In Reserve Studies we utilize an indicator of financial health known as Percent funded for common interest communities like HOA’s and Condominiums. This is a simple and important, but often misunderstood calculation that can provide a Reserve Analyst, Board Members & Community Members a summarized percentage that is created from the much more complicated and extensive research of the components and financial analysis.
(Reserve Account Balance / Fully Funded Balance) x 100 = Percent Funded
In essence it is a calculation of how much the association has in the reserve account versus how much it ideally should have at a particular point in time. To better understand this calculation we need to first understand what each aspect of the formula mean.
This is the amount in the reserve account. This could be the actual bank account balance as of a particular date, a projected balance as of any particular date in the study or an estimated amount based on a mix of bank account and investment account balances. Typically a reserve analyst will request the reserve account balance from the Client as a starting point to determine what level the Association is currently funded at. From this beginning reserve account balance the reserve analyst is able to develop a catered financial strategy – providing recommendations with respects to future reserve allocation rates (amount to be placed in the reserve account).
The reserve account balance is an important number from which the reserve analyst will start the financial analysis in the reserve study. Taking this Client supplied number and adding in interest, taxes, expenditures, inflation, etc., to develop a long term financial plan that is realistic and catered to the Associations long term goals.
As the financial analysis is developed the reserve analyst is able to determine how the reserve account balance is impacted – a financial strategy that results in a negative balance within the study timeframe is not going to be adequate or advised. The reserve analyst will develop financial strategies that results in a reserve account balance that will place the Association on a fiscally responsible path for the life of the study. This can be difficult if an Association is extremely underfunded (has a reserve account balance well below the “ideal” Fully Funded Balance). Note that this reserve account balance will see very large fluctuations as large community projects like landscaping roof, siding, windows, asphalt, and pools are replaced /repaired / refurbished and result in large expenses to the Association.
Whenever possible I like to add the term “ideal” to Fully Funded Balance as it is easier understood by a reader of the reserve study often who is not familiar with industry terms.
Definition: Ideal - 1. satisfying one's conception of what is perfect; most suitable.
I like this definition as the Fully Funded Balance is the “most suitable” balance for a community as a particular point in time. Not meeting this “ideal” balance does not mean the community is going to run out of money or end up special assessing but is the amount a community should strive for if the overall goal is a low risk funding strategy (low risk for special assessments, loans, litigation). So how is this “ideal” Funded Balance (FFB) derived?
Simply put FFB is the ideal amount that would be in a reserve account to offset deterioration estimates to a component (Total Accrued Depreciation) at a particular point in time – this is a mouthful and more easily represented in the formula and table for a component that needs replacement in 3 years:
Parameters for Component
Current Replacement Cost: $5,000
Useful Life of Component: 3 Years
** Formula Components have been bolded**
The above example is a simple one component calculation for simplicity sake but in reality there will be dozens or hundreds of components in a community – all with different cost figures and useful life expectancies. The expenditures for a community will vary over time with some years having much expenditure projected in “Peak Years” while other years have very few projected expenditures. The FFB narrows down these infrequent component expenses into an annual dollar figure so that the Reserve Analyst is able to make recommendations in the reserve study that comply with National Reserve Study Standards, Statutory Requirements and the Association’s long term goals. This FFB takes into account inflation of the costs and the fairness to community members paying their fair share as the FFB calculation is run annually within the timeframe of the reserve study. The FFB will fluctuate up and down from year to year as common area components are replaced and each begins a new life cycle.
Now that we have a basic understanding of the numbers used in the equation to calculate Percent Funded we can dig a little deeper into why it’s an important indicator for an Association.
When an Association has a reserve account balance that is equal to a fully funded balance it is considered 100% Funded. This is the “ideal” amount that is in the reserve account – remember this calculation is based on a point in time as the reserve account balance and fully funded balance both fluctuate throughout any given year and annually throughout the 30 year period of the reserve study. Since we are utilizing the “Cash Flow” method of funding (article on Cash Flow Funding ) which takes a snapshot of expenses over time it is very possible for an Association to never be 100% funded yet have adequate funds the entire time period covered in the reserve study – at this point it comes down to the risk level for an Association.
As the percent funded calculation falls the risk levels for loans, special assessments and litigation factors increases. Historically those communities which are 0-30% funded have a high risk level, communities 31-70% funded have a moderate risk level and communities which are 71-100% funded have a historically low risk level.
But remember this is a calculation at a specific point in time; the percent funded level fluctuates based on fluctuations to the fully funded balance and the reserve account balance. As can be seen in the below chart an Association which has a high percent funded level one year but has a large number of expenses the next, may very well see a sharp drop in the percent funded level (depends on the funding strategy being followed).
With most Associations falling in the Low to Moderate Percent Funding Levels where the risk for loans, special assessment and litigation is highest, the Reserve Analyst has a unique challenge to develop a funding strategy that both adequately prepares a community for the upcoming expenditure’s as well as increases a community’s Percent Funded to a healthier 70-100% range (e.g. - Recommended Funding Plan in above Chart). There are many different strategies a Reserve Analyst will consider during this process and the strategies developed will be catered to the specific Association. Ideally the Association will adopt & implement a funding strategy which leads the community on a path towards a percent funded in the 70-100% range where it is able to consistently stay. Risk factors will be minimized, the members will be paying their fair share of the expenses and the Board will be meeting their fiscal and legal responsibility to the members of the community.
Yes, the percent funded calculation does matter and it is utilized by Reserve Analysts’, Lenders, Buyers and Associations in determining the risk level associated with a specific reserve account balance. It’s important that a longer term outlook of percent funded is viewed and not just take one or two years to base budgeting decisions. As noted above percent funded will fluctuate from year to year and it’s the overall long term trend which has proved to be most important when developing a long term funding models. It's also extremely important that Board members do not make assumptions on short term findings as even a well-funded Association can find itself in a high risk and poor funding level in just a few years if the funding models are not updated and not followed accurately over time.
Written by Joel L Tax - Professional Reserve Analyst - 01/18/2016