What is a reserve planning and why is it important to the sustainability of a homeowners association (HOA)? Most people, including many HOA members, have never heard of reserve planning and have never seen a reserve study. In spite of the critical role reserve planning plays in the long-term sustainability of a common interest development (CID), many HOAs have never conducted a reserve study and do not maintain a reserve account. At the present time there are fewer than 20 states that requires HOAs to conduct a reserve study and in many of those states that do, there is no statutory requirement that the HOA actually fund a reserve account according to any particular schedule.
Before we dive into this somewhat arcane subject in detail we need to establish exactly what we mean by the terms “reserve study” and “reserve planning.” Strictly speaking the term reserve study refers to the process of evaluating the common area assets of an HOA for the purpose of determining in advance, what the future cost of repairing and replacing the assets is going to be. This analysis is then used to develop a reserve funding schedule which establishes the annual contributions that must be made to the reserve fund in order to generate sufficient funds to pay for the repair and replacement of these common area assets when they reach the end of their service life; or when they reach a point in their life cycle when major repairs are required to keep the asset in service.
This process of evaluation, analysis and funding of the reserve account is what constitutes reserve planning for most homeowners associations that do engage in this most important aspect of association governance. In the interest of clarity it should be noted that the American Institute of Certified Public Accountants (AICPA) has taken the position that the use of the term “reserves” is confusing and potentially misleading as the word has more than one meaning in the context of financial accounting (Audit & Accounting Guide for Common Interest Realty Associations – May 1, 2008). In the opinion of the AICPA the reserve fund is more appropriately titled the “fund for major repair and replacement expenses,” or something similar.
Indeed, it is true that many HOAs will set aside “reserves” for other purposes, including covering operating expenses that exceed the budget projections; payment of insurance deductibles and in some instances reserves for capital improvements vs. repair and replacement of existing assets. So it is not unreasonable for the AICPA to take the position that is has with respect to the use of the term reserves.
However, we will use the terms reserve study, reserve planning and reserve fund when referring to fund for major repair and replacement expenses associated with the common area improvements within a homeowners association because they are less cumbersome and are consistent with the terminology used throughout the association management industry and is the most recognized jargon among homeowners and board members who are familiar with the concept of reserve planning.
With that said, we can now address the subject of reserve planning and why it is so important to the long term stability of any CID, whether it is a condominium, planned development or a cooperative. When we speak of the HOAs reserves we are talking about funds which are being set aside in a sequestered bank account for the specific and exclusive purpose of repairing and replacing various common area assets and improvements. These assets and improvements can be anything from the roof or the paint on a building, to the asphalt parking lot; the lounge chairs in the pool area or the pool itself. Strictly speaking the replacement of an asset represents a capital expenditure in the context of financial accounting. Whereas repairs may be classified as capital or non-capital expenditures, depending on the nature of the work involved and how the Internal Revenue Service has weighed in on the matter.
In the modern era reserve planning for HOAs has come to include a variety of non-capital expenditures such as painting, which for many large HOAs is one of the biggest expenditures they will incur over the typical 30 year time-frame covered by most reserve studies. In general the objective of the reserve planning process is to identify major expenses that are expected to occur less frequently than once a year. Expenses which are expected to occur one or more times throughout the course of each year are therefore included in the Association’s operating budget.
The reserve study itself is a document that identifies the long-term expenses in the form of a component inventory. This “inventory” is established through a process very similar to the inventory procedures used by businesses when they reconcile their current stock of merchandise for tax or other accounting purposes. The individual assets or components, are first identified and then quantified, which is to say someone counts them.
Once the inventory of reserve components has been completed the examiner then assigns a useful life to each asset using a variety of methodologies which can vary from one preparer to the next. The useful life analysis is then used to create a projected schedule showing when each of the assets is expected to require replacement. The reserve analyst then prepares a replacement cost analysis which assigns a dollar value to each asset based on the current estimated cost of repairing or replacing the asset in question. At this point a schedule can be created which projects the likely cost of replacement when the component reaches the end of its service life. Finally using this data the reserve analyst is able to create a funding schedule that projects the annual contributions which must be made to the reserve fund in order to have enough money to repair or replace all of the assets included in the funding analysis.
In most instances this funding projection covers a period of thirty years, which is consistent with the statutory requirements of most states that do require HOAs to conduct a reserve study. If this process is managed in a responsible and realistic manner over the life of the community-owned assets it will allow the association to remain viable beyond the typical 30 to 40 year time-frame during which almost all of these assets will reach the end of their useful life expectancy. If an HOA does not reserve funds to pay for major repair and replacement of its assets, it runs the risk of not having the money to pay for critical expenditures when the need arises; a situation which most often leads to deferred maintenance and potentially to a decline in the value of the homes within the community.