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When It Comes to Reserve Funds, How Much Is Enough?
When other states (not CA) passed laws that required reserve funds to be “adequately funded,” those states turned to the Community Associations Institute (CAI) for assistance. Industry attorneys and directors and officers (D&O) liability insurance carriers also needed this defined in order to advise and defend their clients. CAI then turned to a group of CAI Business Partner reserve specialists from across the country and asked them to define “adequately funded reserves.” Here is the definition this group of very experienced reservespecialist’s provided:
If you were expecting a simple answer, like 75%, sorry. It’s just not quite that simple. But, let’s break it down and try to simplify it. This definition is making two key points: (1) have a Reserve Fund (money in the bank) and a Funding Plan that is multiyear, stable and equitable (keep making annual deposits, equitably over time) that does not rely on special assessments or loans and (2) that together (the Fund and the Plan) provide for the timely execution of the association’s major repair and replacement expenses.
A simpler interpretation is: (1) have the Reserve Funds available in the bank, funded fairly and equitably over time, without special assessments or loans and (2) execute the Plan, i.e. spend the Reserve Funds when the repair or replacement is necessary or due.
A Funding Plan is an association’s plan to provide income to a reserve fund to offset anticipated expenditures from that fund. Let’s go back to the key wording in the definition aboutthe Funding Plan – stable, equitable, and multiyear. These words are significant as they may be at the root of the very question - how did we get to the point where state legislatures passed laws requiring Replacement Reserve Funds be
“adequately funded”? As communities aged, replacement reserve funds were not adequately funded, resulting in the inevitable special assessments - which nobody appreciates, least of all the board members forced to make those decisions. Disgruntled homeowners wanted something done. Their property values had declined. The new owner who just purchased had no idea a special assessment was coming and lawsuits were filed. Homeowners across various states complained to their elected officials resulting in a myriadof laws regulating HOAs. These complaints also resulted in California passing laws requiring, among other things, the Disclosure Form, answering questions such as whether or not a special assessment is anticipated, along with the other documents to be mailed annually to all owner-members informing them of the current status of their Reserve Funds, and the 30-year Funding Plan to add to and spend those funds. The intention of the stable and equitable multi-year Funding Plan is to spread the funding of the cost of the repairs and replacement of reserve components evenly over the years, so each owner pays their “fair share” annually. This avoids special assessments or large increases to “catch up” after not adequately funding reserves on an annual basis.
In addition to legislative involvement, prospective buyers and real estate agents have become more knowledgeable about reserve funds. Some buyers have experienced or heard stories about special assessments. They are inquiring about the reserve funds and requesting a copy of latest reserve study. In talking with realtors, the current percent funded does come up in discussion more and more, as does the financial condition of the community.
Percent funded is the measure of the reserve fund “health” expressed as a percentage at a given point in time, typically the beginning of the fiscal year for which the reserve study was prepared. This figure is the ratio of the actual reserve fund on hand to the fully funded balance. A reserve fund that is 100% funded has accumulated the proportionately correct amount of money, to date, for the reserve components it maintains. While a current years’ percent funded is important, the plan is also important. What the 30-year projections indicate the “level of service” the association intends to provide membership. It is a “road map” for the fiscal future that includes when underfunded associations will “catch up” or how properly funded associations will remain fiscally “healthy,” and gives the "California law does require timetables for the repairs and replacements of the components. What the reserve study annually. In most reserve studies, the Funding Plan projections are color coded based on the percent funded for each year. The colors are in green, yellow and red to indicate good, fair or poor. If red is indicated for several consecutive years this can be viewed as undesirable and likely signals the need for a special assessment or large increase to catch up. However, a plan in the red for a year or two, which then moves into yellow, then into the green, shortly thereafter, could indicate an acceptable plan. The goal is to get into the green, which is above 65%, and remain in the green, always heading toward 100%. It’s true, there are no requirements to be a certain percent funded, or 100% funded. However, does anyone want the California legislature to pass more laws dictating funding requirements for California associations?
A primary duty of a board of directors is to maintain the assets of the association which directly impacts home is their largest asset." the property values of each member. For many homeowners, their home is their largest asset. A board that focuses on home values is acting in the financial best interest of its members. Responsible fiduciaries understand the need for long-range planning and preventative maintenance. A board that plans and budgets for preventative maintenance such as regular sealcoating, gate maintenance, and roof cleaning and inspections does save money over the long term. Wellmaintained assets typically reach or exceed their predicted useful life. Contrast this with spending funds on emergency repairs and replacing assets that fail prematurely due to lack of maintenance. The latter has proven to be more costly over time. While paint and asphalt contribute to the “curb appeal” of the common areas, there are those components that cannot be seen like roofs, lake liners and equipment, such as gate operators. Many of these components can have their useful lives extended with regular inspections and preventative maintenance. So, when budgeting, remember to include all components and their preventative maintenance.
One of the goals of having reserves adequately funded is to make it fair and equitable for all homeowners. But California law does not have this requirement. There is no requirement in California that reserves even be funded. It did not seem fair and equitable to have those that just purchased get stuck with the special assessment for the new roofs, when those that had lived there for 25 years and just sold, did not contribute to the replacement of the roofs (or asphalt) they used for 25 years.
If you are wondering why the definition would include execution of the Plan, i.e., spend the money, let me share a common experience. Some boards keep the funds in the bank while the roofs are leaking, the wood is rotting due to lack of paint and the cracks have become potholes in the asphalt. Why? They are proud of their 82% funded and don’t want their percentage to drop. Do you see a problem with this thinking? Meanwhile, the property values are declining.
In summary, a prudent Plan addresses the issues of longrange maintenance, repair and replacement of the common areas. There is a fine line between “not enough” and “too much” in the reserve funds. However, each member should contributetheir proportionate amount of “depreciation” (or use) of the reserve components. Through time, if each owner contributes their “fair share,” then the possibility of large increases or special assessments will be minimized. The reserve study should be updated annually, then reviewed to determine the amount needed to fund the reserves “adequately.”
**Article by CAI Member Business Partner, Robert Nordlund, PE, RS, Association Reserves, and the group of Reserve Specialists (RS) included, Mitch Frumkin, John Poehlmann, Ted Saldado, Peter Miller, Robert Browning. Other CAI reference materials available at www.caionline.org include Best Practices -Reserve Studies/ Management and Reserve Funds: How & Why Community Associations Invest Assets.
Roxi K. Bardwell, PCAM, is an Educated Business Partner and Regional Vice President of Advanced Reserve Solutions in Palm Desert. She can be reached at (760) 295-1864 or by email at Rbardwell@arsinc.com. After serving in various management roles for over 20 years, Ms. Bardwell has been doing Reserve Studies for the past 3 years and is in the process of obtaining her CAI Reserve Specialist (RS) designation.
