CALCULATING RESERVES
By: Gary Porter
For some associations, their governing documents require that reserves be determined and/or funded. In other situations, state law, such as California's Civil Code Section 1365 or Florida's Administrative Code Section 718, requires that reserve studies be prepared. The requirement could also be in the form of case law, such as California's Ravens Cove Townhomes vs. Knuppe Development.
Even if none of the above requirements exist, prudent business practices suggest that an Association analyze its reserves and prepare a funding program. An Association, although generally formed as a non-profit organization, still conducts certain business operations. The reserve study is one of the most important of those operations.
Community associations are generally responsible for the repair, maintenance, and replacement of their common area facilities. The Association should analyze its funding needs and set aside adequate funds from its annual budget to meet its long-term obligations. This is necessary because as the common area facilities of an association age, each component has its own separate life cycle. Although some may never require replacement or major repair, many will deteriorate. Part of the Association’s responsibility of adequately maintaining the common area facilities is providing for a replacement funding program that considers the aging process, anticipates future costs, and provides a method of meeting those future costs.
Preparation of a reserve study permits the association to comply with its obligations. The steps that an Association should go through to ensure that it is preparing a thorough study consist of the items discussed below. The reserve study should be prepared by someone who is competent and capable of preparing the report, and willing to assume responsibility for its accuracy.
1) Review governing documents and statutory requirements - The first step in establishing a reserve study is to analyze the Association documents to determine the exact responsibility of the Association in caring for, maintaining, and replacing the common area components. Also, look at statutory requirements to see if there are overall considerations regarding the preparation of the reserve study.
2) Establish reserve policies - The Association should establish policies with respect to the items to be included in its reserve study. These policies should be adopted to identify major components, but also to keep out components that are too small. For instance, the purchase of a $100 item, whether new or replacement, while it may properly be includable in reserves under other criteria, should be excluded from any reserve study on the basis of immateriality. Since a reserve study is a budget tool to forecast future financial events, it necessarily includes assumptions, many of which are very material in nature. The setting of a scope limitation of items to be included in the reserve study is a necessary step.
3) Establish component list: identify, inventory, and measure components – This is actually a critical step, as it determines the entire scope of work in preparing the analysis. Assuming you have already determined the Association’s maintenance responsibility, and have excluded immaterial components, you now must decide upon the level of detail that belongs in the study. For instance, the association could simply list swimming pools as a single line-item component and provide a blanket reserve for all pool-related components (condensed level), or it could break the swimming pool into further component detail which might include periodic acid wash of pool, periodic re-plastering of pool, replacement of pool, replacement of pool equipment, and replacement of pool decking, furniture, etc.
Generally speaking, establishing a reserve study at a condensed level meets governing documents and statutory requirements and allows for overall budgeting, but beyond that, does not create a useful management tool. Establishing the reserve study at a more detailed level creates a management tool wherein individual components can be easily tracked and information updated as major repairs and replacements occur. This is necessary if the Association wants to have an effective maintenance plan.
The reserve study preparer must also perform a visual observation of the entire complex, being alert for components that have not been included in prior reserve studies, and considering the possibility of hidden components. Hidden components are those items not readily visible to the preparer that could have a significant impact on the reserve study. Examples are in-wall or underground utilities, sump pumps, drains, exhaust fans, or any other item not readily observable.
Complete, accurate measurement of all components should be obtained and retained in the files of the reserve study preparer.
4) Component condition assessment - The reserve study preparer must next evaluate the current condition of each of the common area components. In certain circumstances, the preparer may wish to engage a specialist, such as a consulting engineer or a contractor, to assist in evaluation of the common area components and offer estimates as to their remaining life. The Board of Directors, Association employees and vendors, and community manager (if any) can also be consulted.
5) Estimate life, effective age, and remaining life - The Association should maintain permanent records of the common area components to provide information on dates placed in service, costs, warranties, repair or replacement work performed, and vendors that provided the service. This is a necessary part of a maintenance plan. The maintenance plan should identify when the next work is to be performed, which determines the remaining life, which drives the calculation of funding required. In the absence of that knowledge, it is customary to estimate remaining life based on date placed in service, current age, and an assumption of a normal life span.
Remaining life is a crucial factor in preparing an accurate reserve study, and will depend to a large extent upon the maintenance given to the common area components. That’s why it’s important to understand the Association’s actual maintenance plan. It is also very common to encounter situations where it is clear that components will not last for their expected life cycle, so remaining life must be reduced. However, that is not necessarily an indication that the expected life of the replacement component will also be reduced. Conversely, we more commonly encounter situations where expected life has already been reached, yet the component does not yet need to be replaced; it has outlived its expected life.
6) Estimate replacement cost - One of the most difficult decisions for a reserve study preparer is to determine the current estimated replacement cost of a component. Often there can be a range of costs, depending on certain factors and assumptions. Also, the cost to replace should include all relevant costs: material cost, delivery, sales tax, installation, removal of old component, etc. It’s often easier to estimate costs if it involves just using a single outside contractor.
A separate issue is the estimate of future replacement costs. However, that is generally a factor of applying inflation to known current replacement costs, and is taken into consideration at the funding plan level rather than at the component level.
7) Consider variables, alternates, and substitutes - One method by which the Association can maintain control over the major repair or replacement of common area components is to provide routine maintenance to offset the deterioration process as much as possible. In addition, the Association may consider substitute products and their impact on cost, as well as other alternatives. An example is replacing an old roof with a different roofing material, or replacing wood decks with a composite material that may not have even existed when the original deck was installed. Building code changes may also impact replacement products selected.
The Association should always be alert for new products and processes that may eliminate or substantially reduce the maintenance requirement on the Association property. An Association may be able to apply interim maintenance procedures to enhance the life of a component and thereby prolong the period in which the Association is able to accumulate funds to pay for the replacement of its common area components.
8) Creating a funding plan - In developing a funding plan, the Association should consider assumptions as to inflation, interest earnings, income taxes, annual increases to reserve assessments, loans, special assessments, or other sources of reserve fund income.
Inflation assumptions may be built into a table of replacement costs in an attempt to account for the estimated replacement cost at the time the component is scheduled to be replaced. If an Association is relying upon inflation built into its analysis to anticipate the future increases in replacement costs, it must regularly update the study and challenge inflation assumptions. If an individual were preparing a reserve study and applying the inflation theories in the early 1980's, they would have to have included assumed inflation rates of approximately 16%, which have long since proved to be unrealistic. A scant five years later inflation, rates dropped down to three percent. Many people use a five-year average of inflation for purposes of reserve calculations.
Others hold that the introduction of inflation into a reserve study can be misleading, and that as long as the reserve study is updated on a regular basis (such as annually), the Association will be forced to reevaluate costs each time, thereby keeping the study “fresh.” The difficulty with this approach is that because future inflation is not considered, assessment levels are generally set too low to ever reach a full funding level.
Interest income is retained in reserves by many associations as a means of either accumulating additional funds or attempting to partially offset the impact of inflation. Even though interest income and inflation generally tend to track relatively closely over long periods of time, because interest is earned only on the funds accumulated for future reserve expenditures, and inflation is applied against the much larger future replacement cost amount, interest can normally never fully offset inflation.
Income taxes payable on the interest earnings of the reserve account should be recognized and paid out of the fund that has incurred the income tax liability. Therefore, if interest income from reserve cash balances is retained in the reserve or replacement fund, then that fund should be responsible for the payment of taxes on such earnings.
Note: This article was originally published at Hoa Pulse in April 2013