Why do we say reserves equal sustainability? To answer this question we need to consider what purpose the reserve fund serves for a homeowner association (HOA). The reserve fund serves two primary purposes.
The first is obvious: it provides the funds needed to pay for expenses related to the maintenance, repair and replacement of community-owned assets. By saving money throughout the life of these assets it eases the financial burden on the owners in two ways. For most people it is easier to make small, recurring contributions to the reserve fund on a monthly or annual basis in most instances rather than having to break out the checkbook and write a very large check on an infrequent and/or unscheduled basis.
By spreading these reserve fund contributions out over the full life of the assets it also results in all of the owners who enjoy the use and benefit of the assets having contributed to the cost of maintaining and replacing them; rather than deferring the funding obligation to the generation of owners who just happen to be a part of the community when the time comes to pay for major repair or replacement of community-owned assets.
This principle brings us to the second purpose of the reserve fund, which is somewhat more obscure but equally important: The reserve fund serves as a financial counterweight to the declining value of community-owned assets. In this manner it helps prevent a decline in the value of the homes within the HOA which results from a decline in the value of common area improvements.
In the case of a planned development where each owner is responsible for their own home and yard, the need for reserves to offset the declining value of common area improvements may seem less important especially if these commonly-owned assets are things that someone doesn’t use.The classic example of this situation is the community swimming pool that located in many HOAs. Throughout the industry it is a standing joke that if you poll the residents of an HOA to see which of the recreational amenities they enjoy the most the answer is always the same…10%! It doesn’t matter what the amenity is, 10% like it, and make use of it and the other 90% would just as oon see it go away so they don’t have to contribute to the maintenance and upkeep.
However, in a condominium or attached housing environment, where the HOA is responsible for maintaining the exteriors of the buildings or major components within the buildings, it is an entirely different matter. In these situations the need for adequate reserves becomes a critical and unavoidable issue.
If you live in a condominium and the roof over your kitchen sink starts to leak or the HVAC system quits working in the middle of the summer, the negative impact on property values is immediate; especially if the HOA doesn’t have the money to pay for the needed repairs or replacement of the depreciated asset.
This relationship between the amount of money in the reserve fund and value of common area improvements that is lost through depreciation is extremely important to prospective buyers who are considering the purchase of a home or condominium in an older HOA. In this circumstance it is clearly in the buyer’s best interest to purchase a home in an HOA that has taken a responsible approach to reserve funding and as a result has accumulated sufficient reserves to offset the declining value of aging improvements. Otherwise, this late generation owner is going to be burdened with a disproportionate share of the financial obligation associated with repairing or replacing the worn out assets.
Savvy buyers will recognize a weak reserve fund for what it is and will require that a seller discount the price of their home to offset the depreciated value of the common area improvements. This situation speaks directly to the issue of why it is so important to establish a realistic and equitable reserve funding program early on in the life of the HOA and to persevere with the funding of the reserves through good times and bad. By doing so, the association is laying the groundwork for a community that will remain economically sustainable beyond the life span of the original assets.
In the absence of such a long-term approach to financial planning the HOA will be faced with several challenges once it reaches the tipping point in the life cycle of its asset base. Unfortunately, for many older HOAs it is often the case that these challenges can be very difficult to overcome.
One of the most common problems occurs when the Board of Directors is unable to raise the money needed to pay for repair and replacement of depreciated improvements, either because the owners cannot afford to pay for their share of the expenditures; or the owners simply refuse to approve a special assessment to generate the money in those instances where the Board must obtain the approval of the HOA members in order to levy the special assessment.
In either circumstance the community runs the risk of becoming unsustainable from an economic perspective. When this happens the physical condition of the common areas will begin to show advanced levels of deterioration which in turn leads to further declines in the value of the homes within the community and again, in the case of condominiums or other attached housing schemes, the situation can lead to sudden and noticeable declines in the value of the homes within the community.
The same result is inevitable in a planned development of single-family homes. However, the deleterious effects of the deferred maintenance that results from inadequate reserves, may take longer to manifest themselves for a variety of reasons, but it does happen eventually.
In both instances the financial impact on the owners, in the form of lower property values or special assessments to pay for the repairs, can be significant. For all of these reasons we therefore argue that reserves and the reserve planning process are among the most important, if not the single most important aspect of successful HOA governance over the long term.
Simply put: good reserve planning and adequate reserves result in a sustainable community.