The Importance of the Reserve Fund

Most of the reserve studies performed by our company occur in states that have adopted statutes establishing reserve study requirements. Since most Associations will try to comply with state statutes, it makes sense that more reserve studies are performed in states that have such statutes. However, acceptance of a reserve fund as being a good business practice is also widespread throughout the country, so it’s reasonable to expect that a significant percentage of Associations would still opt to perform a reserve study for that reason alone.

A few weeks ago I was working in a state where there are no reserve study statutes. I had forgotten that in this particular state, the general consensus is that a reserve study is more of a nuisance than anything else. It's not that the Associations in this state don't budget for reserve projects; they do. They just don’t have a formal reserve study prepared. This means they don't have a formal condominium maintenance plan and really have no idea how well-prepared they are for future expenditures.

So what is the potential impact of the lack of a formal reserve study? It's a known fact that at least some level of inflation is still with us, costs are increasing, and common area components are deteriorating. My experience observing Associations trapped in this scenario is that they typically choose to simply defer major expenditures until funds can be accumulated. The danger of this approach is that the cost may grow exponentially until the deterioration reaches a tipping point, requiring complete replacement of components instead of simply performing major repairs. The deferral approach generally results in much higher costs overall. For example, painting siding is a relatively minor cost when compared to complete replacement of the siding itself. However, complete replacement of siding is the likely result if scheduled painting maintenance activities are not performed.

Consider how the reserve situation may look from a prospective purchaser's point of view. A knowledgeable prospective purchaser will want to see a well-funded reserve fund as well as a reserve study to back it up, so s/he can have some idea of what the future may hold in store. Unfortunately, only a small percentage of prospective purchasers are savvy enough to request and understand this information. But those who are informed would be inclined to gravitate towards Associations that do have a reserve plan and have set aside funds for future major repairs and replacements.

It is the Association's responsibility to make sure that funds are available for Association operations. When it comes to the operating budget, this is a somewhat easier task, as budget items repeat annually and each year serves as a potential benchmark for what the next year should look like.

The reserve fund, on the other hand, can look completely different from year to year. In the early years, an Association may accumulate funds without making any expenditures at all. It is simply accumulating funds for known future expenditures. It becomes somewhat more difficult to budget for these types of expenditures. The reserve study is the tool that allows an Association to create this budget.

I have heard the argument that it is a waste to accumulate funds when no money is needed on an immediate basis. However, when one considers this advance funding as an equitable funding approach, it takes on a whole different perspective. Setting aside the appropriate funds even when expenditures will not be needed until years in the future simply means that those individuals who are “using up” the common area components are also paying for them. (The flip side of this argument, of course, is that advance funding places a burden on struggling current owners who may not even be members of the Association when that large expenditure, such as roof replacement, is actually required. Why not let the new buyer pay for that roof?)

Large reserve projects have to be planned for several years in advance if Associations wish to avoid a large special assessment. Ironically, in my discussions with several Association management individuals in this particular state, I discovered that even though the managers may recommend preparation of a reserve study, boards of directors simply don't want to take this action. It appears that their attitude is that what they don't know, won't hurt them.


This article was originally published at HOA Pulse in July 2013