Stone
Mountain Corporation
Re$erve StudiesSM
Re$erve StudiesSM |
|
Myths and Realities of the Percent-Funded Estimate By Chris Andrews – Stone Mountain Corporation – Santa Barbara If you’ve just received your reserve study indicating
your association is 110% funded, does that mean your Board of Directors can decrease
your annual reserve budget? Conversely, if your reserve study indicates your
association is 62.7% funded, does that mean you should increase
your annual reserve budget? The answer to each of the foregoing questions is “not
necessarily.” The percent-funded
estimate is one of the most commonly misunderstood results of reserve studies
(see definition below if you’re not yet familiar with the term). Unfortunately, many association board members make reserve
budget decisions based on how well their association fared in the percent-funded
category: If the association scored
low on the percent-funded estimate, they assume they must increase the annual
reserve budget to ramp the association up to the 100% funded level.
If the association scored over 100% on the percent-funded estimate, they
assume they are “overfunded,” when, in fact, they may be not funding enough. The missing link in the foregoing analysis is that the
Board needs to verify whether or not the association’s annual contribution to
reserves is healthy enough. That
can be proven by a reserve cash flow analysis, preferably a 30-year projection.
“Cash flow analysis” refers to the practice of tracking the inflows
and outflows of cash from year to year over an extended period.
Without studying cash flow to determine whether reserve account deficits
might occur in the future, the percent-funded estimate can actually be
misleading if used as a budgeting tool. Many associations overemphasize the percent-funded estimate as the sole measure of financial health, partly because it is a required annual disclosure per California Civil Code 1365(a)(2)(C). Rather than focusing on percent funded results,
associations should be evaluating whether projected income to their reserve
account can fund future reserve expenses such as roofing, paving, pool
replastering, etc. “Percent-Funded
Estimate” -- Defined Let’s take a simplified example to define the
percent-funded estimate for those not familiar with the term: Suppose your association is a simple planned unit
development that has only one reserve component such as paving of road surfaces.
And suppose for this example that your roads need to be re-paved every 10
years at a cost of $100,000. If
your roads were last repaved 5 years ago, you should theoretically have one half
of $100,000 (ignoring inflation for now), or $50,000 in reserve at this point in
time. If your association currently has $50,000 in reserve, it
would indeed be 100% funded for the depreciation that has occurred to date.
So, we see that the Percent Funded Estimate
is defined as:
And “depreciation” is simply a measure, in dollars, of
how much of an asset (roof, pool, paving, etc.) has been “used up” since it
was new. Examples
of Percent-Funded Estimate “Contradictions” Now, let us suppose your association only has $30,000 in
reserve. The reserve study would
indicate the association’s reserve account is only 60% funded
($30,000/$50,000) = 60%. Is the association “underfunded?” Yes, by the standard definition. However, just because your association clocks in at 60%
funded, that doesn’t justify setting off alarm bells! Before doing so, we first need to look at reserve cash flow. Suppose, upon evaluating the association’s current and
projected reserve budget, we find the association plans to budget $15,000 per
year to reserves. When that $15,000
annual funding is modeled in a cash flow analysis, it would show that the
association will actually have $105,000 in five years ($30,000 reserve balance
saved during the first 5 years) plus (5 years X $15,000).
This will be more than enough reserve cash to pay for the $100,000
re-paving costs. A reserve cash flow analysis would actually recommend that
a $14,000 per year reserve budget will be sufficient to fund the future
repaving. (Note that after-tax
interest earnings on reserve cash is not included in this basic example).
So even though the association’s reserve account is 60% funded, the
cash flow analysis would indicate that your current level of reserve funding was
actually slightly excessive. In
other words: No cause for alarm in spite of a weak percent-funded
estimate! If we take the prior example to the other extreme, let’s
assume during the prior 5 years, the board members had been generously funding
to reserves each year. Thankfully, the association has $60,000 in reserve and
the paving is 5 years old. The
association would therefore be 120% funded ($60,000 reserves/$50,000 required).
Yet if the current Board is funding to reserves at $7,000 per year,
they’re only going to add $35,000 to their reserve account during the last 5
years of life of the paving, leaving them with just $95,000 to try to buy a
$100,000 paving job. In the foregoing case, a 120% percent-funded estimate from
the reserve study could conceivably coax board members into being unnecessarily
complacent with their reserve budget such that future boards would be saddled
with a reserve shortfall. The ultimate example demonstrating how the percent-funded
estimate can be misleading is if our sample association had just repaved their
streets yesterday and had spent all their money to do so.
A reserve study would indicate that they’re 0% percent funded at that
point in time. In this case, a 0%
funded figure is meaningless as a measure of financial health because all their
cash is now invested in the paving that has only depreciated for one day.
In fact, after completing the paving work, the association is actually in
very good financial health because they won’t have another reserve expense for
10 more years and the current reserve expense item is completely paid for. How
soon the funds will be needed is a factor… A key factor in determining whether a low percent-funded
estimate should set off alarm bells is how near is the “day of reckoning”
when those funds will be needed. Using
our paving example, suppose the reserve study is done in the ninth year of the
10-year paving cycle, showing the association is 77% funded ($70,000 in reserve
for a $90,000 depreciation-to-date on a $100,000 paving job).
Since there is only one year remaining to fund the remaining $30,000, it
is very likely that the percent-funded estimate is indeed cause for alarm. However, suppose the reserve study is done after the first
year of the 10-year paving cycle and the association has absolutely nothing in
their reserve account. The
association would be 0% funded ($0.00 in reserves to fund one-tenth depreciation
of a $100,000 future paving job). Indeed,
the 0% funding estimate shows the board has been overly complacent, or even
negligent. Yet it isn’t
necessarily cause for alarm, provided the board takes corrective action and uses
the 9 remaining years to “catch up” for the prior year’s improper funding. Keep in mind, however, the foregoing example isn’t meant
to encourage skipping a year of reserve funding!
Uneven reserve funding doesn’t fairly distribute the costs of
depreciation over all owners for those 10 years. Some owners who move out may avoid paying for the
depreciation that occurred during their stay and the new owners who move in have
to foot the bill! Unfortunately,
this happens in many associations. Having a reserve study that accurately determines the
correct annual reserve funding results in the most equitable distribution of the
burden of depreciation over all owners. In summary, once you think of the percent-funded estimate
as a snapshot of the strength of your reserves relative to depreciation of your
reserve assets (roof, pool, paving, etc.), then you’ll see that it is not a
forward-looking measure. Rather, it
is as if you are looking in a rear-view mirror to evaluate how diligent prior
board members have been in setting aside sufficient reserve funds. However, in order to determine your next year’s reserve budget, you’ll need to be looking forward. Evaluating anticipated future reserve income against future reserve expenses, otherwise known as cash flow analysis, is a good start. |
|
Do you have further questions about Reserve Studies?
|
