Reserves: If You Fail to Plan, You Are Planning to Fail
By Kerry-Lynn Goto, LCMCA, LSM, PCAM, RS
You’ve heard it before: if you fail to plan, you are planning to fail. Planning for the future, whether for the purchase of a new home or car, a vacation or retirement, involves thoughtfulness and commitment to a savings plan. The same concept holds true in charting a financial course for future community asset repairs and replacements.
Developers of communities in recent years have adopted a practice of commissioning reserve studies at the on-set of development activities, and funding reserves according to plan through transition. While this ensures a stable financial future for newer communities, sadly, many older communities that did not have this advantage are plagued by deteriorating common area components and little or no financial resources to make necessary repairs and improvements.
The subjects of reserve studies and reserves funding are being considered by law-makers in many states, and some jurisdictions have adopted legislation mandating reserve studies. If you are unfamiliar with the what, when and why of reserves, here are a few brief explanations of reserves concepts.
What are Reserves?
Reserves are a portion of assessment funds that are set aside in a separate, interest-bearing account and used to replace commonly-owned capital components. These funds are separate from funds used for routine maintenance and operational expenses. In other words, the funds are used to pay for asset repair or replacement expenses that occur other than annually.
Where do Reserves Fit into the Association’s Budget?
Associations operate on an annual budget generally consisting of three components: the operations budget, the maintenance budget and the reserves budget. The operations and maintenance pieces include allocation of funds for administrative expenses and routine maintenance, such as pool maintenance, street sweeping, landscape maintenance and other expenses that are projected to occur during that fiscal year. The reserves budget is set aside to cover long-range expenses such as periodic painting, pool refurbishment, roofing, street resurfacing/sealcoating and maintenance, that will occur during a 30-year cycle.
Why are Reserves Maintained?
A community’s Board of Directors has a duty to preserve, protect, maintain and enhance the community’s assets. Failure to follow-through on these commitments can result in decreased property values and, sometimes, litigation. Having funds available for major repairs and replacements on a timely basis allows the board to comply with the Association’s governing documents and to satisfy its fiduciary duty to protect, preserve, maintain and enhance the physical assets and property value of the community, and that of the financial interests of the homeowners they represent.
What Happens if Reserves are Inadequate?
Inadequate reserves can result in assessment dues increases and/or special assessments to make necessary repairs. Both of these can pose financial hardships for homeowners. Deferred maintenance can lead to a loss of curb appeal and a decrease in property values, and possible board liability for breach of fiduciary duty.
How is a Reserve Study Useful?
A reserve study may be required by the Association’s accountant during the annual audit process, and afford personal liability protection for Board Members with regard to reserve components and funding. Reserve studies are often requested by lending institutions during the loan due-diligence process. The report is also a very useful management tool for scheduling, coordinating and planning future repairs and replacements, as it contains measurements and cost estimates that are useful in evaluating contractor bids. The funding component of the report serves as an annual disclosure to the membership concerning the Association’s financial condition.
Why is a Reserve Study Important?
A reserve study provides a fair and equitable plan for funding of reserves over time, allowing an Association to have the funds on hand when the time comes to repair or replace big-ticket items. It provides an independent, skilled assessment of future reserve funding needs and helps alleviate future financial crises due to a lack of long-term financial planning.
What Causes Reserve Fund Failures?
Most community association financial crises occur due to one or more replacement reserves failures. The four most common failures are lack of long-term reserves planning, failure to adjust reserves for deteriorating physical conditions, failure to adjust reserves for inflation over time, and inappropriate use of reserve funds.
The importance of considering replacement reserves in the strategic planning process can’t be overstated. If your Association doesn’t have a current reserve study, place this subject on the agenda for your next Board meeting.
Kerry-Lynn Goto is the principal of Great Boards, LLC, a full-service consulting firm serving the community association industry.
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