California DRE Cost Manual

The California Department of Real Estate has published a Cost Manual to assist developers in establishing budgets for new associations within California.  While not all inclusive on the types of reserve common area components in associations, it does include cost information on the most commonly occuring components.

Interest and Inflation

Many people have asked about the inclusion of interest earnings and inflation factors in the reserve study. The first question, of course, is should they be included in the reserve study The second question is, does interest earnings offset inflation, so that they cancel each other out and can be ignored?  The last question is, how should they be calculated?

The answer to the first question is yes, both inflation and interest earnings should generally be considered in the funding plan of a reserve study.  To ignore these would be to ignore reality. While it is a policy matter of the board of directors whether or not to include these items, it is common practice to include both interest earnings and inflation in the funding plan of the reserve study.  A small minority of associations will not include interest earnings because it is their policy to transfer any interest earned to the operating fund, and pay the related income taxes from the operating fund.  These associations will increase their reserve assessments to compensate.  Inflation should never be ignored.  Failure to consider inflation will generally lead to significant underfunding, unless the association updates its reserve study and underlying cost assumptions annually.  We have attached historical tables of both interest rates and inflation to put current rates into perspective.  Note that regardless of sometimes significant annaul variations in rates, the moving five and ten year averages smooth out the rates considerably.  Since the reserve funding plan typically projects for a 30-year period, it is usually safe to ignore current extreme changes in rates in favor of longer term moving averages.

We have included some intersting tables and charts trakcing anc comparing historical interest and inflation rates from 1930 to the presnt date.  The charts included with the 1971 to current table plot both interest and inflation on a single graph, to demonstrate how they generally move in the same direction.   We have also provided moving averages at 5 year and 30 year intervals for both rates.  Since the reserve study is normally a 30-year financial forecast, we believe it is acceptable to consider long term averages when building a 30-year funding plan, particularly if current rates are volitile.  Note that the moving averages tend to "smooth out" the extremes, the spikes and valleys, that generally occur for relatively short periods of time.

Historical interest earnings and inflation rates for the years 1930 - 1970

Historical interest earnings and inflation rates for the years 1971 - 2009

The answer to the second question is no, interest earnings does not offset inflation.  While interest rates and inflation rates generally move in tandem, the fact is that the inflation factor is applied to the total estimated future expenditures for all common area components included in the funding plan.  This is (virtually) always a higher number than the current funds set aside for reserves.  Conversely, the funds set aside for reserves is (virtually) always a smaller amount.  The net result is that interest earnings can generally never offset inflation, because the computation bases are so different.  An example is that an association may anticipate spending $10,000,000 over the next 30 years, which includes inflation calculations.  The current reserve cash on hand may be as little as a few hundred thousand dollars, as that is all that is required to pay for planned expenditures arising in the next few years.  Consequently, the interest earnings will be very small compared to the inflation.

The last question, how do you calculate these rates, has no correct answer.  Some people use a rule of thumb.  Others look at their current interest earnings rates as a guide.  Current interest earnings rates cannot be ignored, but if they unusally high or low, it is not practical to expect those rates to continue indefinitely. However, so long as you keep your assumed interest earnings rate relatively the same as your inflation assumption, you shouldn't get into too much trouble, as they do usually move in tandem.  California associations be aware that California law limits the interest rate assumptions that may be used in a reserve study to 2% above the discount rate published by the San Francisco Federal Reserve Bank.