Reserve Studies Typically Exclude Dues Income and Operational Expenses

Started by SteveB25 • 20 replies • 651 views

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SteveB25 (Arizona)
Posts: 77

Posted:

A recent reserve study was performed for our HOA which I take issue with.

I have reviewed several reserve studies of our HOA. And, I have looked over dozens of reserve studies performed for other HOAs. I have found a common trend in professionally prepared reserve studies is that they all excluded annual dues and operational expenses. In all the cases that have seen, the reserve study practitioners derive the fully funded balance of the reserve components and compare that FFB to the current reserve fund balance to compute the current percent funding. All fine so far. Then the reserve practitioner typically assumes that the HOA should be 100% funded and declares that the HOA is either under or over funded. Generally under funded. They then provide a reserve contribution rate and declare their job done.

My goodness. This practice borders on total incompetence. By excluding operational expenses and annual dues incomes, one can never create a credible capital budgeting plan. And thinking that an HOA needs to be 100% funded ignores the principal objective of the reserve fund, which is to have enough money to cover reserve expenses when those reserve components require maintenance or replacement. I see too often where HOAs and reserve study service providers imply that the only way to safely achieve that objective is maintain 100% funding ... which is entirely false.

Would love to hear from others on this.

What has been your experience with reserve study service providers?
Did you prepare a long term capital budgeting plan? How did you account for operational expenses and annual dues incomes?
Did your reserve study service provider accurately include all reserve components? Did they include components that should not have been included?
In your HOA, did you target 100% funding? Or did you establish a lower percent funding target, for example 70% funding?

My personal observation is that an HOA can likely do a better job of performing a reserve study themselves versus using a outside provider. This, of course, assumes that the HOA makes it a goal to understand the principals of sound capital planning. Most will not and therefore they are at the mercy of reserve study service providers and many of them are incompetent and nearly all of them take the easy way out performing financial analysis by excluding dues income and operational expenses.

Love to hear from you all.

MelissaP1 (Alabama)
Posts: 13,836

Posted:

I don't think you factor that in. Dues and operational expenses are not part of a reserves study because they are not part of Capital improvements. They are daily expenses and need to be met immediately. A capital expense is a long term project that is paid out 1 time. Sometimes taking a special assessment if not able to meet the expense.

A capital improvement project works differently. These are things like Roof replacements, street projects, or other large scale responsibilities. It's not a "adding a clubhouse/amenity" type of thing either.

Think you may be confusing a few things. Honestly, I don't see an issue with not having dues or operational expenses in a reserves study.

Maybe someone can explain this better than me. It's been awhile since taken my Business accounting course...

Former HOA President

TimB4 (Tennessee)
Posts: 21,059

Posted:

Steve,

I get the impression that you are looking at reserves from the perspective of the cash flow method vs. the perspective of component method.

From reserveadvisors.com:

Cash Flow Method - A method of developing a reserve funding plan where contributions to the reserve fund are designed to offset the variable annual expenditures from the reserve fund. Different reserve funding plans are tested against the anticipated schedule of reserve expenses until the desired funding goal is achieved

Component Method - A method of developing a reserve funding plan where the total contribution is based on the sum of contributions for individual components. See "cash flow method.

Either method works with their own pros and cons.

That said, regardless of what method is used, operating funds/expenses don't enter into the equation for the reserve study because this is all about savings. That is, how much should be in your savings account and what will it take to get there. However, income level, operating costs, etc. are used by the board when the Board decides how much to actually allocate to savings.

To help illustrate what I am saying:

A rule of thumb for households is 3 to 6 months of normal expenses (mortgage, utilities, food, transportation, clothing, etc.) should be in your savings. The family (looking at how much they earn, their expenses and where savings can be made) decides how much to set aside each paycheck to reach that goal. Until that goal is reached, your household savings would be considered underfunded.

There is no rule of thumb for HOAs. This is why a study is done to determine what should be in your savings and, as a guide, how much should be deposited regularly (monthly, quarterly, etc.) to meet that goal. The Board (looking assessments, typical delinquencies, costs and where savings can be made) make the decision how much those regular deposits will be. Again, until that goal (based on the reserve study) is reached, the reserve are considered underfunded.

MelissaP1 (Alabama)
Posts: 13,836

Posted:

Thanks Tim! Knew you could explain it better. Early morning and rushing to work...

Just don't confuse your home income with the HOA's. They do not work the same. Similar but not the same. Your dealing with a corporation and EVERY members money. Which is why you have to budget in a HOA for the whole and not the one.

Former HOA President

CathyA3 (Ohio)
Posts: 6,299

Posted:

In addition to what Melissa said, the amount of your income does not determine your spending needs. It's the other way around. And many states have laws about co-mingling operating and reserve funds. Tapping the reserves to pay for current expenses is nearly always frowned on and may even be illegal, and if the board is trying to do it regularly, it's a sign that they are not budgeting properly or setting assessments high enough.

There are a couple of reasons why it's not appropriate for the HOA itself to do reserve studies.

* Lack of skills, primarily engineering and financial. Doing a reserve study is significantly more complex than coming up with sensible operating budgets. It's not a job for amateurs, which many board members sadly are.

* Lack of impartiality. If boards are tempted to understate their operating expenses, they are doubly tempted to do so when big bucks are involved. And many homeowners resent the fact that they must set aside money "for future owners' benefit when I'm not even going to be living here then". (Our current board president is on record as saying she doesn't believe that she should have to pay for roofs in twenty years, conveniently ignoring the fact that somebody else paid for her roof.) When state law makers wrote the rules for governing HOAs and COAs, they were trying to save these communities from their own bad judgement. Thus the requirement to use an independent third party.

Reserve studies are always educated guesses based on a number of assumptions. Some of these assumptions will be spot on, others not so much. It's reasonable for a board to question things that don't appear to agree with what's actually going on. And it's smart for the company doing the reserve study to provide feedback at various points during the process so that they can make the results as close to reality as possible. But the HOA should limit their role to providing accurate input, not trying to determine the final outcome.

AugustinD
Posts: 5,144

Posted:

Quote:

Posted By SteveB25 on 06/29/2020 11:30 PM
A recent reserve study was performed for our HOA which I take issue with. I have reviewed several reserve studies of our HOA. And, I have looked over dozens of reserve studies performed for other HOAs. I have found a common trend in professionally prepared reserve studies is that they all excluded annual dues and operational expenses. In all the cases that have seen, the reserve study practitioners derive the fully funded balance of the reserve components and compare that FFB to the current reserve fund balance to compute the current percent funding. All fine so far. Then the reserve practitioner typically assumes that the HOA should be 100% funded and declares that the HOA is either under or over funded. Generally under funded. They then provide a reserve contribution rate and declare their job done.

My goodness. This practice borders on total incompetence. By excluding operational expenses and annual dues incomes,one can never create a credible capital budgeting plan.

Of the several studies I have reviewed, all advise what adjustment to make to the current assessment to achieve 100% funding in the next several years (or less if possible). This of course requires assumptions about annual operating expenses. All the studies have disclaimers that effectively say that the reserve study is a guide. The reserve study staffers are all completely willing to adjust estimates of reserve components per discussions with the board.

Maybe you could clarify? Do you want a professional to advise on how the HOA spends its operational funds? If so, I think this is a different issue.

Reserve studies are not perfect. But I think they do help keep condos/HOAs on track and should be done at least every five years. Ideally there is a HOA/condo member who can reproduce the reserve study professionals' spreadsheet and advise the board a bit every year about how things stand. Older condos in particular are highly vulnerable to surprise capital expenses never anticipated. When these happen, and if the expense is large enough, an adjustment should be made to the reserve study done in recent years should be made. But for condos, where the reserve study is extensive, good luck finding a qualified individual to do this.

One of the reasons I sold my last condo was because the percent funded value was about 25%, and surprise, large capital expenses were arising regularly. The board did not understand percent funded. The board simply did not want to raise assessments. I expect the chances are high it will be one of those condos that has to take out a loan within the next five years or so.

Quote:

Posted By SteveB25 on 06/29/2020 11:30 PM
And thinking that an HOA needs to be 100% funded ignores the principal objective of the reserve fund, which is to have enough money to cover reserve expenses when those reserve components require maintenance or replacement. I see too often where HOAs and reserve study service providers imply that the only way to safely achieve that objective is maintain 100% funding ... which is entirely false

First, if you google on this subject, generally speaking reserve professionals will rate a reserve fund fine if it is at least 70% funded. This takes into account that reserve studies are not an exact science.

Second, what "percent funded" value should reserve study professionals use to advise HOAs on adjusting their annual assessments? I do not understand your objection. Do you want to throw out "percent funded" as a measure of a HOA's reserve account's health? If you google on this, you will see criticism of "percent funded." But I am not sure other metrics (for measuring reserve account's health) capture the big picture as succinctly.

In my experience none of a HOA's/condos directors understand the reserve funding spreadsheet; the metric "percent funded"; and the need to go through the reserve study line by line and be comfortable with the way the professionals were estimating the future cost of replacement of each component. The board typically ignores the reserve study, claims it is wrong, and that there is no need to raise assessments. My state has zero regulation of reserve accounts and reserve studies. Other states do have some statutes addressing reserve studies.

AugustinD
Posts: 5,144

Posted:

Quote:

Posted By CathyA3 on 06/30/2020 5:47 AM
many homeowners resent the fact that they must set aside money "for future owners' benefit when I'm not even going to be living here then".

The above has been my experience with condo/HOA members as well. I believe that this one, relatively simple principle is beyond the understanding of like 99% of HOA/condo members nationwide. They do not understand that they are enjoying the benefit of, say, roofs now and so should pay an appropriate fraction of this benefit.

An alternative way to look at this is that a condo with a roof needing replacement in the next three years or so, yet with a reserve account having zero funds available for roof replacement, will simply result in a large special assessment on future owners. A potential buyer of a condo, who happens to be incredibly savvy and maybe a former reserve study professional, will review the reserve study and factor the likelihood of a large special assessment into the price she or he is willing to pay for the condo unit. Or more likely, this savvy potential buyer will look around and see that the other members are unlikely to have enough cash to pay a large special assessment, so the HOA/condo will be facing a high likelihood of taking out an expensive loan. Now owners are stuck with not only paying for the capital asset, but also paying the costs of a loan. I understand loans for condos/hoas are not cheap.

Quote:

Posted By CathyA3 on 06/30/2020 5:47 AM
(Our current board president is on record as saying she doesn't believe that she should have to pay for roofs in twenty years, conveniently ignoring the fact that somebody else paid for her roof.)

What a great example of ineptness when it comes to reserve planning. When I speak of ignorance of 99% of HOA/Condo members when it comes to reserve planning, the above is what I am talking about.

Quote:

Posted By CathyA3 on 06/30/2020 5:47 AM
When state law makers wrote the rules for governing HOAs and COAs, they were trying to save these communities from their own bad judgement. Thus the requirement to use an independent third party.

Let's be clear about the boards of condos in particular: They are unpaid volunteers who put in extraordinary hours into the monthly sturm-und-drang having nothing to do with budget planning and reserve considerations. They understand (sort of) the melodrama, so they go at it with enthusiasm. But math is hard for them. Infrastructure issues are hard for them (unless they have owned a home for a long time or are civil, mechanical or other similar engineers). A spreadsheet projecting costs into the future is unfathomable.

JohnC46 (South Carolina)
Posts: 14,265

Posted:

Once a Reserve Study is complete, it has to be decided how/when to fund it. As an example: say roofs have to be replaced in 10 years at a cost of $200K. If no money has been set aside for this then to fund it you will need to contribute $20K a year. There is no need for that fund to 100% funded as of today or for that matter, in the next 10 years. Only at the end of the 10 years is 100% funding needed. The question then becomes how do we get the $20K per year? Do not forget inflation.

We went through such an issue and it concerned roofing. We needed to raise dues $240 per year, per home to have a roof fund adequately funded meaning 100% come new roof time.

AugustinD
Posts: 5,144

Posted:

Quote:

Posted By JohnC46 on 06/30/2020 8:37 AM
As an example: say roofs have to be replaced in 10 years at a cost of $200K. If no money has been set aside for this then to fund it you will need to contribute $20K a year. There is no need for that fund to 100% funded as of today or for that matter, in the next 10 years.

To be clear: This is not what "percent funded" means. If after three years, and assuming roofs are the HOA's only capital asset and $60k has been set aside for the roofs, then the percent funded value is 100%. If after three years, only $50k were in the fund, then the percent funded value is 50/60 or 83%. If after four years, only $70k were in the fund, then the percent funded value is 70/80 = 88%.

Quote:

Posted By JohnC46 on 06/30/2020 8:37 AM
Only at the end of the 10 years is 100% funding needed. The question then becomes how do we get the $20K per year? Do not forget inflation.

I suppose a HOA could aim for a non-linear annual funding model so that the reserve fund has the required amount in ten years, saving say $10k the first year but then saving $30k the following year. But first take a survey and see who among the board and membership can define "non-linear."

MarkW18
Posts: 1,290

Posted:

Following is a quote from an attorney about reserves studies.

A reserve study is not actually a "study" of the roofs, boilers, streets, etc. Instead, it is a list of the major common area components with an estimate of their remaining useful life. Reserve studies should be done by someone who specializes in reserve studies.

California requires that HOA's have a reserve study and it is to be updated every three years. In addition, the study is supposed to be reviewed annually. If a reserve company were to perform this service, a typical 100 unit complex would likely spend $3000.00 over three years to have an on-site view and two updates. A board will get the 45 page report, scratch their heads and file the report somewhere never to be seen again.

I perform the reserve studies for all our clients, with their permission and blessing. I charge $200.00 annually. I don't do the initial study, mainly because I don't want to get up on roofs any longer. As the attorney stated, it is just a list of major common area components, nothing more, nothing less. I've used three different software packages over that time, but recently found one that is heads and tails better than the rest because of the number of updates and enhancements done over the years.

The software I use allows the inclusion of annual income and operation expenses. It is nice to have all the information in one place when reviewing the study. When needed, the study is updated throughout the year, but the real focus comes after Labor day when budget and disclosure season starts. To the majority of boards, they could less about it and even more that don't understand how to use it. In the hands of the right person, it is an invaluable tool especially to HOA's that have a number of components. It should be used to help manage your reserve savings accounts and how monies are allocated, long term and short term savings strategies.

I am dealing with a particular situation with one association. It was taken over two and half years ago with little reserves and roofs that hadn't been addressed, and dues that hadn't been raised in 20 years. Roofs will have to be fixed. They have 25 buildings all with tile. Bids came in between $750K-$800K. A special assessment will have to be done, possibly as an emergency. The upfront cost per unit is $7800.00. No way that would happen. So we are going to take out a bank or SBA loan over 20 years with per unit cost of $36 per month. If a unit sells in two years, the loan will transfer to the new owner and is disclosed to a new buyer. The current owner only pays for the period of time they actually live there.

Most people don't know what percent funded means. If the only component a HOA has is a pool heater and the replacement cost is $2500 with a lifespan of 5 years, then $500 per year is needed to fund for the replacement after 5 years. If at year 4 there was $2000.00, then you would be 100 percent funded. If you had only $1000.00 then you would only be 50 percent funded.

AugustinD
Posts: 5,144

Posted:

Quote:

Posted By MarkW18 on 06/30/2020 9:45 AM
Following is a quote from an attorney about reserves studies.
A reserve study is not actually a "study" of the roofs, boilers, streets, etc. Instead, it is a list of the major common area components with an estimate of their remaining useful life. Reserve studies should be done by someone who specializes in reserve studies.

...
As the attorney stated, it is just a list of major common area components, nothing more, nothing less.

One can google and learn that the many companies that perform reserve studies of course include much more information and analyses than a mere list of major components with their remaining useful life.

SteveB25 (Arizona)
Posts: 77

Posted:

Here is why one should include operational expenses and income from dues in a reserve study.

An association’s income is almost totally reliant on income from dues. There may be other income sources, but dues are, for the most part the only source of income.

The association uses their income to pay for both operational expenses and reserve expenses.

Operational expenses are subject to inflation just as reserve expenses. Generally, at lower rate, but operational expenses will inflate over time.

Associations typically have at least two funds … reserve and operational. It is generally advised not to mix the two, but when unexpected expenses occur or a budgeted expense ends up costing more than originally planned, it is quite OK to dip into reserve funds to pay for the expense … as long as it is documented and a strategy to replace the funds is implemented.

A reserve study should be not limited into being merely a “capital replacement plan”. A better approach, especially for an HOA, is to have a long-term capital budgeting plan. And when preparing a long-term capital budgeting plan, there are several factors that must be considered:

* Decisions must be based on cash flows
* NEVER use the component method for analysis. Always use the cash-flow method.
* Overall cash flow must include all expenses and all incomes
* Capital replacement is extremely sensitive to timing due to inflation
* The reserve study must consider all available funds.

One key aspect is that the reserve study must consider all available funds. And, the only source of funds for an association is annual dues. And these dues must also cover operational expenses. Ergo, excluding the operational expenses from a reserve study, ignores the principle that the study must consider all available funds.

As I stated earlier, I have observed two flawed beliefs or practices with all the reserve studies I have examined. The first is that the reserve study ignores operational expenses and dues income. By focusing only upon the capital replacement aspect, results in a partial analysis. At least as far as the HOA is concerned. How good is a reserve study that only derives what the HOA must contribute to a reserve fund without also including how much the HOA needs to maintain their income stream. A better approach is to include the operational expenses and dues income in the analysis. This is not to say that the analysis will dictate how operational funds will be spent. The underlying assumption in the analysis is that the reserve fund/expenses are separate from the operational fund/ expenses.

The second flawed belief is that the HOA needs to be ... or should be … at 100% funding. This concept of 100% funding is linked to the concept of component funding, which should never be employed in a reserve study. The main drawback to relying on percent funding as an indicator of the reserve fund strength is that percent funding fails to address the timing of expenditures.

I believe that percent funding should only be used as a casual indicator of the strength of a reserve fund. A far better approach is to develop a cash flow analysis that considers all aspects (operational expenses, reserve expenses, loans, special assessments, earned interest, inflation, etc.) and project the estimated annual available funds versus the estimated annual expenses. And this, my friends, is the downfall of reserve studies that do not consider all the financial aspects.

So, to my friends here in HOATalk … how did you utilize your reserve study (which only considered capital replacement) to develop a financial plan for your community? Who developed that plan? I assume the reserve study service provider did not.

And a comment for CathyA3 in Ohio … only the State of Nevada has a requirement to use professional reserve study service providers. For all the rest, there is no such requirement. In my opinion, there is high likelihood that someone in a typical HOA can perform reasonable physical assessments, especially with the assistance of the local vendors and service providers. Doing the financial analysis requires knowledge or the use of a good software package.

By the way … the absolute best document that I have encountered for reserve studies is titled, “Reserve Studies – The Complete Guide”, by Gary Porter and Pierre Del Rosario. It is available here …
http://www.hoapulse.com/reserve-studies-the-complete-guide-details.

I would also rate the State of California’s “Reserve Study Guidelines” document very highly as well. It is available here …
https://dre.ca.gov/files/pdf/re25.pdf

MarkW18
Posts: 1,290

Posted:

Quote:

Posted By AugustinD on 06/30/2020 9:55 AM

...
As the attorney stated, it is just a list of major common area components, nothing more, nothing less.

I'm guessing that was intended as a jab toward myself. My suggestion to you is take a course in "reading comprehension".

There are two parts to what the attorney stated, one, the study is not describing what roof tile use, where it comes from, which tile is better, none of that. The "study" lists all the components, useful life, replacement cost, etc.

BTW, the reports I do for the HOA have about 70 some pages which also includes a Powerpoint presentation. The software, as I said, is the best I have used. It has been updated over the years and get recommendations from the people who actually use it. They even have their very own users group. If there have ever been any bugs, they gave quickly been addressed and fixed.

The software I use is was actually developed and maintained by the OP. Sorry about the plug, but you're not going to get away with making false statements!

AugustinD
Posts: 5,144

Posted:

Quote:

Posted By MarkW18 on 06/30/2020 10:32 AM
I'm guessing that was intended as a jab toward myself.

Nope. Contrary to what you wrote twice, a reserve study is not merely a list of components with their life expectancy. But I do agree that the right people can take an early, professionally done reserve study and revise it in subsequent years, with some caveats.

MarkW18
Posts: 1,290

Posted:

It appears the lights are on, but nobody's home.

GenoS (Florida)
Posts: 4,276

Posted:

Quote:

Posted By SteveB25 on 06/30/2020 10:21 AM
So, to my friends here in HOATalk … how did you utilize your reserve study (which only considered capital replacement) to develop a financial plan for your community? Who developed that plan? I assume the reserve study service provider did not.

We've never had an official "Reserve Study" done in my HOA. Nevertheless, I've participated in a yearly "analysis" of our reserves and the plan for funding them. Parenthetically, Florida does not require reserve studies. The annual budget for HOAs in Florida, according to statute, consists of 2 parts: The operating budget and the contribution toward reserves. From everything I've read, never the twain shall meet. You've advocated for things that are highly irregular. The estimated operating budget should never consider the reserve balances. The two are apples and oranges. You take the dollars from the estimated operating budget and add to that the computed reserve contribution. That drives your assessments.

I've never seen or heard of it being done differently. Sure, you can borrow from your reserves if you've got a detailed plan to replace the funds, but that's a horse of a different color.

You've outlined things I consider outrageous. Too many to address on a point-by-point basis. Reserve studies are not "flawed" because they don't consider the operating budget. That's what they're supposed to do.

JohnC46 (South Carolina)
Posts: 14,265

Posted:

Once a Reserve Study is complete, it has to be decided how/when to fund it. As an example: say roofs have to be replaced in 10 years at a cost of $200K. If no money has been set aside for this then to fund it you will need to contribute $20K a year. There is no need for that fund to 100% funded as of today or for that matter, in the next 10 years. Only at the end of the 10 years is 100% funding needed. The question then becomes how do we get the $20K per year? Do not forget inflation.

In my above example are some saying that is the $20K a year is done, then the roofing fund is at 100%? ala if at $100K after 5 years it is 100% funded versus only being 50% funded. Is this an accounting or semantics issue?

TimB4 (Tennessee)
Posts: 21,059

Posted:

Quote:

Posted By CathyA3 on 06/30/2020 5:47 AM

There are a couple of reasons why it's not appropriate for the HOA itself to do reserve studies.

I think this depends on what common components there are.

If the Association is responsible for buildings, I agree.
However, many companies (based on my experience) are more then happy to assist you in determining what regular maintenance is needed and expected remaining life of an item. Therefore, it depends on what you have to base the reserves on and the skill of those doing the work.

SteveB25 (Arizona)
Posts: 77

Posted:

Quote:

Posted By GenoS on 06/30/2020 2:03 PM

You are correct that the two budgets should not be co-mingled. But consider this ... the income for the operational budget and contribution toward reserves is the same source. Typically annual dues. So, if the income is the same source for both, then it is then good practice to include both when developing what increases are appropriate so that you can provide adequate funding. I doubt that your association or any other association has two distinct annual dues invoicing ... one for operational expenses and one for contributions to the reserve.

From a fiduciary perspective, it would be more responsible develop an overall financial plan that addresses all expenses ... operational and reserve expenses. That is not to advocate that one should merge the two budgets. Far from it. The budgets should always be separate and well documented.

GeorgeS21 (Florida)
Posts: 3,808

Posted:

Assessments - Reserves = Operating Budget?

Or, like some communities: Assessments - Operating Budget = Reserves? (usually deposited stuff the end of the year)

CathyA3 (Ohio)
Posts: 6,299

Posted:

Quote:

Posted By GeorgeS21 on 06/30/2020 5:55 PM
Assessments - Reserves = Operating Budget?

Or, like some communities: Assessments - Operating Budget = Reserves? (usually deposited stuff the end of the year)

Or how we do it: Operating Budget - Reserve Contribution (per recent study) = Assessments. Necessary income is determined by spending needs, not the other way around, although we have some wiggle room. Setting the operating budget at some arbitrary number nearly always means deferred maintenance and short-term thinking.

We're condos, so we have a number of expenses that can't be postponed or reduced through bids such as electricity, water and trash pickup (we're already with the lowest-cost provider for the last item). State condo law also requires us to fund the reserves in accordance with the latest reserve study unless the membership votes annually (unanimously, I think) to allow under-funding. Law makers wanted condo owners to acknowledge that they are doing something that is going to bite them in the fannies in the future.

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