Financial Management of Community Associations | Budgets and Replacement Reserves Part 4
Part 4 : Reserve Account/Reserve Funds
The reserve account consists of funds put aside in “reserve” for the replacement of major components of a community’s common property (aka “assets”). Typically the reserve account is used to replace asphalt paving, concrete sidewalks, roofs, central heating and cooling plants, swimming pool, tennis courts, elevators, and many other property components. Revenue raised for adding a major item will be a major improvement expense; revenue raised for replacing that item when it deteriorates will come from the reserve account.
Major items that either come with the initial construction or are added later are placed on a replacement reserves schedule. The schedule is a framework for accumulating and spending the funds replacing major components of the property. The funds are put aside over a period of time to ensure that adequate amounts are available to replace components when necessary, either due to deterioration or technological improvements. The components, cost to replace the components, and the remaining useful lives of the components, will determine how much should be in the replacement reserves at any given time.
It is important to note that the IRS does not consider painting to be an eligible reserve component, which is deemed an operating expense (it is maintenance, not replacement). For those associations that want to set aside funds for a regular paint program, they should create a separate line on both the balance sheet and the statement of revenue and expenses, separate from the reserve budget allocation and/or fund, to track the monies set aside for this project (i.e., a painting reserve). Otherwise, if it audits the association, the IRS may impose additional tax obligations and penalties.
Reasons for Maintaining a Reserve Account: Often times owners will question the value of their contributions, since several items may not require replacement for several years, especially if they don’t plan to live in the community that long. Reasons for maintaining a reserve account that may help convince the owners of the importance of budgeting replacement reserves include:
- Maintaining a reserve account meets legal, fiduciary, and professional requirements. A reserve account may be required by:
- Any secondary mortgage market in which your community association participates (I.e., Fannie Mae, Freddie Mac, FHA, VA)
- Your state’s statutes, regulations or court decisions
- Your community’s governing documents
- Industry standards
- Maintaining a reserve account provides for the planned replacement of major items. Owners expect the community association to fulfill its obligations. At some point in time, the work will have to be done.
- Maintaining a reserve account equalizes the contributions of old and new owners. Major items deteriorate during use. Although a roof may be replaced when it is 25 years old, every owner who lived under that roof should pay a share of its replacement. Just as both old and new owners benefit from the presence of such an item, both contribute to deterioration.
- Maintaining a reserve account minimizes the need for special assessments. Owners, especially those on fixed incomes, have limited resources. They may not be able to afford the large special assessments that would be required if replacement reserves are insufficient to cover a major replacement. Special assessments have the reputation of being indicative of poor management, which could make it more difficult for an owner to sell their property.
- Maintaining a reserve account enhances resale values. Lenders and real estate agents are aware of what a reserve account is and the ramifications for a new buyer if reserves for replacement are inadequate Many states have replacement reserves disclosure requirements for potential buyers in a community association. Most lenders require adequate replacement reserves before approving a loan application. Some states require replacement reserves for replacements and/or replacement reserve studies.
Funding Goals: The answer to the critical question of how much replacement reserves are “enough” or “adequate” is not simple. Each association has different needs, so $100,000 may be excessive to one association but extremely low to another. (This is one reason why you can’t easily compare assessments at one community to another; you don’t know if their assessment allows for adequate funding of the association’s reserves to properly maintain the community.)
Note that reliance on special assessments to pay for capital replacement projects is not considered a responsible funding plan. Funding plans are expected to project the revenue and expenses of the reserve account for 30 years or more. Many associations include the effects of interest earned from their reserve accounts “on deposit” and the effect of inflation on projected future expenses. While interest earnings tend to reduce the effects of inflation, the two factors do not offset each other, since interest is earned only on the reserve balance, while inflation affects the total replacement cost of all the reserve components.
Reserve Studies: Maintaining the association’s common property is one of the Board’s most serious responsibilities, and it takes a long range plan to prepare successfully for repair or replacement of the association’s major common area assets. The reserve study is a budget planning tool with which the board can use to offset ongoing deterioration and prepare for inevitable future expenses. Reserve projects are typically the largest expenses that an association faces, and proper financial preparation is essential.
A reserve study is also used for developing a reserve account budget. The study addresses all major common physical components of the property that the association must repair, replace, restore, or maintain. The study should contain, at a minimum, a statement of the remaining useful life of each item; an estimate of the current cost of repair, replacement, or restoration of those items; and an estimate of the total annual contribution necessary to defray the cost of repair, replacement, or restoration, of those items after deduction of existing reserve funds. In essence, the study must include all items for which the community has long-term replacement responsibility. If your association does not have a Reserve Study, your Community Association Manager can get you proposals to have a study conducted.
Consequences of not having a reserve study:
▪ Under-funding: Special assessments, bank loans, deferred maintenance, or a combination of these
▪ Over-funding: Paying too much (more than owners “fair share”), for the benefit of future owners
▪ Board member liability: Exposure to claims of fiscal irresponsibility and loss of D&O insurance coverage
The physical components in community associations are constantly changing. As a reserve study is based upon facts at the time the study was conducted, managers and boards should plan for an update of their reserve study on a regular basis - typically 3 to 5 years - to ensure accuracy. Another reason to consider an update is if the association deviates from the reserve funding or spending plan. A reserve cash flow statement shows the amount to be funded and the amount to be expended from the replacement fund over a given period of time.
The board should review its reserve study annually, particularly its funding plan, because the association’s physical assets may deteriorate at different rates than initially projected, interest and inflation rates change, and the association may change its reserve strategy from conservative to aggressive (or vice-verse). Associations should be encouraged to plan responsibly for the future, using the reserve study as a valuable tool.
Interest earned on the investment of reserve funds can be added to the replacement reserves on hand. If you do not update your reserve budget each year, you should add its interest income directly to the reserve account. This will help your reserve account keep up with increases in prices due to inflation.
Reserve Specialist: Whenever possible, use an experienced, qualified person to prepare a reserve study because of the technical detail involved. What is the value of having the reserve study conducted by a reserve specialist?
▪ Reduced liability exposure: Community managers and board members can limit liability by relying on expert advice.
▪ Independence: No potential conflict of interest
▪ Focus: Allows managers and board members to concentrate on running the association
▪ Credibility: If the person or committee preparing the reserve study isn’t credible enough to effect a change in the association’s budget, there is no point expending time on the study. A reserve specialist, by virtue of his or her credentials, has already established respect and credibility with the board.
▪ Accuracy: The reserve specialist does this year-round, and is well-versed in the implications of all the decision points.
Preparation of a Reserve Account Budget: to maintain the association’s major common area assets, the board and manager must determine an appropriate level of revenue to segregate into a reserve account or replacement fund to pay for the eventual replacement of those assets as they wear out during the life of the development. Without a plan (a reserve study), it is strictly a hit or miss proposition. Usually a separate section of the budget packet includes the replacement fund budget.
Our previous articles looked in depth at Budget basics, roles and responsibilities and budget presentations. Find out how financially healthy your community association is now & get an email with your score!