This article has been written to provide a solid base for the understanding of what a reserve study is, why they are important to common interest communities and how they are beneficial to the long term financial strength of an Association. The more detailed formulas and in depth analysis are not going to be covered so that the basics are not confused with gray areas and mathematical situations that come up.
We have much more information and in depth articles, videos and presentations at the Knowledge Corner area of this website. Most importantly please do not hesitate to call or email us with questions.
What is a Reserve Study?
A reserve study is a budgeting tool which will include a list of common area component that are the HOA’s responsibility, a projected schedule for replacement/repair of these common area components and funding plans which guide the HOA on a path of fiscal responsibility so that the projects can be adequately paid for in a stable, fair and responsible manner.
There Are Three Levels of a Reserve Study
Why Have a Reserve Study Completed?
What Standards Are There?
The Problems Association’s Face?
Common area reserve expenses are typically irregular and the large expenses are often infrequent. As can be seen in this Expenditure Graph there may be years of extremely high expenses while others years have minimal to no expenses projected. These fluctuating expenses are a budgeting headache as Board members need to determine appropriate reserve account allocation amounts from the relatively stable HOA dues and years in advance. How to do this fairly and accurately?
The Solution Reserve Study Companies Provide
This is where a reserve study is most beneficial to an Association. A component list is developed and funding plans are created to show how an Association can pay for these component expenses in a stable, fair and responsible way so that the HOA dues can remain stable and predictable for the community members.
While the component repair & replacement expenses fluctuate year to year the recommended reserve contribution rate will have a stable but slightly increasing trend. It takes into all the concepts and standards related to fairness and stability while meeting the projected expenses (note that the reserve contributions are not stagnant but increase at a stable rate of 3% per year to offset inflation).
The overall objectives of having adequately funds in the reserve account when needed while fairly distributing these expenses to the community membership over time is met. There will be minimal risk for special assessment, loans or deferred maintenance. [TOP]
The First Step – The Component Analysis
The Component Analysis is the first step in developing a reserve study. The resulting component list is the most important aspect of the reserve study as all projections, recommendations and funding plans are based on this list which is developed from the site inspection, a review of the governing documents, interviews with Board Members and per National Reserve Study Standards. Most importantly the reserve component list will be for projected and known expenses; these fluctuating and infrequent costs we noted earlier are actually predictable expenses that can and should be budgeted for well in advance of the actual expenses occurring.
Developing the Component List
The reserve analyst will develop a component list after a review of the governing documents, compliance with Statutory Requirements and per National Reserve Study Standards 4 part test.
Below is an example of a reserve component list. Within this list is the current cost of each component, the useful life (how long it is projected to last) and the remaining useful life (how long is remaining until the projected failure). These are all determined from the site inspection and research necessary during the first step of the reserve study. [TOP]
While a Board may view these component expenses as unpredictable and difficult to manage – a knowledgeable reserve study provider will be able to see these expenses as stable and predictable. This is due to the experience, education and knowledge gained from completing thousands of reserve studies, researching the components and interviewing professionals – the reserve analyst has encountered similar situations over and over which is the basis for their expertise. If we have a predictable cycle of repair/replacement and costs then we can provide funding plans that will adequately address the problem of how much and when to adequately budget for them.
The Second Step - The Financial Analysis
The second step of the reserve study is two parts in that we determine the adequacy of the reserve account balance (known as Percent Funded) as well as develop funding plans which follow National Reserve Study Standards, Statutory Requirements, Client Goals and Recommendations by the Reserve Analyst. There are numerous concepts, standards and statutory requirements that the reserve analyst must take into consideration during this step.
Important Concept – Reserve Contributions Are Not For The Future
Reserve contributions are to offset current deterioration not for a future projected costs. This is an extremely important concept as this is the basis on which the funding plans that are created for fair and stable reserve contributions over time and through changing membership and changing Boards.
As the components deteriorate the reserve account balance increases so that expenses are addressed as they occur. There is a common misconception that the reserve account is just a savings account for future expenses. See the below example for an example of this concept:
A Community needs to paint a building in 5 years at an estimated future cost of $5,000 (inflation & interest being ignored)
As the above example shows Community A adequately budgets a fair and stable reserve allocation rate to offsets the annual deterioration of the paint. At the end of five years Community A has the necessary amount in the reserve account to pay the paint vendor while the community members each pay their fair share into the reserve account. Community B has elected to only contribute half of what would be ideal in years 1, 2, 3 & 4. The result of the poor budgeting now requires the community members in year 5 to contribute a much larger amount to the reserve account than what is fair; what should have been a $1,000 reserve contribution in year 5 has to be increased to $3,000. In the end the amount needed to pay the paint vendor is still the same but Community A has budgeted in a fair and stable manner while Community B has not.
As seen above, component expenses occur infrequently but the deterioration is ongoing and steady which is best addressed with a steady reserve account allocation rate. The community members should pay their fair share as the deterioration occurs. Doing so takes into account all the factors that impact project expenses like inflation, interest, and cost variables.
The big challenge to a Board is that community membership will almost always request lower HOA dues as can be seen in the example of Community B above. The community membership in Years 1, 2, 3 & 4 are likely happy with the lower HOA dues they are being charged without realizing they are not paying their fair share to the paint project. The community members in Year 5 will be stuck with the higher portion of the bill than they should be. Additionally any membership that has remained in the community for the full five years will be paying a higher amount than if they paid their fair share over time due to the benefit of interest gained on the reserve account balance. It is essentially human nature to want more for less but it is the Board that carries the responsibility and liability of making decisions that are in line with the legal requirements for being on a Board of a Nonprofit Corporation.
Percent Funded is a calculation of how much an Association has in its reserve account versus how much it should ideally have at a particular point in time (i.e. has the reserve account balance kept up with the estimated deterioration to the components). This is a helpful calculation which shows in percentage figured 0-100%+ of how adequate the account is at a particular point in time. 100% funded indicates the Association is in track to meet its future projected obligations. This is not a calculation of the total costs of the components or total replacement of the buildings it is just a barometers of adequacy. It is important to know and understand that Percent Funded is not the whole story; a community can have a high percent funded calculation one year and then have low percent funded in future years due to loans & special assessments in specific years, if reserve contributions are not kept up or there are changes to components list & financials of an Association. Below are examples of percent funded:
A Community needs to paint a building in 5 years at an estimated cost of $5,000 (inflation & interest being ignored)
As can be seen in the above example, Community A has adequately budgeted a stable and fair amount to the reserve account, an amount that equals the annual deterioration to the paint. The result is that this community is one hundred percent funded each and every year and has an adequate amount to pay the paint vendor at the end of year 5. Community B has decided to fund only half of what would be ideal and the result is that it is only 50% funded each year and at the end of year 5 that have only half of what they need in the reserve account. Community B will need to rely on a loan, special assessment or defer the paint project until they can save the additional $2,500 needed to pay the paint vendor.
Cash Balance Versus the Fully Funded Balance
Many Boards make the mistake of assuming they are well funded when the reserve account reaches a level they perceive as being very high. Often at this point Boards are tempted to dip into the funds to make up for deficits in the Operating Account or to utilize them for capital improvements like a new park or swimming pool. However the adequacy of the reserve account cash balance should not be measured by an arbitrary dollar amount, it needs to be compared to the Fully Funded Balance (the ideal amount at a specific point in time). As can be seen in the below example the Fully Funded Balance is the amount of the total deterioration of the components in a community.
A Community needs to paint a building in 5 years at an estimated future cost of $5,000 (inflation & interest being ignored)
The above example is simple and takes into account just one paint component but in a real life scenario there will be many components with many different replacement cycles so the fully funded balance will fluctuate over time.
Peak Year Expense Cycles
Most communities will have cycles of expenses that are infrequent but which make up the bulk of the community’s obligations. Components like roofing, asphalt, windows, siding are all relatively infrequent but are very costly and require significant reserves many years in advance. There is the additional common scenario of several of these large expense items occurring within a short time frame of one another, roofing and asphalt overlay are a great examples as they often have similar useful lives. A very large reserve account balance is often quickly eaten up in these “Peak” years expense cycles. One of the most difficult challenges for the reserve analyst is to create funding plans which get past these “peak” year cycles of expenses with adequate reserves in the account. The below chart shows a community with obvious peak year cycles (“Disbursements” in dark red) that will need to be carefully and responsibly budgeted for many years in advance if they are to have an adequate amount in the reserve account when the costs are projected to occur. This is a common scenario where this community has noticeable expenses every 5-10 years and then very large expenses between 20-30 years but very few expenses in the years in between. Without a reserve study a Board and the community members will be tempted to keep HOA dues stagnant or reduce them as they have the perception that there are few expenses in the community.
How Much Should an Association Contribute?
After a percent funded calculation is determined the reserve analyst will need to determine how much an Association will need to contribute into the reserve account for the different funding plans being developed. The question of “How Much Should We Contribute” is not typically one that is relevant to a reserve analyst as each Association and each Funding Plan has a different goal in mind. While the ideal amount in the reserve account would be a Fully Funded Balance (100% Funded), this is not a realistic level to reach for most communities in their immediate future. There will be some funding plans that have a higher reserve contribution, higher percent funded and a much lower risk for reliance on special assessments and loans while others will have a lower reserve contribution but a higher risk for reliance on special assessments and loans. It is up to the Board to decide what they are most comfortable with based on the risk tolerance of the community. That being said, any scenario which projects the reserve balance to reach zero is not one that should be followed as the risk for special assessments, loans and deferred maintenance is highest.
Following a reserve study schedule and suggested reserve contributions (specifically the Recommended Plan) has multiple benefits
Developing Funding Plans
In developing funding plans the reserve analyst will take into account the current reserve account balance, percent funded, and standards like fairness and adequacy over time. In addition to this minimum statutory requirements must be met. In a typical reserve study there will be several funding plans developed and included:
Recommended Funding Plan - The recommended funding plan will help steer the community into a high funded range over a period of 30 years. This funding plan is very realistic for most communities but may require significant increases to the HOA dues to a level that is more realistic. This funding plan will help provide a path for which a community can follow to reach a high percent funded level. The recommended funding plan requires an Association to allocate the recommended allocation amount into the reserve account with annual increases over the 30 years covered in the study. Four Basic Principles are taken into account when developing this plan:
As can be seen in the above graph the Recommended Funding Plan guides this community from a low 20% funded level to a 100% funded level by the end of the 30 year mark.
Baseline Funding Plan - The baseline funding plan is a bare minimum approach which has a goal of only keeping the reserve account balance above $0 and typically long term will not place a community in a good funding range (above 70%) for much of the time period over the 30 years covered in this reserve study. We do not suggest following this funding method due to the higher risk for reliance on special assessments and loans to fund these expected expenditures. The risk associated with this funding plan typically comes from deviations from the projected costs or useful life of components which are just estimates in the reserve study. If a large expenses component fails even a years or two early an Association will have a high risk of not having an adequate amount in the reserve account. As can be seen in the above graph the Baseline Funding Level remains under 50% Funded for almost all of the 30 year timeframe of the study and projects to hit just above $0 at year 2042, after a peak expenses year. Should these components fail even a couple of years earlier than projected it is likely this Association would not have enough in the reserve account.
Current Funding Plan - The current funding model is based on the financials supplied by the Client and typically will assume a assumes a 3% increase to the Current reserve allocation rate. This funding plan will highlight the adequacy of the current reserve contributions over the 30 year time period in the reserve study. Since most communities are underfunded this current funding plan often will show a deficit in the reserve account which indicates a high likelihood that special assessment, loans or deferred maintenance issues will be relied on if the current funding plan is followed. Approximately 25% of Associations are in a high funding level (above 70%) where a deficit in the account is unlikely. As can be seen in the above chart this Association is projected to be zero percent funded in only 5-6 years.
Client Goals, Assessments/Loans - Additional funding plans can be based on a variety of factors including Client goals, inclusion of assessment or loans or what if scenarios. Since every Association is different these additional funding plans are essentially unlimited. [TOP]
What are the Benefits of following a Funding Plan to a High Percent Funded?
What are the Negatives to remaining in a Low Percent Funded Range?
Is It Even Possible to reach a High Percent Funded Range?
Yes, approximately 30% of the communities we work with are already in the High Percent Funded range of 70-100%. Most of these communities have been diligent in their budgeting efforts over the years and unsurprisingly also typically have higher HOA Dues than similar communities in a lower percent funded range. Unfortunately this means that seventy percent of communities out there are significantly underfunded.
Being Too Optimistic
Board often makes the mistake of being too optimistic with regards to component costs and component useful life. This is usually just wishful thinking or just wanting to ignore the reality of the situation. But neither being too optimistic nor ignorance will cause the project costs to disappear. In the end the owners in the community will get stuck with the bill and it is up to the Board to determine if that is going to be a large and unfairly assessed bill or one which is fair and has been adequately budgeted for. [TOP]
Updates to the Reserve Study
One of the main benefits to update a reserve study is the Board will have updates and reliable data and recommendations to base their budgeting decisions on. The reserve analyst will indicate which components are aging as expected and which ones appear to be deteriorating more rapidly. This is extremely important as an initial reserve study will have various assumptions that time will prove to be accurate or not. It has been our experience that reserve studies get more accurate as time progresses and updates are completed. Actual costs and useful life information will be incorporated into future reserve studies so the resulting projections will become more accurate and reliable with time. [TOP]