Preparing the annual budget and overseeing the association's finances are perhaps the most important responsibilities of board members. The annual operating and reserve budgets reflect the planning and goals of the association and set the level and quality of service for all of the association's activities.
A reserve study is an important tool which an association can reference to determine adequate funding levels to meet current and future reserve component expenditures. Within this study you will find recommended allocation rates to the reserve account as well as a timeline for expected common asset replacements costs and their respective schedules for repair/replacement. The study can be broken down into two parts:
Component Analysis
The Reserve Analyst will determine component condition assessments and research associated cost for the common area assets to be included in the study based on a limited scope visual inspection (Level I). The reader of this report will find current condition levels, anticipated remaining useful life and projected repair and/or replacement costs for common area assets.
Financial Analysis
The Reserve Study Professional will provide recommendations for current and future reserve contribution rates to the reserve account based on current and expected financial data provided by the Client as well as take into account the timeline of expected expenditures over the 30 years covered in this study. The Reserve Analyst’s recommended financial strategy will guide the association on a path to becoming “Fully Funded” in a manner which is predictable, fair to the membership and in line with statutory requirements.
Reserve Study – Levels of Service
Reserve studies fall into one of three categories as defined per statutory requirements:
Reserve Study Goals
Typically the goal of the Reserve Study is to create a funding strategy that guides the Association towards a fully funded balance within the 30 year period covered in this report. A "Fully Funded" reserve balance would ideally fund all expected component repair and/or replacement expenses. While this is the goal, future costs, interest rates, inflation rates and actual life expectancies of components, will vary which will likely result in a funding balance that will fluctuate above and below the fully funded level even when allocating the ideal amount towards the reserve account. [TOP]
Reserve Study Methods
There are numerous accepted methods used to prepare reserve studies; the two most common being the Cash Flow Method and the Component Method.
Cash Flow Method
The cash flow method develops a reserve-funding plan where contributions to the reserve fund are designed to offset the variable annual expenditures from the reserve fund. Different reserve funding plans are tested against the actual anticipated schedule of reserve expenses until the desired funding goal is achieved. This method sets up a "window" in which all future anticipated replacement costs are computed, based on the individual lives of the components under consideration. Typically this funding strategy is more flexible in a real world scenario, specifically when component remaining useful life falls below what is expected at the onset of a reserve study.
Component Method
The component method develops a reserve-funding plan where the total contribution is based on the sum of contributions for individual components. The component method is the more conservative (typically higher reserve account balance) of the two funding options, and assures that the association will achieve and maintain an ideal level of reserves over time. This method also allows for computations on individual components in the analysis. However this method has also limitations with respects to variations in actual useful life of components and is much more time intensive to accurately follow this funding strategy.
We have analyzed each reserve component and provided a useful life expectancy, an estimated remaining useful life, and projected repair/replacement cost for each component. Future reserve expenditures have been calculated utilizing average historical inflation rates.
Unless noted otherwise, the present repair/replacement costs have been estimated using cost manuals such as the National Construction Estimator, RS Means and/or Marshall & Swift, all of which are nationally recognized for accuracy; modifications to the costs are applied using their appropriate regional cost adjustment factors. When possible, Association vendors have been interviewed for their historical and firsthand knowledge of components.
After the expected component expenses are established your Reserve Analyst then determines the appropriate contribution rate and creates a financial plan which will adequately cover the current and future projected expenses. This financial plan will guide the Association to a fully funded reserve balance, minimizing the risk of special assessment(s) and deferred maintenance. [TOP]
Reserve Study Process
This Reserve Study has been completed utilizing numerous steps which can be broken down into several main categories
Percent Funded Analysis
We utilize the concept of "Percent Funded" to measure the reserve account balance against a theoretically ideal balance. Percent Funded is often used as a measure of the "Financial Health" of an association. The assumption is, the higher the percentage, the greater the "Financial Health" and the less likelihood that there will be a reliance on special assessments or loans in the future. The question of substance is simply: "How much is enough?" To answer the question, some understanding of Percent Funded is required.
For simplicity sake let’s assume your community has one common area asset, exterior siding paint, which has a useful life of 5 years and a cost to replace of $5,000. We are going to ignore interest and inflation for this example. The paint will depreciate 20% per year until it has exhausted it useful life and will need to be recoated at the end of year 5. To be fair to the membership of the community (current and future members) each year the members should be charged an amount equal to the amount the roof has deteriorated; an amount that equal to $1,000; ($1,000 per year x 5 Year = $5,000).
This is visually expressed; the Communities being at different levels of “Percent Funded” due to their respective allocation rate differences. Community A matching the monetary deterioration to the exterior paint, Community B being marginally ready but still will fall short of the total expected costs at the end of year 5 and Community C will be significantly underfunded with their respective allocation amount to the reserve account.
Simply put, Percent Funded is the ratio of how much money is in the reserve account versus how much money the reserve account “ideally” should have at a specific point in time.
It is important to remember that there is no right or wrong “percent funded” but the lower percent funded an Association is the higher the risk of reliance on special assessments or loans to meet expected cost related to repair or replacement of common area assets when their useful life has been exhausted. Additionally Associations that are consistently in the Low Percent Funded range are at a much greater risk of litigation from its membership, usually due to the perceived lack of fiscal responsibility. [TOP]
Fully Funded Analysis
A Fully Funded Balance (FFB) is defined as the Current Cost (CC), multiplied by the Effective Age (EA), divided by the Useful Life (UL). Interest Rates (r) and Inflation Rates (i) are then calculated into the equation. This number has been summed together for each component creating a fully funded balance.
In essence, Fully Funded is a reserve account balance equal to the estimated accumulated depreciation of the association’s common area assets. As common area assets grow older, they depreciate until they no longer perform their intended function, at which time; the asset is fully depreciated and must be replaced. The fully funded balance will equally match this depreciation to the assets over time.
The fully funded balance is simple enough to determine if the community has only one common area asset as the above roof example shows. Community” A” is fully funded as the reserve account balance is equal to the estimated amount the roof has depreciated at year 5. Most communities however have many components and a corresponding fully funded balance that ranges from one year to the next as components are repaired/replaced, remaining useful life expectancies are updated over time and the common area asset list grows or shrinks over time.
It's important to realize that a fully funded balance is not the total replacement cost of the common area assets. A community which has a fully funded balance one year then decides against following recommended increases to offset inflation can very likely fall below a fully funded balance in a relatively short period of time. This is a common scenario when membership request lower dues and the reserve account balance appears to be very large. [TOP]
Underfunded Versus Overfunded
Most communities we encounter are underfunded, some severely so, with respects to their common area assets. In the above roof example this simple scenario has relatively easy to manage expenses (the one roof). In reality, communities have many common area assets each with their own useful life and remaining useful life. Costs and the timeline for expected replacement/repair are often difficult to manage; the proper use of a reserve study can be extremely helpful for a community’s manager.
One of the main goals of the reserve study and the recommendations of the Reserve Analyst is to create a financial strategy which is fair to the current and future community membership. [TOP]
Funding Strategies
There are four basic funding strategies most commonly utilized and accepted in the reserve study industry. It is recommended that associations consult professionals to determine the best strategy or combination of plans that best suit the Association's need. Additionally, associations should consult with their financial advisor to determine the tax implications of selecting a particular plan. The four funding strategies and descriptions of each are detailed below.
Funding Levels
The goal of this reserve study is to guide the Association towards a path of becoming fully funded over the 30 year period covered in this report. The graph and comments below illustrate and explain the adequacy of the different funding levels.
Impact of Component Useful Life
The projected life expectancy of the major components and the reserve funding needs of the association are closely tied. Performing the appropriate routine maintenance for each major component generally increases the component useful life, effectively moving the component expense into the future, which reduces the reserve funding payments of the association. Failure to perform such maintenance can shorten the remaining useful life of the major components; increasing the reserve funding payments of the association. [TOP]
Included Common Area Components
Reserve expenses of common area components are major expenses that occur other than annually and which must be budgeted for in advance in order to provide the necessary funds in time for their occurrence. Reserve expenses are reasonably predictable both in terms of frequency and cost. However, they may include significant assets which have an indeterminable but potential liability which may be demonstrated as a likely occurrence. They are expenses that when incurred would have a significant impact on the smooth operation of the budgetary process from one year to the next if they were not reserved for in advance.
A common concern among Associations is what common area components are to be included and funded for in the Reserve Study. Nationally recognized Reserve Study Standards indicates reserve components need to meet the following criteria:
We have found the above criteria cover the vast majority of components but there can be exceptions, such as components which are not clearly recorded in the governing documents. In these instances we will discuss the options available with the Association and determine how they have been historically treating these “gray” areas. Examples of included Common Area Components are:
Excluded Common Area Components
Some common area components may have been left out of the study or been included in the component list as an “excluded item” and not been funded for. These components will typically fall into one or more of the categories listed below.
Additionally, budgeting is normally excluded for repairs or replacements of assets which are deemed to have an estimated useful life equal to or exceeding the estimated useful life of the facility, community as a whole, or exceeding the legal life of the community as defined in an association's governing documents. Examples include the complete replacement of the foundation, elevators, wiring and often times plumbing. Also excluded are insignificant expenses which may be covered either by an operating or reserve contingency, or otherwise in a general maintenance fund. Costs which are caused by acts of God, accidents or other occurrences which are more properly insured for, rather than reserved for, are also excluded. Examples of typical excluded Common Area Components are:
About the Reserve Study Sections
This Reserve Study includes thirteen sections for you to utilize in the long term planning goals of the Association. They are listed below with descriptions of each:
1. Reserve Disclosures - Part 1
Part 1 of the Reserve Disclosures includes the parameters which were used in making calculations in this study and providing a brief summary of the finding related to the percent funded based on the current allocation rate. Information you will find on this page include the number of units, inflation rate, interest rate, current reserve allocation rate, current reserve balance, expected fiscal year start balance and a recommended reserve allocation rate listed under the “Proposed Budget” heading and then broken down to the year, month and per unit.
2. Reserve Disclosures - Part 2
Part 2 of the Reserve Disclosures lists all building components alphabetically by category (e.g. roofing, painting lighting) together with their respective current cost, useful life and remaining life. This list should be thoroughly reviewed by the Client before the final is requested as the inclusion or exclusion of components can impact the current percent funded and the long term expenditures listed in this study. The Total Current Cost for the Common Area Components is as of the site inspection date and is the accumulative amount for all components should all be replaced as of the site inspection date. Note that this is not the “Fully Funded Balance” which is only a small percentage of this total amount.
3. Cash Flow Analysis
The Cash Flow Analysis is a breakdown of the findings and recommendations of this study. This page is the most comprehensive in the whole study and should be reviewed annually to determining the allocation rate and expected expenses in the near term and long term future of the community. The headings of this page are explained below:
a. Fiscal Year - The actual study begins in the fiscal year indicated in Part 1 of the Reserve Disclose Page but also lists the year the site inspection has taken place.
b. Fiscal Year Start Balance - This expected starting Reserve Balance is provided by the Board
c. Interest Earned - Based on the annual % assumption listed in the Reserve Disclosures and applied to the expected Reserve Balance (based on recommended allocation rate) in the years covered in this Reserve Study.
d. Reserve Allocation Rate (based on the funding strategy used –e.g., Threshold, Statutory, Baseline) - This is the recommended allocation rate based on the funding strategy used and increased annually to keep up with inflation.
e. Allocation Increase Rate - The % the allocation rate is increased annually; typically in line with inflation estimates. Note that there may be a large increase initially from the current allocation rate. This is typical of many Associations which are poorly funded and need to implement substantial increases to their allocation rate in order to meet expenditure cost estimates.
f. Special Assessments - Typically will be provided by the Board if any are planned. Rarely will we recommend a special assessment. If there are special assessments, comments in the Preface of this Study as well as the Component Details section will go into detail as to what they will cover.
g. Disbursements - The estimated total accumulative expenditures for replacement/repair of common area components included in this study in any given year.
h. Fiscal Year-End Balance - The expected year-end balance in the reserve account after the reserve allocation amount, disbursements, interest and special assessments are taken into account. This is based on the reserve allocation recommended by your Reserve Analysts.
i. Fully Funded Balance - This is the ideal 100% funded balance in any given year. Note that this is not an amount the equals the total replacement costs of the components but equals an amount which offsets the depreciation to those common area components in any particular year. A reserve balance equal to this amount indicates the Association is well prepared for future expenditures and would be 100% fully funded. Note that this balance increases and decreases over time, taking into account replacement/repair of common area components over time as well as inflation of costs and interest earned on account balances.
j. Percent Funded – The percent funded the community is based on the expected reserve balance as of the fiscal year start date noted in this study. The recommended allocation amount is then applied to the expected reserve balance and increased annual thereafter at the allocation increase rate. Over time the Percent Funded will increase at a rate that is line with the Funding Strategy (typically 100% funded within 30 years unless otherwise noted).
4. Yearly Review Chart
The Yearly Review Chart is based on the recommended thirty year projections and data outlined in the Cash Flow Analysis. This chart is an excellent visualization of the data for the fiscal year end balances versus disbursement and the overall percent funded based on the recommended allocation rate over the thirty years covered in this reserve study. Additionally the Baseline Funding Plan (keeps the reserve account above a $0 mark) and corresponding Percent Funded for this funding strategy is included per statutory requirements. The Current Funding Plan and corresponding Percent Funded are included when possible to show the long term impact of following the current funding strategy. Note that often this current funding plan will fall to zero within the 30 years covered in this study.
5. Category Breakdown Chart
The Category Breakdown Chart shows the allocation percentage of the recommended allocation rate each Category encompasses. This is also a good visual to see where most of the Association’s reserve funds are expected to be implemented in the coming years. Typically one or two categories will have a large percentage of the total recommended allocation.
6. Disbursement by Year
The Disbursement by Year section of the report details the estimated disbursement, by year, for each component over the 30 years covered in the reserve study. These disbursement amounts are based on actual estimated cost to repair/replace the common area components in any particular year. Note that these are inflated costs and not current costs as inflation increases the expected costs over time. A review of this section of the study on an annual basis is recommended to adequately prepare for expected expenditures in the current or upcoming years. The total provided at the end of this section is the total expenditures of all included common area components over the 30 years covered in this study. Note that this amount is much higher than the Total Current Costs as it is the accumulative costs of the expected disbursements over the 30 years covered in this study.
7. Reserve Balance Distribution
The Reserve Balance Distribution section outlines the amount allocated, from the current “fiscal year start balance” to each reserve component, categorized by their respective categories. Depending on the current “percent funded” amount there may not be enough to allocate money to all of the components, in which case the items with the shortest remaining useful life will be funded for first and those with a longer remaining useful life, may not be funded for at all in this first year. The percent allocated from the current “fiscal year start balance” has also been provided for each component that is being funded for. Please note that with an ideal 100% percent funded reserve balance all components would be funded for in this section of the report.
8. Allocation Breakdown
The Allocation Breakdown section outlines the amount allocated to each component, categorized by their respective categories (alphabetically), from the “Recommended Reserve Allocation Rate”. This reserve allocation rate is broken down to per year, per month and per unit per month for each reserve component. The percent allocated from the totally allocation rate is also provided for each component.
9. Fully Funded Balance Breakdown - Next Fiscal Year
The Fully Funded Balance Breakdown section shows each component in their respective categories (alphabetically) with current costs, useful life, remaining useful life and the fully funded balance for each reserve component. The “Fully Funded Balance” for each component is based on an ideal 100% funded reserve balance. These reserve components are then totaled to show the total cost for all reserve components as well as the fully funded balance for the next fiscal year. Note that the total costs of the components in this section of the report are slightly higher than the total of the Current Costs in the Reserve Disclosures – Part 2 of this study. This can be attributed to this section of the study for the next fiscal year and subject to inflation over this period of time.
10. Category Summary – Next Fiscal Year
The Category Summary section breaks down the current total cost and the fully funded balance for each category (sum of reserve components) for the next fiscal year. The useful life and remaining useful life minimum and maximum has also been provided; based on the reserve components in each category.
11. Component Details
The Component Details section details each component with pictures (when available), comments, quantity, unit of measure, unit cost, source code (reference to where cost and/or useful life was obtained), the percent of the component being repaired/replaced, contingency percentage and the extended costs (total estimated future cost of the reserve component). Additionally, when applicable, component specific comments on the condition rating and maintenance of the component are included.
12. Field Report
The Field Report section provides some general comments and advice on care and maintenance of typical reserve components that are large expense items for common interest communities. Following maintenance recommendations will typically lead to longer useful life’s of components and higher aesthetic appeal in the community.
13. Appendices
This section of the study covers assumptions, calculations, definitions, and disclosures in developing our opinion for a funding strategy we have recommended for your community. Referring to this section for industry specific terms and calculations helps a reader to better understand the methods, finding s and overall strategy we are recommending. [TOP]
Keeping Your Reserve Study Current
We believes that funding studies are an essential part of property management. People and property are constantly changing and evolving. As a result, the useful life of a funding study is at best a few years. It’s also important to remember this Reserve Study is a fluid document that will change over time along with your community, Association goals, statutory requirements, financing requirements, etc. It is a good idea to have this reserve study updated:
Special Assessments
Special Assessments will typically been included in the recommended reserve funding strategy, unless specifically noted otherwise. Special Assessments are utilized only as a last resort to fund items which are too costly to be covered by member dues. With proper planning there are few instances that they should be a necessity. [TOP]
Interest, Inflation & Taxes
The reserve study has utilized an estimated after tax interest rate on the reserve balance in deposits. This rate has been based on historical averages as well as actual interest rates provided by the association, when available.
Inflation rates included in the study will be been based on historical averages which is the best indicator of the future average over the 30 year period of the study. Inflation rates may be less than or greater than this historical rate, in any specific period of time, but are likely to average out to historical averages over time. [TOP]
Report Assumptions
The below assumptions have been utilized to come to a well-supported and documented Reserve Study for the Association.
Items Beyond the Scope the Reserve Analysis Study
This reserve study has been conducted to outline a financial plan for the proper and adequate budgeting of the Association component repair and/or replacement. This report should not be utilized for any other purpose and should not be considered or deemed appropriate or reliable for, but not limited to, any of the following:
Disclosures
The below disclosures are in accordance with reserve study standards developed by CAI, APRA and statutory requirements for reserve studies completed in Washington State.
Written by Joel L Tax - Professional Reserve Analyst - 04/01/2016