“How do you tell a good reserve study from a bad one?”
This is a question the HOA Detective is often asked during presentations and classes he teaches on financial due diligence. Considering that reserve studies and reserve study providers are not created equal it is a fair question to ask…Unfortunately there is no easy answer.
In order to determine whether any reserve study is accurate and complete the reader would need to know quite a lot about the homeowners association (HOA) that is the subject of the reserve funding analysis. Since prospective home buyers aren’t likely to know everything they would need to know about the HOA to determine whether its reserve study is accurate, they must rely on rules of thumb or the opinions of others who may be better informed.
As with reserve studies, reserve study providers are not created equal; a fact which only adds to the problem of how to distinguish a good reserve study from a bad one. Several factors must be considered when evaluating any reserve study. For readers who are not familiar with reserve planning principles here is a summary of the more notable elements of a high-quality reserve study:
Objective Analysis: The reserve study provider should be an impartial, third-party who has no conflicting relationship with the client that may prevent them from rendering an objective opinion regarding the reserve funding requirements of the association. For this reason it is inappropriate for the board of directors or the association’s management company to prepare the reserve study. It is equally unacceptable for a vendor who has an ongoing business relationship with the HOA, in any capacity other than as a reserve study provider, to prepare the reserve study.
Timely Analysis: Reserve planning is a dynamic, not a static process. The information which forms the basis for the funding analysis is constantly changing. Therefore it is critical that the reserve study be updated each year. A reserve study that is more than one year old is of little value in assessing the financial stability of an HOA. For this reason it is the standard in states that require HOAs to conduct a reserve study to also require that the reserve study be updated annually.
Percent-Funded Analysis: The percent-funded calculation measures the relationship between the association’s accumulated reserve funds and the loss in value of its common area improvements due to depreciation. While it is not a perfect measure of the fiscal health of an HOA’s reserve fund, the percent-funded analysis does provide useful insight into the association’s reserve funding strategy. Low percent-funded levels mean the association is kicking the can down the road with respect to its reserve funding obligations. This means that future generations of owners will shoulder a disproportionate share of the reserve funding burden. Any reserve study that does not include a percent-funded analysis is of little value for a prospective home buyer who is trying to evaluate the financial health of the HOA before committing to a purchase.
Period of Analysis: The reserve funding process is supposed to generate funds for the major repair and replacement expenses the are expected to occur over the long-term. In this context the phrase “long-term” means exactly that…the long term. It is not appropriate to include incidental maintenance and repair expenses or expenditures which occur every year; and it is not appropriate to include a line item in the reserve budget to pay for insurance deductibles that may result if the the association files an insurance claim. Nor is it appropriate to include annual inspection costs that result in a recurring revenue stream for the reserve study provider. The industry standard as far as the length of time covered by a reserve study is 30 years. Anything less will result in a skewed interpretation of the reserve funding requirements of the association; particularly in the case of an HOA that is more than 10 years old.
Detailed Analysis: Reserve studies are very much a case of garbage in-garbage out. If the study lacks sufficient detail it makes it all that much harder to assess the quality of the analysis. The details that are important to the analysis include component quantities; replacement cost source references; in-service dates; life expectancy estimates and footnotes or comments that provide insight into the analysis. Lack of detail results in a sloppy analysis and is often the kind results one sees with reserve studies prepared by management companies or the board of directors.
Accurate Analysis: If detail is important then accuracy is paramount. It doesn’t do much good to include the square footage of the parking lot if the number isn’t accurate. Nor does it matter much if the analysis includes the unit replacement cost for the roofing or the carpet in the lobby if the cost estimate isn’t accurate. While it is true that no reserve study provider is going to hit the nail on the head with every cost estimate and it isn’t necessary to measure the exact surface area of the roof or the pavement to the square inch, it is important that the numbers are within an acceptable margin of error. Exactly what that margin of error is, will vary depending on a variety of factors but it is reasonable to suggest that the more accurate the estimating process is, the more reliable the reserve study is going to be for all of the uses it is intended to serve.
Complete Analysis: Detail and accuracy are great but if the reserve study does not include major expenditures that are likely to occur within the time period covered by the study then it is of little use in determining the financial stability of the HOA. If the subject property is more than 10 years old the list of components and improvements that are likely to require major repair and replacement spending over a 30 year period will generally include several major expenditures that would not be found in a study that was conducted for a newer HOA. For this reason reserve studies that are conducted for older properties can be much more tedious and time-consuming. If the HOA is not prepared to spend the money to obtain a detailed, accurate and complete analysis, the results of the study are not likely to represent the true reserve funding needs of the association.
Certification of the Analyst: The reserve study business is almost completely unregulated. With the exception of Nevada the only thing anyone needs to be a reserve study provider is a business license and a relatively inexpensive piece of software to generate the reserve studies. In Nevada reserve study providers must register with the state but the process is more akin to obtaining a permit to operate a reserve study business than it is an acknowledgement of the provider’s qualifications. There are two trade organizations that “certify” reserve study providers. The oldest is the Community Associations Institute (CAI) and the second is the Association of Professional Reserve Analysts (APRA). Both organizations offer a certification that is largely based on field experience. Neither requires any sort of verified educational curriculum or testing. Neither is in any way a regulatory body and neither is a truly independent, third-party as both organizations have direct ties to the industry. That being said, it is far better to have a reserve study prepared by a certified provider than to have one prepared by an uncertified, random individual because there is at least a code of professional standards and practices that the certified practitioner is supposed to abide by.
All of these factors combined are what determines the integrity of the analysis. In future installments we will examine each of the elements of a reserve study and why each is important to the integrity of the analysis.