The Science and Art of the Reserve Study

Provided By Realty Times

Preparing the annual budget and overseeing a homeowner association's finances are perhaps the most important responsibilities of the board. It is also a primary duty of the board to maintain and preserve market values of member property. To do so properly, directors must develop a schedule and funding plan for future repair or replacement of common elements, such as swimming pools, decks, paving, concrete, fencing, signs, etc.

To fund future renovation, HOAs have several funding options, including:

1. Regular assessments
2. Special assessments
3. Bank financing, or
4. A combination of 1-3.

#2 and #3 are needed only when regular and adequate assessments have not been collected.

Why Reserve Funds Are Necessary. Owners are sometimes reluctant to contribute to reserve funds because they feel that these funds are an added cost of living. This is not true. Reserves are designed to replace assets as they are used up. When contributions are made, they pay only for the benefits received by those that got the benefit, not for some stranger in the distant future.

Another recent trend is for lenders to require a current reserve study to approve a buyer purchase or owner refinance loan. Those that don't have it risk getting loans denied. This is becoming more common because recent history has proven that HOAs that properly plan and put aside reserves have a much lower loan default and foreclosure rate among members then those that don't.

Other reasons for creating and adequately maintaining a reserve fund include:

1. Fulfills the board's fiduciary duty
2. May be required by state law
3. It eliminates the need for unfair, unpopular and possibly uncollectible special assessments
4. Reserves enhance resale values, and
5. Accounting standards require reserve plans.

Types of Reserve Studies. There are three categories that describe reserve studies from an exhaustive to minimal level of service.

1. Full Reserve Study includes:

• Component inventory
• Condition assessment based on visual observations
• Life and valuation estimates
• Reserve Funding Plan and recommendation

2. Reserve Study Update With Site Inspection. Takes a prior year's Full Reserve Study and reviews component condition and updates the Reserve Fund Starting Balance, rate of return on invested funds, current inflation rate and known cost changes for certain repairs.

3. Reserve Study Update With No Site Inspection. The components are not physically inspected and only financial aspects of the study are updated like the Reserve Fund Starting Balance, rate of return on invested funds, current inflation rate and known cost changes for certain repairs.

Component Inventory. The governing documents generally define which components are considered common elements. The standard is to include any component that has a useful life of 2 to 30 years.

Reserve Funding Methods. There are four funding strategies:

1. Full Funding is designed to attain and maintain the reserves at or near 100 percent every year. If, for example, a roof has a 20 year life and costs $20,000, $1000 should be reserved each year to maintain 100% funding. If the same approach is used on all components, reserves are maintained at or near 100% each and every year. This is the most responsible model since all members pay a fair share of expenses directly related to their time in ownership.

2. Baseline Funding keeps the reserve cash balance above zero at all times. This means that each component is not fully funded and the reserve balance can drop to zero during the projected period. This model is likely to result in one or more special assessments.

3. Threshold Funding is similar to Baseline Funding but sets a minimum reserve cash balance as the threshold of, say, $50,000, instead of zero.

4. Statutory Funding is based on state statutes which may establish specific funding minimums.

Baseline and Threshold models contribute less to reserves (sometimes a lot less) which ultimately will result in special assessments to fill the shortfall. Planning to fund reserves by special assessments is not recommended because they are unfair to those must pay them and sometimes uncollectible due to individual financial circumstances.

Understanding the Reserve Study. The board should only use a user friendly reserve study so that all members "get it". It is also strongly recommended that the reserve study be distributed to all members since they are entitled to know the recommendations.

Due to the experience required to perform an accurate reserve study, the board should only use specialists like those that hold the Professional Reserve Analysts (PRA), the highest credential available in the industry awarded by the Association of Professional Reserve Analysts. See www.apra-usa.com for a list of members which carry this credential.

A properly prepared reserve study is both science and art. The science involves accurate costs, measurements and useful lives. The art recognizes the political dynamics of HOAs and members' desire to protect their castles.