Reserves, Operational Expneses, and Contingencies

Started by CathyA3 • 19 replies • 416 views

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CathyA3 (Ohio)
Posts: 6,299

Posted:

The recent threads about reserve funding have prompted this new thread.

So here are the rules of engagement:

* Operational funds cover current expenses.

* Reserve funds are earmarked for future spending on the big ticket items.

* The board may not tap the reserves for operational expenses except for short-term loans that have to be repaid within the current fiscal year. In other words, the loan can fix a cash flow problem but cannot address an under-budgeting problem.

* There are no contingency funds. In fact, some state laws actually prohibit such funds - if not explicitly, then through the requirement that unused operational funds must be returned to the membership at the end of the fiscal year.

* State laws may or may not require reserve funding. Even those states that do require it often give the membership the right to under-fund if the membership votes to do so (typically an annual vote).

* The annual budget funds *anticipated spending needs* plus (maybe) contributions to the reserves.

Does anyone else see the holes in the logic here?

In the ideal HOA or COA as envisioned by lawmakers, there are no unanticipated events. There are only planned expenses plus money set aside for future spending. Anyone who has spent any time serving on their association board knows, there are always unanticipated events. The older the community, the more of these there are. In condos it's often worse because of the high percentage of common elements.

So what options does a board have when a roof springs a leak (not storm damage, so not an insurable event) or a sewer pipe collapses due to settlement? They have to either delay repairs (not an option with the two events I just mentioned), or they find the money somewhere. "Somewhere" means a special assessment, loan, or tapping the reserves. Many boards opt for the path of least resistance and hit the reserves.

The reserve funds can leak money in other ways. For instance, reserve specialists will ask what the cut off is for including an expense in reserve planning? Is it over a certain dollar amount? Or over a certain percentage of the operating budget (although I'm not sure how that works since future budgets are an "unknowable unknown")? At any rate, there are assumptions built into the reserve planning.

However, many boards - when faced with an unplanned expense - will think "oh, that's a reserve item" and take the money from the reserve accounts *regardless of the size of the expense*. If your reserve study assumed only expenses over, say, $10K, and the board hits the reserve accounts for a series of expenses under that amount, then the reserves will never reach the levels planned in the last study.

Ironically, all of the above is best-case scenario where the rules of engagement force the boards' hands. I haven't even mentioned boards that consistently under-budget for operational expenses and make up the difference by hitting the reserve accounts, which I view as deliberate mismanagement.

So...

There are in fact contingency accounts, regardless of state laws. The reserves perform this function. Even if boards do everything else correctly, you can't outlaw unanticipated events. And requiring all such events to be handled through special assessments directly contradicts many state laws that require reserves *to avoid the need for special assessments*.

I think that I need to bend the ears of my state lawmakers.

TerriS6 (California)
Posts: 3,284

Posted:

I'm wondering if anyone else is using "threshold" funding instead of "full" funding? We only have roads and greenbelt to maintain, neither of which require full replacement cost but require ongoing maintenance. Our reserve study was based on full funding which makes no sense for our development since the roads will never have to be replaced all at once. Also, the reserve study did not establish a "useful life" or a "remaining life;" it only listed a range of years which could be interpreted any which way.

SheliaH (Indiana)
Posts: 6,964

Posted:

Discussing this with state lawmakers would be helpful. In fact, I think those guys and gals would do well to take a few CAI classes (or from someone else) on HOA issues like reserves, rule enforcements, etc., and then read a few documents from communities in their area, a year's worth of board meeting minutes and income-expense statements so they can see how some of the laws they come up with may sound good but are not centered in reality. At all.

If you live in a state where you can't have contingency accounts, your points are a great place to start when talking to them (if you don't know which legislative committee handles HOA issues, start with your own representatives). In light of what's happening with HOA master insurance (getting more expensive and hard to find), giving HOAs the ability to establish contingency funds is very timely. In the meantime, it may be helpful to talk to your association accountant, tax preparer and maybe your association attorney, (not to mention the master insurance carrier) about establishing a contingency line item in the operating budget. The amount could be based on past spending to start with, and if you didn't use the money at the end of the year, roll it over into next year's budget.

If it is not right do not do it; if it is not true do not say it. Marcus Aurelius

CathyA3 (Ohio)
Posts: 6,299

Posted:

I use the word "threshold" as the deciding factor of what expenses are considered reserve and what are considered operational. We consider minor plumbing or roof repairs to be operational expenses, even though the plumbing and roofs are common elements and reserve items.

But there's no hard and fast rule about this. Different communities can do things differently as long as the board is being consistent. If they're deciding that only repairs over $10K are reserves expenses for planning purposes but then turning around and tapping the reserves for smaller expenses, then the community will never have the money they need to pay for the big ticket items with accumulated funds.

I think this latter scenario is actually pretty common, so it may make sense to assume all expenses for reserve items should come out of the reserve funds. The end result would be lower operational budgets but higher reserve contributions. And when interest rates are higher, a community would actually be in a bit better shape if they went with this option. This is assuming that the membership can't vote down reserve contributions. In the latter case, all bets are off and we should stop pretending that the board is actually in charge of things.

Ultimately all the money comes out of the same place, so at some point we're just disagreeing about labels - a distinction without a difference.

ElleN (Idaho)
Posts: 1,334

Posted:

Quote:

Posted By CathyA3 on 12/10/2024 5:33 AM

* There are no contingency funds. In fact, some state laws actually prohibit such funds - if not explicitly, then through the requirement that unused operational funds must be returned to the membership at the end of the fiscal year.
.
.
.
[per long-established rules of grammar, ellipsis mean snippage]
There are in fact contingency accounts, regardless of state laws. The reserves perform this function.

?

-- One best practice is to have an 'operating contingency account' of a few months of annual operating expenses. It is a "cushion."

-- Your assertion that unused operating funds must be returned is highly inaccurate. This is largely about IRS rules, an increasingly common owners' vote on the topic and more. This has been discussed many times here.

TimB4 (Tennessee)
Posts: 21,059

Posted:

We actually have a contingency line item in our reserves for the purpose of covering overages in the reserves.

We also maintain a minimum balance in our operating funds for the purpose of covering expenses while waiting for payments. I would call this an operating contingency fund.

KerryL1 (California)
Posts: 14,550

Posted:

We, too, have a contingency line item in both our operating budget (O.B.) and in our 3 reserves funds.

We have 182 reserve components b/c we're two tower high rises. Many, many of our reserve components components have elements in them that we repair using our O.B. e.g. minor roof repair, plumbing repair, etc.

Btw, our national and highly respected Reserves Firm recs its that are less than 0-1% of our annual budget not be in reserves. An HOA's certified reserves specialist will most likely rec. an amount or %.

A new national Reserves Guideline line was published in 2023 by a task force of reserves experts. I never remember where to find it--somewhere on CAIonline.com?

I agree that HOAs vin required ti returned excess funds at year's end is not require much that I've heard about.

Cathy wrote: "So what options does a board have when a roof springs a leak... or a sewer pipe collapses ....? They have to either delay repairs (not an option with the two events I just mentioned), or they find the money somewhere. "Somewhere" means a special assessment loan, or tapping the reserves."

But this is what reserves are for. When reserve components fail, reserves pay to fix or replace them. Even if they fail prematurely. Roofs & sewer pipes should be on the Reserve Study. So the reserves aren't "leaking" funds, they're being used execacty as intended. Do these premature failures affect the reserves, % funds. Yes.

Cathy also wrote: "* Reserve funds are earmarked for future spending on the big ticket items." To clarify: they earmarked for big ticket components that are listed on the Study. (i.e not to fund new big tic items)

CathyA3 (Ohio)
Posts: 6,299

Posted:

Quote:

Posted By KerryL1 on 12/10/2024 10:32 AM
... snip ...

Cathy wrote: "So what options does a board have when a roof springs a leak... or a sewer pipe collapses ....? They have to either delay repairs (not an option with the two events I just mentioned), or they find the money somewhere. "Somewhere" means a special assessment loan, or tapping the reserves."

But this is what reserves are for. When reserve components fail, reserves pay to fix or replace them. Even if they fail prematurely. Roofs & sewer pipes should be on the Reserve Study. So the reserves aren't "leaking" funds, they're being used execacty as intended. Do these premature failures affect the reserves, % funds. Yes.
... snip ....

<

If the study was done with the assumption that it was looking at replacement costs which will be incurred on a schedule that more or less coincides with remaining useful life, and nothing else, then using reserve funds for repairs prior to full replacement is not using them as intended.

Of course, if the study did account for repairs along the way, then everything is OK. But the reserve studies I've seen didn't make this assumption - mostly because these repairs may be unpredictable, meaning they have no place in a reserve study which deals only with predictable events. These studies assumed that repairs under a certain dollar amount would be handled out of operating funds. But this won't happen if the operating budget did not account for these expenses.

That's the problem. The operating accounts and the reserve accounts are funded with inconsistent assumptions.

This isn't necessarily deliberate. New and inexperienced board members probably won't check with the latest reserve study before developing annual budgets. They won't even know that there is something that needs to be checked, let alone what to do with the information if they did look.

In this case it boils down to lost institutional memory, among other things.

KerryL1 (California)
Posts: 14,550

Posted:

In my opinion, any reserve firm worth its salt can & SHOULD estimate WHEN roofs are likely to start needing repairs based on a lot of info that they have. So our Study has a repair or sometimes "refurbish" line item and a replace line item for many components.

WE, for example, entirely rehab our lobbies and eveyrthing in them down to outlet plates, exit signs.Our 2025 Reserve Study has lobby remodel (replace) with a 15 yer RUL. Different line item is Lobby refurbish - 8 years. This incudes solely replacing furniture.

I'd also argue that is a sewer line "fails" prematurely, it most likely needed to be replaced or portions of it. IMO, reserves are the approprite place to expense these cost reserve comments.

I encourage everyone to read the 2023 National Reserve Standards. I remember Terri found it for us not long ago.

ElleN (Idaho)
Posts: 1,334

Posted:

Quote:

Posted By CathyA3 on 12/10/2024 11:04 AM

If the study was done with the assumption that it was looking at replacement costs which will be incurred on a schedule that more or less coincides with remaining useful life, and nothing else, then using reserve funds for repairs prior to full replacement is not using them as intended.

I disagree. These studies make clear that the "remaining useful life" figures are estimates. If a reserve component fails sooner than planned, of course a HOA may lawfully draw from the reserve account to replace the reserve component, and this will be using the reserve funds "as intended."

Reserve studies never advertise themselves to represent "exact science." They do quite the opposite. They are a crude tool but nonetheless, an invaluable one.

DeanJ
Posts: 1,786

Posted:

Quote:

Posted By CathyA3 on 12/10/2024 5:33 AM
The recent threads about reserve funding have prompted this new thread.

So here are the rules of engagement:

* Operational funds cover current expenses.

* Reserve funds are earmarked for future spending on the big ticket items.

* The board may not tap the reserves for operational expenses except for short-term loans that have to be repaid within the current fiscal year. In other words, the loan can fix a cash flow problem but cannot address an under-budgeting problem.

* There are no contingency funds. In fact, some state laws actually prohibit such funds - if not explicitly, then through the requirement that unused operational funds must be returned to the membership at the end of the fiscal year.

* State laws may or may not require reserve funding. Even those states that do require it often give the membership the right to under-fund if the membership votes to do so (typically an annual vote).

* The annual budget funds *anticipated spending needs* plus (maybe) contributions to the reserves.

Does anyone else see the holes in the logic here?

In the ideal HOA or COA as envisioned by lawmakers, there are no unanticipated events. There are only planned expenses plus money set aside for future spending. Anyone who has spent any time serving on their association board knows, there are always unanticipated events. The older the community, the more of these there are. In condos it's often worse because of the high percentage of common elements.

So what options does a board have when a roof springs a leak (not storm damage, so not an insurable event) or a sewer pipe collapses due to settlement? They have to either delay repairs (not an option with the two events I just mentioned), or they find the money somewhere. "Somewhere" means a special assessment, loan, or tapping the reserves. Many boards opt for the path of least resistance and hit the reserves.

The reserve funds can leak money in other ways. For instance, reserve specialists will ask what the cut off is for including an expense in reserve planning? Is it over a certain dollar amount? Or over a certain percentage of the operating budget (although I'm not sure how that works since future budgets are an "unknowable unknown")? At any rate, there are assumptions built into the reserve planning.

However, many boards - when faced with an unplanned expense - will think "oh, that's a reserve item" and take the money from the reserve accounts *regardless of the size of the expense*. If your reserve study assumed only expenses over, say, $10K, and the board hits the reserve accounts for a series of expenses under that amount, then the reserves will never reach the levels planned in the last study.

Ironically, all of the above is best-case scenario where the rules of engagement force the boards' hands. I haven't even mentioned boards that consistently under-budget for operational expenses and make up the difference by hitting the reserve accounts, which I view as deliberate mismanagement.

So...

There are in fact contingency accounts, regardless of state laws. The reserves perform this function. Even if boards do everything else correctly, you can't outlaw unanticipated events. And requiring all such events to be handled through special assessments directly contradicts many state laws that require reserves *to avoid the need for special assessments*.

I think that I need to bend the ears of my state lawmakers.

While you are at it, get them to pass a law that restricts investors in condo communities to 10% and restricts lending so people can only have mortgage payments of <20% of their monthly gross income.

CathyA3 (Ohio)
Posts: 6,299

Posted:

Quote:

Posted By ElleN on 12/10/2024 5:42 PM

I guess I'm not explaining my issue clearly enough.

I know that reserve studies are educated guesses at best.

Where I'm seeing trouble isn't the fact that remaining useful life or projected inflation rates are estimates. It's what happens during the period before the board says "yeah, that roof is shot, replace it". If the study assumes only two possibilities (the roof is perfectly OK vs. the roof needs to be replaced NOW), then it won't capture any of the expenses that occur during the period between those two extremes.

Where does that money come from? If the study assumes the money for repairs comes out of operating funds, and a board assumes "reserve item - pull the money out of reserves", then the board has just magicked away a significant category of expenses.

In other words, the problem isn't that reserve studies are estimates. It's the fact that the cost of repairs to items that aren't ready for replacement aren't being captured anywhere - not in the reserve study and not in the operating budget. The money is always elsewhere - which means it's nowhere.

Without accounting for this expense, the board won't be able to decide when the ongoing repairs are basically throwing money away and it's time to bite the bullet and replace. It's kinda like the guy who's driving a junker that's always in the shop. At some point he's spent enough in repairs to have bought a solid, late-model used car - and he's still driving the junker.

I've watched this happen in a number of communities, including my own. It goes like this. The reserve study only considers the cost of replacement of capital assets (repairs paid for out of operating). We have an unanticipated expense: "that's a reserve item, take the money out of reserves". "Wait a minute, it's a repair - the money should come out of operating." "Well, we didn't budget for it, take it out of reserves." Add to this boards who think they can keep expenses down by under-budgeting and who don't contribute to the reserves, and this community is digging itself a hole that it may not be able to climb back out of. And then the banks start giving the community some side eye...

It's not just a reserve funding problem or just a budgeting problem - it's a "not understanding the interplay between them and how money actually works" problem.

CathyA3 (Ohio)
Posts: 6,299

Posted:

CathyA3's Aphorism of the Day:

It's important to understand how money works. If you lie to yourself about it, then money will always work against you. If you understand and act accordingly, then you can make money work for you. The latter is always better, especially if you don't have a lot of it.

TerriS6 (California)
Posts: 3,284

Posted:

Quote:

Posted By CathyA3 on 12/10/2024 7:13 AM
I use the word "threshold" as the deciding factor of what expenses are considered reserve and what are considered operational. We consider minor plumbing or roof repairs to be operational expenses, even though the plumbing and roofs are common elements and reserve items.

But there's no hard and fast rule about this. Different communities can do things differently as long as the board is being consistent. If they're deciding that only repairs over $10K are reserves expenses for planning purposes but then turning around and tapping the reserves for smaller expenses, then the community will never have the money they need to pay for the big ticket items with accumulated funds.

I think this latter scenario is actually pretty common, so it may make sense to assume all expenses for reserve items should come out of the reserve funds. The end result would be lower operational budgets but higher reserve contributions. And when interest rates are higher, a community would actually be in a bit better shape if they went with this option. This is assuming that the membership can't vote down reserve contributions. In the latter case, all bets are off and we should stop pretending that the board is actually in charge of things.

Ultimately all the money comes out of the same place, so at some point we're just disagreeing about labels - a distinction without a difference.

I'm using threshold as the funding type where a minimum amount is always maintained in the reserve account. I find it problematic that we hired a reserve study company that utilized the "full funding" model for a component that will never have to be replaced all at one time, our roads. So we have been allocating too much money to reserves (except it somehow never gets to reserves) and in doing so have postponed any road work for 4 years. That's why I think "threshold funding" would be better suited to our development.

CathyA3 (Ohio)
Posts: 6,299

Posted:

Quote:

Posted By DeanJ on 12/10/2024 8:00 PM

While you are at it, get them to pass a law that restricts investors in condo communities to 10% and restricts lending so people can only have mortgage payments of <20% of their monthly gross income.

Too many Big Money interests and others profit from the status quo, unfortunately. I had a big "ah ha!" moment a while back. I realized that community associations exist to benefit everybody except the homeowners. Homeowners are essential components of system - the same way bricks and steel and concrete and asphalt etc. are essential components. They're also equally interchangeable.

Cynical? Possibly - but convince me I'm wrong.

ElleN (Idaho)
Posts: 1,334

Posted:

Quote:

Posted By CathyA3 on 12/11/2024 5:59 AM
the problem isn't that reserve studies are estimates. It's the fact that the cost of repairs to items that aren't ready for replacement aren't being captured anywhere - not in the reserve study and not in the operating budget.

Maybe at your association the board is still getting up to speed and has not figured this out. At my last condo association of course there was a line item in the operating budget for mundane roof repairs. The latter of course is essential to maximizing the roof's life.

Roof //maintenance// ought to be much much lower in cost than roof replacement. Nor do I think the decision to pay for this maintenance from the operating funds is difficult. Pound on the why's of this here, if you want.

Same for roads, exterior walls and other items that cost a fortune to replace but do require regular maintenance to maximize life.

SheliaH (Indiana)
Posts: 6,964

Posted:

Quote:

Posted By CathyA3 on 12/11/2024 6:07 AM
CathyA3's Aphorism of the Day:

It's important to understand how money works. If you lie to yourself about it, then money will always work against you. If you understand and act accordingly, then you can make money work for you. The latter is always better, especially if you don't have a lot of it.

Yup! Here are a few more observations:

When money realizes that it's in good hands, it wants to stay and multiply in those hands - Idowa Koyeniken

Do not save after spending, but spend what's left after saving - Warren Buffett

A budget is telling your money where it should go instead of wondering where it went. John C. Maxwell

If it is not right do not do it; if it is not true do not say it. Marcus Aurelius

CathyA3 (Ohio)
Posts: 6,299

Posted:

Quote:

Posted By ElleN on 12/11/2024 10:49 AM

Yup. I'm a rip-the-bandaid off kind of person - I want all the bad news on the table so that we can at least make realistic plans for dealing with it even if we can't solve all of the problems immediately.

We're doing a new reserve study right now. Preliminary numbers are a little eye-popping. But I expected this after the community was in the hands of the Low Assessment crowd for several years.

Our new management company also wants to move us to line items, which I'm in favor of. It helps identify problem areas early. Roof maintenance is less costly than replacement. But the community is aging, the number of repairs keeps increasing even though we have the roofs inspected regularly. At some point we'd be better off replacing rather than continuing to repair - but identifying that sweet spot is a challenge. And don't mention plumbing issues...

CathyA3 (Ohio)
Posts: 6,299

Posted:

Quote:

Posted By SheliaH on 12/11/2024 4:13 PM

I was very lucky to have grade school teachers who taught us about personal finance. I still remember the day they explained the wonders of compound interest - I felt like I'd been given the key to a treasure chest!

What was more surprising is that I was taught by nuns and priests. For people who took a vow of poverty, they were pretty savvy about how money works. Then again, people who don't have a lot of money can't afford to be stupid about it. Only folks with a lot can afford to make dumb decisions.

ElleN (Idaho)
Posts: 1,334

Posted:

Quote:

Posted By CathyA3 on 12/12/2024 5:28 AM
But the community is aging, the number of repairs keeps increasing even though we have the roofs inspected regularly. At some point we'd be better off replacing rather than continuing to repair - but identifying that sweet spot is a challenge.

Just saying (for your "yup" approval?): All directors need to be comfortable with the reality that one will never know if they got as many years and months out of the roofs as possible. This remains fuzzy science (a.k.a "engineering"). All should accept it.

One criterion: When the risk of leaks causing damage to owners' property or other HOA-owned property seems high, replace. Do not look back. Any CCOs complaining about budgeting: Have him prepare and present a summary of conventional wisdom on roof replacement.

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