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Common
Questions & Answers About Reserve Studies
August 2004 - SCHA Newsletter
By
Chris Andrews – Stone Mountain Corporation – Santa Barbara
Spring and summer is usually reserve study season for most
associations because they’re looking ahead to preparing their annual budget in
the fall and they need to have their reserve study done ahead of their budget
meetings.
Consequently, now is the time when board members start to
ask various questions about reserve studies, many of which are similar.
So here are some typical answers to some of the typical questions.
1. What is a reserve study
(have to start with the basics...)?
A reserve study is a long-range financial planning report
used by homeowners associations to budget for long-term capital expenses (such
as roofing, paving, etc.). Preparing
a reserve study involves several steps:
1)
Develop an inventory of reserve components (roofing, paving, etc.) the
association is obligated to maintain
2)
Determine current replacement cost, useful life and remaining life for
those items
3)
Perform a financial analysis to determine how to methodically fund those
long-term costs over time.
The net result of a reserve study is a dollar amount that
your association should set aside each year so funds will be available when
reserve expenses occur. That amount
is your annual reserve funding budget.
The reserve budget is not to be confused with your
operating expense budget. Think of
your association’s annual pro-forma budget as two budgets running in parallel.
One is your operating budget, typically consisting of expenses incurred
for normal day-to-day operations such as insurance, pool maintenance, utilities,
etc. The other is your reserve
budget which consists of long-term capital expenses derived from your reserve
study. These two budgets, added
together, comprise your overall annual budget.
Your operating budget is much easier to forecast than your
reserve budget because projecting expenses such as next year’s landscaping
service, utilities, etc. is usually straightforward, whereas projecting the cost
of a roofing project 3 years from now can have wide variances.
Reserve expenses can vary widely from year to year and the magnitude of
the costs can be staggering in comparison to your operating budget.
Indeed, the dollar magnitude of your annual operating expense budget
pales in comparison to the total value of your roofs, streets, and amenities
covered by your reserve budget. The
potential for huge shortfalls in your reserve budget underscores the need to
establish a detailed reserve funding plan.
2. Are reserve studies
required?
Reserve studies are required every 3 years for most
California homeowners associations per California Civil Code 1365, with annual
reviews in interim years. Here is
an excerpt from CC 1365.5(e) for your enjoyment:
“At least once every three years the board
of directors shall cause to be conducted a reasonably competent and diligent
visual inspection of the accessible areas of the reserve components which the
association must repair, replace, restore, or maintain as a part of a study of
the reserve account requirements of the common interest development if the
current replacement value of the major components is equal or greater than one
half of the gross budget of the association which excludes the association’s
reserve account for that period. The board shall review this study annually and
shall consider and implement necessary adjustments to the board’s analysis of
the reserve account requirements as a result of that review.”
The reason reserve studies are required for most, but not
all, associations comes from the phrase: “…if the current replacement
value of the major components is equal or greater than one half of the gross
budget of the association which excludes the association’s reserve account for
that period.” This phrase
exempts associations that have minimal maintenance obligations from being
required to do reserve studies. Typically
these might be associations having only a common area green space to maintain
and no exterior structural maintenance or roads.
For most all other associations, reserve studies are required.
Does the State of California actually have the resources to
enforce Civil Code 1365 if your association doesn’t do a reserve study every 3
years? Probably not, but it is in
your best interest as an association to adopt sound fiscal planning practices.
And as members of your association’s board of directors, you probably
won’t want to be considered negligent for not having a reserve study done.
3. Must our association do a
reserve study every year?
Assuming your association is not one of the “minimal
maintenance obligation” associations that is not required to do reserve
studies, your association must do reserve studies every 3 years with annual
reviews in interim years. However,
in practice, many mid-to-large sized associations have “reserve study
updates” in the interim years in addition to the on-site reserve study done
every three years. For mid-to-large
sized associations, having a reserve study update is a routine part of the
budgeting process. This is because
enough factors change each year that their boards prefer to systematically
calculate the next year’s reserve funding level during annual budget time.
Another reason to do a reserve study more often than every
three years is when your association has just incurred substantial reserve
expenses and your board needs to know what is the appropriate level of annual
reserve funding now that those expenses have been paid.
For example, suppose your association re-roofed in the last few months
and roofing costs were higher than you had anticipated so you now have less in
reserves than you expected. But the
good thing is you now have a 30-year roof instead of a 20-year roof, so the next
roof replacement cost can be amortized over 30 years instead of 20 years.
What impact will these changes have on your reserve budget going forward?
Running a 30-year reserve cash flow analysis will show how this plays out
and will determine how much your association now needs to set aside each year to
your reserve account. Surprisingly,
reserve studies sometimes recommend that you can actually lower your annual
reserve funding.
4. Must our association actually
fund the amount to reserves that was recommended by the reserve study?
California Civil Code 1365 doesn’t explicitly
require your board to fund to reserves exactly as recommended by the reserve
study. Try to divine the intent of
the legislative lawmakers from this Civil Code 1365.5 excerpt:
“The board shall review this study annually
and shall consider and implement necessary adjustments to the board’s analysis
of the reserve account requirements as a result of that review.”
Suppose the board reviews the reserve study and disagrees
with the timing of trim painting, for example?
Does the board have to fund the reserve budget as recommended by the
reserve study anyway?
One could interpret the above phrase to mean that implicit
in the board’s “review” of the reserve study is some degree of board
discretion.
Perhaps a more pragmatic answer to the question is to
acknowledge that it is your fiduciary role as a board member to provide for
proper maintenance of the common area assets of the association via proper
reserve funding. You also don’t
want to be potentially labeled as negligent in the future. The foregoing are indeed rational reasons for following the
reserve funding recommendation.
There are cases where your board may decide not to adopt an
annual reserve budget exactly as recommended by the reserve study.
You may, for example, opt to special assess for some large expenses
instead of raising monthly association fees.
In this case, the net funding to reserve would be essentially the same as
that recommended by the reserve study, but the funding schedule would be
different due to the special assessment.
5. The reserve study suggests
that our association is way behind in reserve funding.
Can we do a one-time special assessment to catch up while keeping our
monthly fees about the same?
Yes, this is fairly common because homeowners typically
prefer to keep monthly fees low, if possible.
Higher monthly fees can be a disincentive for new home buyers to buy into
an association and can potentially have a tangible adverse affect on resale
values.
Keep in mind that Civil Code 1364 allows your board to levy
special assessments up to 5% of the budgeted gross expenses for that fiscal year
without member approval. Larger
special assessments require a simple majority vote of a quorum of your members
(check to see if your CC&R's have different requirements).
6. Our association is 30%
funded. Should we be concerned?
The percent-funded estimate is a measure of how much money
you have in reserves compared to how much your reserve components (roofing,
paving, pools, etc.) are “used up.” If
your association is 100% funded, you would theoretically have the exact amount
of cash in reserves to pay for the portion of those items that has been used up.
If your association is 30% percent-funded you may or may not need to
raise reserve funding levels. It
all depends on how healthy your current contributions to reserves is.
The percent-funded estimate evaluates how well past board members have
saved reserves for the future.
For an in-depth discussion on this subject, see the June
2002 Issue of the SCHA Newsletter titled, “Myths & Realities of The
Percent Funded Estimate.”
7. Why can't our association
simply pay for roofing/painting/paving/etc expenses as they come up?
This question implies that the board would like to levy
special assessments for expenses as they occur. Some associations operate this way, but there can be
significant drawbacks.
The primary drawback is that your board may have trouble
collecting all of the necessary money from all owners when large reserve
expenses occur. Suppose some owners
may not be able to cough up $10,000 for a roofing special assessment when your
association really needs it. It is
better to collect the money gradually every year so your association has those
funds when they’re needed.
Another drawback of the special assessment funding method
is that it unfairly penalizes those homeowners who happen to be living in the
association at the time of the special assessment. A reserve study calculates an annual reserve funding amount
which ensures that everyone pays equally for the depreciation that occurs while
they live in the association. (Depreciation
is the process of “using up” an asset such as roofing, streets, etc. over a
period of time).
8. As a senior citizen who may
have to move to a long-term care home in 5 years, why do I have to help pay for
the roof replacement that will happen 20 years from now?
Senior citizens are not the only ones who pose this
question. Young people who consider
a condo as a starter home and don’t plan on living there for more than several
years ask the same question. The
problem with the “short-timer” logic is that these people are benefiting
from the use of the roofs, streets, pool, etc. while they’re living in the
association. If the roof is a
30-year roof and they live in the association for 5 years, then the value of the
benefit they derive from the roof is 5/30th
or 1/6th of the cost of the roof replacement.
It is indeed fair that they pay for their incremental use of the roof,
streets, pool, etc. even though they may not be living in the association in the
future when the actual replacement occurs.
Stone
Mountain Corporation 