Am I too aggressive with my HOA's reserve plan?

Started by RonW7 • 20 replies • 2081 views

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RonW7 (Ohio)
Posts: 122

Posted:

I can't seem to keep this post short. Let's see who can be bothered to read it all.

As a new HOA president who has recently gone into full duty mode, I've taken what I believe to be a rational approach to putting together our annual budget. Here's our HOA in a nutshell:

Units: 20
Monthly fee: $130
Annual income: $31.2k
2013 Fixed expenses: $24k
Net gain after expenses: $6.2k
2013 year-end bank balance: $23k
Reserve funding: $0 (no reserve funding)

I've met a great deal of resistance to my new reserve plan as everyone appears to think it is too aggressive. We're not accounting for any reserves right now, so I put together this plan:

- Insurance claim replaced all roofs in 2012 with new 20-year roof for $100k
- $100k / 20 years = $5k per year that we need to set aside
- Also need to set aside at least $1k per year to build up a secondary emergency reserve so we can repave drives, replace mailbox units, use our insurance deductible, etc.

We're netting only $6.2k, so putting $6k of that into reserves means we only have an available surplus of $200. While this meager surplus may not be able to afford niceties like attractive landscaping or other non-essential community improvements, at least we're properly funding our reserves, so we're in good shape, right? Not so fast.

We now have a large expense looming overhead as 16 of our emerald ash trees need to be removed. This is going to cost us at least $6.5k. If we don't account for reserves, we can certainly take that hit since our net gain would be $6.2k. However, since I am funding reserves now, I want to assess the community for the full amount, but this proposal is facing fierce opposition. The argument goes like this:

Me: We need to assess the community for the cost of the tree removal.
Them: We have plenty of money in our account. We don't need to assess.
Me: We're putting $5k per year into the roof reserve and also an additional $1k into an emergency reserve. We can't afford the hit.
Them: Why are we funding for a 20-year roof in 2014? By the time the roof needs to be replaced, most of us will either be gone or dead. Let the future residents deal with it then.

The ORC says this about reserve funding:

http://codes.ohio.gov/orc/5311.081

"Adopt and amend budgets for revenues, expenditures, and reserves in an amount adequate to repair and replace major capital items in the normal course of operations without the necessity of special assessments"

The board is claiming that this wording is too ambiguous, that there's no objective method for determining the cost of a roof 20 years from now. Therefore, funding for the roof now should not be a concern for the association. Of course, the residents are all going to agree because, in today's economy, everyone has little choice but to look out for themselves.

My question:

How does an association protect itself from such self-serving mentality? Is it possible for an HOA to simply be doomed? Is there no reprieve? Or maybe my funding protocol is indeed irrational and excessively aggressive. Can I get some input here?

MikeS1
Posts: 521

Posted:

Ron - We're in Virginia which by law requires that a Reserve Study be done every 5 years. We just paid to have a engineering Firm complete this task (again) and it's a great document. Personally, I would not take on this task myself (not even for a small HOA). In most cases, they advise that the board should seriously consider hiring an outside firm to perform the reserve study, but we do recognize that you only have 20 units. Apparently, from what I see (I'm not an attorney), but Ohio law does not specifically require a reserve study.

Here is some resources for you.

http://realtytimes.com/consumeradvice/hoaadvice1/item/355-20130410_hoareservestudy

http://www.ohiocondolaw.com/articles/budgets_new_reserve_req.htm

http://www.ohiocondolaw.com/articles/sample_reserve_letter.htm

"NEW LAW HELPS OWNERS

With the enactment of House Bill 135 the Ohio legislature has attempted to greatly reduce the need for associations to levy special assessments by necessitating the funding of reserves absent a vote to waive the requirement. The new Section 5311.081(A)(1), therefore operates in pursuit of fairness. It will cut down on situations in which owners are “hit” with special assessments unexpectedly and without knowledge, but it also includes a method for associations either unwilling or unable to fund reserves to waive the requirement. As a result, all boards are required to make a choice: either 1) adopt a budget that provides sufficient reserves to avoid special assessments (pay a little more now), or 2) obtain a majority vote of the ownership waiving the reserves required for that particular year (and pay a lot more later)."

RonW7 (Ohio)
Posts: 122

Posted:

MikeS1, I've seen those documents and they look promising at first. However, when you consider that 1) reserve studies are not required in Ohio, 2) the requirement in the ORC is too ambiguous, and 3) the community is not interested in funding a reserve that will only serve to benefit the association after they are long gone, it seems next to impossible to properly fund our reserves and charge the appropriate fee. Plus, a reserve study would merely offer a proposal to the members, a proposal they can reject if they simply don't like it even if it's the right way to go.

In short, everyone's more interested in a low monthly fee rather than instituting a proper budget. We have retirees who are on fixed income who can't afford the increase, owners who selling who want to keep the fee low so it's more attractive to naive buyers, and owners who sublet who want to keep their rent low. These owners have zero financial interest in raising fees and comprise of a large portion of our community. What is an HOA to do?

GlenL (Ohio)
Posts: 5,491

Posted:

Ron IMHO no you are not being too aggressive but if the increase in assessments is drastic you may need to ease into it. As Mike posted you need to fund the reserves or a majority of homeowners must vote every year not to:

5311.081 Powers and duties of board of directors.

(A) Unless otherwise provided in the declaration or bylaws, the unit owners association, through the board of directors, shall do both of the following:

(1) Adopt and amend budgets for revenues, expenditures, and reserves in an amount adequate to repair and replace major capital items in the normal course of operations without the necessity of special assessments, provided that the amount set aside annually for reserves shall not be less than ten per cent of the budget for that year unless the reserve requirement is waived annually by the unit owners exercising not less than a majority of the voting power of the unit owners association;

(2) Collect assessments for common expenses from unit owners.

I'm sure the not fund crowd is counting on being gone before the bill comes due but the down side to that is most banks follow the FHA guidelines and they will find that buyers will NOT be able to get financing without an adequate reserve fund.

Studies show that 5 out of 4 people have problems with fractions

KellyM3 (North Carolina)
Posts: 2,239

Posted:

Hi Ron,

I like the way you're thinking about Reserve Funds, but here are my thoughts (NO, an HOA isn't doomed)

1. Don't leave $200 of your budget as unaccounted cash or "excess." Allocate it Reserve Funds or savings or you'll buy landscaping when you should be removing trees.

2. I can't gauge if your rates are high enough because we can't know how many expensive things (roofs, trees) that you have around your property. If it's only roofs, then $6,000 per year, for 20 years, will leave you with $120,000 by the time your roof needs replacing in 2034. You'll pay $6,500 for tree removal soon. That leaves you with $13,500 to spend on other reserve items (paint, etc) over the next 19 years combined. Your HOA is cash starved so expect a special assessment in the future, but not now.

3. Regarding the trees, I would think your Reserves (in theory) could absorb that financial cost, leaving your bank account with $16,500. But, after that expense, you need to focus on Reserve Fund creation and building.

4. Your senior/elderly board members need to pay for the property as they use the property. Therefore, they are using the roof....they should pay a reserve fund payment for the year. It's not incumbent on future residents to pay for items they didn't use. I consider this a form of theft - if only ethically.

5. To gauge the value of the roof in twenty years, take the $100,000 cost.....check the inflation rate (or use a standard 3% inflation rate) and make it a target. That's what you'll need in 20 years to replace the roof. If you get a deal in 20 years, the Reserve Fund is strengthened. Goal-setting is important. The reserve funding rules are clearly articulated.

HOAs cannot protect themselves from self-serving mentalities as HOAs consist of the The People who live in the HOA.

HOAs won't be doomed because under-funded HOAs will special assess when they haven't saved money for repairs and replacements. If the "I'm on a fixed income" crowd is screaming about monthly dues, just wait for when the $5,000 special assessment comes for paint, roof, etc. It's worth a younger owner suing their HOA for negligence when maintenance is purposely ignored because "they'll be dead by the time the project needs doing." You'd deserve to lose.

Your funding protocol is rational and possibly too conservative (see #2 on my list). It's difficult to convince people to pay more money in order to save it for tomorrow, especially Baby Boomers. But, when they see big projects get funding using Reserves - and then see that Reserve Funds are the best insurance policy AGAINST special assessments, they'll change their tune. But, you'll never argue your way to victory. Proof is in your implementation and budgeting skills.

I think you're off to a great start but it's a multi-year journey to fully integrate a board's philosophy to include reserve funds.

SteveM9 (Massachusetts)
Posts: 3,699

Posted:

Boiling a frog.....

Instead of a big jump in dues, just keep raising them in small increments. $5 here, $9 here.

KellyM3 (North Carolina)
Posts: 2,239

Posted:

Quote:

Posted By SteveM9 on 04/04/2014 6:53 AM
Boiling a frog.....

Instead of a big jump in dues, just keep raising them in small increments. $5 here, $9 here.

Absolutely. If you hold monthly expenses in line (or find efficiencies and save money), you can feather the nest of the Reserve Fund more easily.

TimB4 (Tennessee)
Posts: 21,059

Posted:

Ron,

There is never a net gain. If there were, you would need to pay taxes on that gain (as it would be considered profit). This is why others said to allocate every dime you plan on taking in.

The assessment amount should be based on what is needed to pay yearly expected expenses plus a small miscellaneous amount for unplanned repairs/budget overages, plus the planned amount you obligate to the Reserves. Income minus all those expenses should equal zero on the budget.

We have two accounts. Operating fund (checking) and Reserve fund (savings). All assessments are deposited into the operating fund and all expenses are paid from the operating fund. Deposits into the Reserves are considered an expense to the operating fund. When there is an expense that is to be paid for with Reserve funds, those funds are transferred from the Reserves and into the operating fund.

The Operating fund starts with an amount equal to approx 2 months expenses (rounded to the nearest thousand) at the beginning of the year plus any prepaid assessments. The operating fund ends the same way at the end of the year. Any under-budget line items are deposited into the Reserves (contingency line item) at the end of the year.

Prior to doing our first Reserve Study our Association placed anything left over after paying expenses into savings. They had zero idea how much money they really needed. When we did our first reserve study, we realized that we had to increase assessments by 20 percent to fully fund the Reserves. This required membership approval and, due to many articles explaining what reserves were for and providing a copy of the Reserve study with the meeting notice, our membership approved the increase. Had the membership disapproved the increase, the Board would have budgeted what it could into the reserves.

Our fiduciary duty would have technically been met once we held the vote.

MikeS1
Posts: 521

Posted:

Quote:

Posted By RonW7 on 04/04/2014 6:13 AM
MikeS1, I've seen those documents and they look promising at first. However, when you consider that 1) reserve studies are not required in Ohio, 2) the requirement in the ORC is too ambiguous, and 3) the community is not interested in funding a reserve that will only serve to benefit the association after they are long gone, it seems next to impossible to properly fund our reserves and charge the appropriate fee. Plus, a reserve study would merely offer a proposal to the members, a proposal they can reject if they simply don't like it even if it's the right way to go.

In short, everyone's more interested in a low monthly fee rather than instituting a proper budget. We have retirees who are on fixed income who can't afford the increase, owners who selling who want to keep the fee low so it's more attractive to naive buyers, and owners who sublet who want to keep their rent low. These owners have zero financial interest in raising fees and comprise of a large portion of our community. What is an HOA to do?

Ron - "What is an HOA to do?" It's called "SPECIAL ASSESSMENT". If you do not place monies into the reserve fund and you are grossly under reserved, the banks and the astute prospective , potential purchasers see this as a problem. Pay me now or pay me later. What about the folks that buy into the community and then they get hit with a large assessment when the HOA has not properly funded the Reserve account. That's not really fair to the new homeowner either to get slapped with an special assessment right after they move in.

I can relate to Tim's experience. For years the old Board wanted to remain very popular so that did not raise the assessments. Then they saw their reserves as they were about to be depleted so we also saw a couple of hefty increases in the assessments (to include one at 20%).

CarolR11 (Colorado)
Posts: 2,563

Posted:

More later, Ron. But for now I suggest you review davis-stirling.com and those CA HOA attorneys' various discussions of reserves. It's a great way to learn. Although set up to help HOAs understand the Davis-Stirling CA legislation, many of to topics are generalizable to any HOA in the country.

Go to the site above, then Main Index, then Reserves, which'll take you to a very large menu of choices. Click on 100% Funded or Fully Funded to get started.

Without having a chance to read others' replies here, I'll just start by saying it'll ease the pain if you don't try for 100% funding right away. Shoot for maybe 40-60% for now and gradually increase the owners' contributions to reserves.

JohnB26 (South Carolina)
Posts: 1,569

Posted:

NO, not too aggressive.

Put it to the vote.

If passed - good to go.

If defeated - you did your job - decide whether you, personally, could afford the special assessment(s) down the road.

If yes - stay put.

If no - mooooooove now before the idiot's property values plummet.

JohnC46 (South Carolina)
Posts: 14,265

Posted:

Ron

It is typical that people want to kick the can down the road. Review the CC&R's as to how much a BOD can raise dues without owner approval. Typically in the 5-20 range. If such exists then do so ASAP with the additional monies going into a Reserve Fund.

Many docs give the BOD the right to assess for "required/necessary" repairs so just do so when needed versus build a Reserve Fund.

The fallacy in my method is if something needs to be paid for, people will be screaming to pay for it out of the reserves. Face that argument when it arises.

You can lead horse to water but you cannot make it drink.

RonW7 (Ohio)
Posts: 122

Posted:

Quote:

Posted By TimB4 on 04/04/2014 7:49 AM
Ron,
There is never a net gain.

I am wondering is this is the sentence to set me straight once and for all.

Are you saying that an HOA should never have excess money that is not allocated to reserves, that it can never build up a surplus to use down the road for a non-essential community improvement? Does an HOA have to allocate all surplus to reserves and then specifically budget for any non-essential improvements?

Also, thank to everyone for the replies. I can't reply to all later, but several of you have been really helpful. I'll address you later.

DavidW5 (North Carolina)
Posts: 565

Posted:

Quote:

Posted By RonW7 on 04/04/2014 1:54 PM

Posted By TimB4 on 04/04/2014 7:49 AM
Ron,
There is never a net gain.

Ron,

We have had an operating surplus in each of the last 4 years. The board adopted a resolution creating a separate capital improvement fund (CIF) and transferred the surplus to the CIF (BTW - our replacement reserves are fully funded). The CIF funds have been used to dig a well to supplement our irrigation system, install a modern wireless sound system in our ballroom, and to purchase a tractor to allow some of our problem landscape areas to be mowed by our in-house staff. We currently explicitly budget an amount in our operating budget to transfer to the CIF just as we do with the transfer to replacement reserves.

JohnC46 (South Carolina)
Posts: 14,265

Posted:

Quote:

Posted By RonW7 on 04/04/2014 1:54 PM

Posted By TimB4 on 04/04/2014 7:49 AM
Ron,
There is never a net gain.

Ron

I say an association (BOD) can "budget" any way they so desire such as Undefined Reserves, Defined Reserves, Specific Reserves, Capital Improvements, New Clubhouse Flooring, Parking Lot Paving, BOD Liquor Bill, ad nauseam. The catch is having the money and owners not objecting, not approving, recalling the BOD, etc.

I sat your issue is getting more money versus defining what for.

CarolR11 (Colorado)
Posts: 2,563

Posted:

Now that I've read all the replies, I can see why you're impressed, Ron!

I still would agree with those who suggest starting out with less than 100% funding per year. And your current owners do need to be reminded that they now benefit from your reserves components. And as some have pointed out, banks really dislike an HOA with no or skimpy reserves. These owners looking at the short term may have a hard time selling if banks won't finance. This point may be useful with your landlords who may want to sell sooner than owner occupants.

This is what we have done. Before we good guys were on the board, there were three flippers who got the majority of the board to replace a very expensive component that was much more attractive than the developer's original. These three wanted to sell their four year-old condos at the top of the market, which they did. But it wasn't scheduled for replacement for several more years, so our entire reserves pool took a big hit. It's taken us seven years to get from 21% funded to our current 52%.

Among the couple of components you listed that should be reserved for, Ron was " our insurance deductible." Unless I misunderstand you, that is not a reserve component and reserves shouldn't be used to repair/replace components that have been damaged or ruined by acts of nature or human carelessness. Insurance covers that and paying for it is in your operating budget, where you might also have a line item to pay for insurance deductibles for items your HOA is responsible for.

Beyond mailboxes and repaving drives, do you have other components? Fencing perhaps, or an entrance monument, or common area light fixtures? If fencing, for example, the estimated life will be a lot shorter than for roofs. Some components by their very nature do not last very long.

Every year our Board votes what to do with any operating budget surplus at year's end. The majority always votes to place it in the next year's operating budget rather than reserves. We then put our rec on the ballot that goes to Owners for our annual election in late October. The majority of Owners always vote to put it in the operating budget. Come to think of it, I've never looked at CA HOA legislation to see if we're required to do this or if we're proceeding properly!

RichardP13 (California)
Posts: 1,767

Posted:

Carol

It's called IRS Ruling 70-604.

TimB4 (Tennessee)
Posts: 21,059

Posted:

Quote:

Posted By RonW7 on 04/04/2014 1:54 PM

Posted By TimB4 on 04/04/2014 7:49 AM
Ron,
There is never a net gain.

I am wondering is this is the sentence to set me straight once and for all.

Are you saying that an HOA should never have excess money that is not allocated to reserves,

No, I'm saying that the money should be allocated to something. You indicated that you had a net gain. Perhaps this was over simplifying your budget for posting purposes. However, in case you were not doing that, I (and others) are pointing out that an Association should not have any funds that aren't allocated to something. Otherwise, if I were a member in your Association and you indicated that the Association had a net gain, I would ask why the Assessments are so high that this is occurring. However, if the Board indicates that all funds are allocated to something and demonstrate how the Association utilizes funds that were leftover from line items that came in under budget (like transferring them to the Reserve contingency line item as we do), then, as a member, I would be less likely to question why assessments are being raised.

When you determine your budget for the year, total income should equal total expected expenditures.

In our budget we always allocate funds to line items we may or may not actually use that year (legal fees for example). By doing this we know that, if needed, we have set assessments high enough to pay for what might be typical fees (a legal opinion) that year. We also allocate funds to a miscellaneous line item and specify that this line item is for:

1) unexpected, non-reserve item, repairs.
2) to cover expenses when the income expected is not yet received (we have a 30 day grace period)
3) to be initially used to cover line items that go over budget (like snow removal)
4) to cover the income expected but not received from delinquent accounts (those over 30 days late)

We have a similar line item in our Reserves but call it a contingency line item.

As I said earlier, the Board has also determined that the operating fund will start the year with a balance equal to two months expenses (rounded to the nearest thousand).

I've attached a sanitized version of last years budget proposal to the board (to determine this years assessments) and a copy of the proposed budget as presented to the members. Perhaps this will help illustrate what I'm trying to convey. (as a side note, in addition to the budget summary, the members also get a detailed income and expense statement for both the operating fund and reserve fund)

Hope this helps,

Tim

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TimB4 (Tennessee)
Posts: 21,059

Posted:

Quote:

Posted By RichardP13 on 04/04/2014 6:45 PM

It's called IRS Ruling 70-604.

Here is a link to a guide on the ruling: Revenue Ruling 70-604 – The Complete Guide by a CPA

Here is a link to the ruling itself: IRS Revenue Ruling 70-604

Here is what the applicable part of the ruling requires:

"the resolution indicates that any excess membership income will be applied to next year's dues, which is in lieu of returning the excess money to the individual association members. "

TimB4 (Tennessee)
Posts: 21,059

Posted:

Muddying the waters further - here is a link to http://www.revenueruling70-604.com's Other Relevant Tax Citations page. This page shows all the other rulings and court decisions that affect or clarifies 70-604.

Bruce or Richard please correct me if I'm wrong. 70-604 can apply when filing form 1120 and not form 1120H. However, the general determination is that the excess funds need to allocated, applied to the following years assessment or refunded to the members is always applicable.

KellyM3 (North Carolina)
Posts: 2,239

Posted:

Ron,

What you're calling "excess money" isn't excess money. If you know, months ahead, you want to spend excess funds on ornamental landscaping, you owe it to your dues payers to place it in the budget. That way, your revenues are accounted and it shows that you chose not to fund Reserve Funds/Capital Improvement. Since you're a new president, if you dial in this "excess revenue" and tell your dues payers where every dime is allocated, you'll earn their support or, at least, recognition of the effort.

Your operating budget is paying its bills, leaving $500/month in "excess revenue." That needs to be Reserve Fund savings, plain and simple....creating a balanced budget.

Your next step is assuming how much money you need and will need to flow into Reserve Funds to avoid assessments. Then, dues need to raise to meet those future obligations while holding your monthly budget in check. That's how you financially heal, legal mumbo-jumbo aside.

You're "getting it." Keep up the hard work and harder study of your budget situation. You're under-estimating how underfunded your HOA budget is.

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