. By dividing the cost by the number of years, determine an amount needed to be set aside each year

Continuing with the deck example:

$10,000 (replacement cost) divided by 20 (years before replacement) = $500 per year 500 (sealing cost) divided by 5 (years between each sealing) = $100 per year

Therefore, an amount equal to $600 should be saved each year to cover the planned future expenses relating to the deck.

If the deck was an Associations only capital component, then adding the $600 to the annual expenses and the amount being set aside for contingencies will fully fund the reserves.

Granted this is very basic and actual studies are typically far more complex. However, this would be the basic steps.

Once completed, your study should be reviewed each year for inflation and completely redone every 5-7 years with annual assessments adjusted as needed.

Hopefully this will help guide someone else who showed up to the meeting late or was the last in line when the BOD was deciding who should head up what project.

Please share your experiences, tips and/or problems when you completed your Associations reserve study.

Hopefully someone will find this information useful. If not today, perhaps in the future.

Tim

Tim,

Very nice write-up!

When I was on the board of my former assn I did our reserve study. This was a very small assn with only 49 single family homes, a playground and large,landscaped water retention area. It wasn't difficult to prepare the reserve study and I used info from CAI to guide me.

If an assn decides to do their own reserve study they must make certain all the items that should be included in a reserve study are included. FYI, following are the components in my assn's reserve study which is professionally prepared:

replace metal fences
refurbishment of irrigation system
trees/shrubbery replacement
granite replacement (for those states in the SW who use granite in place of grass)
refurbish entry monuments
repair stucco walls
repaint block walls
repaint decorative lights
replace pole lights
replace metal and concrete park furniture
replace pet stations
replace play equipment
replace playground turf (artificial mat that playground equipment sits on)
replace basketball court
repait ramadas
refurbish ramada roofs

If you have man-made lakes:
repair shoreline
repair lake bed liners
dredge/repaid lake bed
repair lake shoreline
rplace air lines
replace compressors
reolace diffusers
replace and/or replace pumps

All these components have a useful life of from 1 to 28 years

Roger,

Good Point.

I probably should have clarified it better but the reason for reviewing the study every year was specifically for the inflation rate.

We found it extremely difficult to try and factor in material costs and inflation rates. This was very evident to us as we got quotes on road repairs. Since asphalt uses a petroleum product the cost varied as quickly as the cost of oil varied. Therefore, we decided to look at everything in today's dollars (this was mentioned in the report we produced). Once it gets fully funded (we have a second try at doing that on Dec 1) future boards would only have to adjust annual assessments for the inflation rate.

Tim

I agree that having a company revise it every year would be expensive. However, some States, like Virginia, require it to be reviewed every year:

§ 55-514.1. Reserves for capital components.

A. Except to the extent otherwise provided in the declaration and unless the declaration imposes more stringent requirements, the board of directors shall:

1. Conduct at least once every five years a study to determine the necessity and amount of reserves required to repair, replace and restore the capital components;

2. Review the results of that study at least annually to determine if reserves are sufficient; and

3. Make any adjustments the board of directors deems necessary to maintain reserves, as appropriate.

Very helpful Tim. Thank you!

Bruce,

Excellent points.

Is that requirement for all Associations or just Condominiums?

Do you have a link to the ruling?

Tim

Our condo association is going through the FHA Approval process right now. As a surprise to us, they required us to raise our fidelity coverage (in our master insurance policy) to match our net worth - which includes the money you have in reserves. We had to raise the amount from $50k to $160k. This added $500 to our premium. If we add $20k more to reserves this year, we'll need to up that coverage again.
Hope this information is helpful to someone.

At what point would the IRS get involved with reserve fund decisions. I've never heard of such a thing.

Great, concise post! As a CPA, I can add that the tax code and related rulings are all about dotting your I's and crossing your T's. Very carefully, in most cases.

If you are the president or treasurer on a board considering this, it doesn’t hurt to read Revenue Rulings 74-563, 75-370, and 75-371. Don't worry, they are not very lengthy! :-) Or consult your CPA.

These rulings allow the portion of the budget dedicated to reserves to be accumulated in a separate capital account, if the requirements of the rulings are met. Generally speaking, this segregation of funds is done by stating the purpose on a separate line item or section in your budget, notifying owners, and keeping the funds in a separate bank account.

In other words, the amounts are not taxable when an association collects them. On the flip side, the amounts are not tax deductible when used (spent) for the designated purpose. The association benefits by not having to pay income tax up front, upon collection.

In addition to painting, the IRS does not allow amounts held in a contingency fund to qualify for this capital contribution treatment.

For example, in Florida, the condo law (Chapter 718) and rules (61B-22, Florida Administrative Code) mandate that associations maintain and fully fund reserves, unless member/owners vote not to fund or partially fund reserves. The rules also allow the establishment of nonstatutory reserves, such as for painting and contingencies.

Not surprisingly, many associations in Florida set up a hurricane fund or reserve! Insurance or debt service reserves are other possibilities.

I strongly recommend that the statutory reserves, painting reserve, and contingency reserve(s) all be kept in separate bank accounts. This severely limits the ability of the IRS to come in and try to say that all the reserves are taxable income.

Put another way, if the IRS sees that painting and other funds are mixed with funds to replace your roofs, roads, swimming pool, etc., they might try to say that all the funds are taxable!

Despite its usefulness in prolonging the life of an exterior, painting is deemed to be a cosmetic activity!

Please note that these revenue rulings are not quite as important in years when an association chooses to file Form 1120-H, and thereby observe Code Section 528. However, it is vital to keep the separate reserves functioning for years when an association needs to file Form 1120, similar to a regular corporation. Also, Form 1120-H and Section 528 are not available to commercial associations, or those with a high amount of transient (short term) rental activity.

When developers set up the original reserves study (required in CA), they sometimes overestimate the estimated life of various components, and underestimate the replacement cost. This helps keep the dues lower to attract more buyers.

Our building opened in 2001.

Cheap example: There's a desk & chair in the security kiosk, which are used 24/7. The reserve schedule says that they'll last 25 years!

Expensive example: Cooling towers (operate our HVAC) on the roofs of our twin towers were estimated to last 25 years & the replacement cost was est. at $450,000. Even if they hadn't been defective in a couple of ways, they only would be expected to last 15, maybe 20 years. We replaced them for $900,000.

The developer also sometimes "miss" a component. We just found one maybe 3 years ago: a holding tank for water for our ceiling fire sprinklers.

Tim's list is really nice. To see detailed aspects of everything you want to know about reserves, go to davis-sterling.com, Main Index, scroll to Reserves.

I add to the developer underestimate to the developer didn't even do a reserve study. Our dues in 2004 were set to $170 and after taking ownerhsip realized how underfunded we were. Dues went to $280 and now 8 years later range from $340 to $380 a unit. If you are reading this and you are contemplating purchasing a NEW condo make sure the developer does a reserve study by an outside firm, review it for accuracy and then make sure its being acccounted for in the dues you are being quoted.

It has been my experience that when the counter stays at zero it's an indication that the individual withdrew from the forum.

One thing I think that many reserve estimates fail to consider is that what costs $1 today is likely to cost $2 fifteen years from now and $3 twenty five years from now.

A couple of different reserves analyst firms that we'd had over the past 6 years both factored in inflation. On the detailed chart, the current replacement cost is listed and a est. future cost.

Re: my remarks from a few months ago below. A neighboring high rise had a detailed study done a few months ago and the analyst told them that a lot of components' lives were overestimated and the replacement cost of others underestimated--to the tune of 1 million bucks!! I'm guessing the total value of their assets is about $10 million. They're talking special assessments for the next couple of years to catch up.

Duane,

After we did our first reserve study we had to go to the membership and request a 20% increase in assessments in order to fully fund the reserves. Fortunately, they approved it. However, we were very transparent on how the process was done, ran articles about reserves and provided copies of the study. I believe that the transparency aided the approval.

Laura,

Since I am continuing to expand our own version of a reserve study worksheet, it would be very helpful to me to also have a copy of the recent reserve study done for your association, if that is possible. Let me know if that would be possible and how to communicate directly with you. Thanks.

Frank

Thanks Tim ... great info as always.

To keep this thread on topic of learning about Reserves, I used Jose's post and started a new thread on retention ponds.

Please post information about retention ponds on that thread:

http://www.hoatalk.com/Forum/tabid/55/forumid/1/postid/178571/view/topic/Default.aspx

I found this web page: Reserve Study Laws & Legislation by reservestudy.com. However, you should always verify the information by reviewing your State statutes.

Additionally, even if a study isn't required, it's a good idea to have one done and plan for the future.

As I pointed out, my Association did our study ourselves. It wasn't as complete, but it was better than no study at all. This year, I'm talking with reserve study specialists to see what the costs may be so we can hopefully budget for a professional one to be completed next year.

Sorry, a little off topic but the FHA was brought up in the postings.

Does the FHA require that 10% of the yearly income be budgeted for reserves or that the total reserves are 10% of the yearly budget?

Thanks

The amount of reserves needed are based on the reserve study.

There is no formula to say that an association with x% going to reserves is good, bad or indifferent.

An Association that has no amenities but an entrance sign will need a very low amount going to the reserves (perhaps $100 a year).
An Association that has roads, pools, storm water retention ponds, etc. would need several thousands going to the Reserves per year.
A Condominium would certainly need several thousand per year going to reserves.

For more info on HUD approval specifics see: HUDs Condominium Project Approval and Processing Guide. The section dealing with financials start on page 31.

Note: Even though HUD approval is not required, lenders are also looking at the financials of Homeowner Associations (vs. Condominium Associations). The main reason is that they want to make their own determination that the financial health of the Association is good enough to prevent a special assessment that may keep the borrower from making a mortgage payment (which is also what Fannie and Freddy look at when they purchase mortgages from the lenders).

In order to update this thread with more info, it gets reactivated.
However, it's always good to keep Reserves and Reserve Studies on the mind if your a Director.

The update I wish to add is a spreadsheet developed by another member of this forum, SteveB25.
He has been utilizing the feedback given on his thread and made the spreadsheet better.

Here is a link to that thread, Subject: Reserve Study Analysis Spreadsheet:

http://www.hoatalk.com/Forum/tabid/55/forumid/1/postid/214592/view/topic/Default.aspx

Steve has provided links in that thread to his drop box to download a 32 bit or 64 bit version as well as a readme file. The files are simply too large to have as an attachment to this thread.

Tim

I don’t think that matters. If you re-do your reserve study every three years the new number will be included and you annual reserves contribution can be adjusted accordingly.

I disagree with this. You should conduct a reserve study every few years. The new cost of replacement will be discovered, and your association fee can then go up as needed. That is, it makes more sense to gradually increase your fees to adjust for inflation than charge excessive fees today so you don’t have to adjust them for twenty years.

We are involved in this argument right now on our finance committee.

You can also run afoul of some state laws that require unused funds to be returned to the members at the end of the year. I think it's pretty clear that HOAs/COAs are not intended to accumulate huge piles of money, with the exception of the reserve funds which are earmarked to be spent on a schedule.

It's also counterproductive when you think about the purchasing power of those dollars while they're sitting in low-yield, fixed income investments. Every year those dollars buy less. This is why financial advisors recommend that workers put as much of their retirement funds in stocks as they're comfortable with - stocks are the only investments that historically have kept pace with inflation. But they are not a suitable investment for reserve funds because they can lose value unpredictably, and reserve funds need to be predictable. By putting aside only the funds that the reserve study says are needed, you're limiting the damage done by inflation in the only way available to community associations. (It's good money management.)

There is also the issue that people who contribute to the reserves may no longer be living in the community when those dollars are spent. This is a common objection to the whole concept. The justification is that you had a functional roof or whatever when you bought your home, and you're paying in installments to maintain that functionality into the future. But this reasoning breaks down if the association is trying to accumulate funds in excess of those needed to keep the roof functional.