What is reserve planning and why is it important to the sustainability of a homeowner association (HOA)?
Most people who purchase homes in HOAs have no idea what a reserve study is, or why it is important. 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.
As of the beginning of 2018 fewer than 20 states require HOAs to conduct reserve studies and even fewer require the reserve account to actually be funded according to the recommendations of the reserve study provider. Typically, state laws task the Board of Directors with the responsibility for ensuring that the reserves are adequate or sufficient to meet the reserve spending obligations of the Association, but generally stop short of defining exactly what an adequate level of funding may be. The majority of states do not require HOAs to conduct a reserve study or to fund, or even maintain, a reserve account.
In states that do mandate some sort of reserve planning and/or funding it is common for the law to require that the funds be warehoused in FDIC-insured bank accounts or in some form of government guaranteed securities such as treasury bonds. Most statutes also restrict the Board’s ability to spend the reserves by requiring that the funds only be used to pay for expenses that are identified as reserve funding expenditures in the reserve study.
This means the Board isn’t allowed to spend the reserves on anything they choose to spend them on…at least not in theory. However, many states allow the Board to “borrow” funds from the reserve account with varying degrees of oversight in terms of how the borrowing is documented and how long a period of time the Association can take to pay the funds back. Once the funds are borrowed the Board is then free to spend the money to pay for expenses that are not classified as reserve fund expenditures.
What is significant about almost all state statutes is that they generally contain little, if any enforcement language in the wording of the law. As a result these statutes often have a minimal impact on HOA governance since the consequences of non-compliance are relatively minor.
Before we go any further we need to establish exactly what we mean by the term reserves. In the lexicon of reserve study professionals the term “replacement reserves” refers to funds which are set aside to pay for the maintenance, repair and replacement of specific assets that are owned in common by all members of the HOA. In this context the reserves are not a slush fund that may be used for all manner of maintenance and replacement expenses.
The American Institute of Certified Public Accountants (AICPA) has taken the position that the use of the term reserves when referring to the funds that are earmarked for replacement of commonly owned assets 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.”
It is true that many HOAs maintain 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.
In spite of the AICPA’s position on the subject the industry continues to use the term reserves, or replacement reserves, to refer to those funds that are set aside to pay for maintenance, repair and replacement of commonly owned assets.
Purpose of Reserve Planning
The objective of the reserve funding analysis (reserve study) is to determine what the future reserve spending obligations of the Association are going to be in order to ascertain what the reserve funding requirements will be. The spending analysis is used to develop a projection of future reserve spending which is then used to prepare a schedule showing how much money will need to be contributed to the reserve fund each year in order to generate sufficient funds to pay for the future reserve expenditures. The outcome of the reserve planning exercise is a long-term budget that is similar in many respects to the capital budgeting process that businesses and institutional entities use to forecast future spending (and funding) needs.
The future expenditures that are established by the reserve spending analysis are a form of implied liability, since the analysis implies that the Association will need to spend this money at some point in the future. The purpose of the reserve study is to create a structured plan that formalizes the Association’s obligations with respect to maintaining the common area improvements within the community, most importantly, the financial cost of doing so.
The financial burden that results from the obligation to maintain the common areas is a future or forward liability of the Association. Because each owner is obligated to pay for a portion of the Association’s debts and operating expenses, the forward liability that is established by the reserve funding analysis results in a future liability for each member of the HOA, assuming the Board of Directors formally approves the reserve study as the basis for funding the reserve account.
Purpose of Reserve Funds
The replacement reserves serve two purposes. One is, obviously, to pay for the maintenance, repair and replacement of the commonly owned assets within the community. The second is not so obvious and frankly is often overlooked by many HOA Boards.
When the accumulation of replacement reserves is consistent, and in keeping with the rate at which all of the commonly owned assets are depreciating, then the accumulated reserves serve to offset the loss in value that occurs as the assets depreciates. Since the value of the homes within the community are to some extent dependent on the condition of the commonly owned assets it can be argued that the accumulation of reserves helps preserve the value of the individual homes as well as the community as a whole.
In the case of condominiums and other attached housing schemes it is particularly important to accumulate replacement reserves at a rate that is more or less consistent with the rate at which the various building components are wearing out.
If the roof on a condominium building is 20 years old and has reached the end of its service life it does not contribute to the monetary value of the units within the building. If a buyer (or a mortgage lender) is smart enough to realize that the building needs a new roof then they have every right to expect the price of the unit to be discounted to offset the cost of replacing the roof.
On the other hand, if the accumulated reserves are sufficient to pay for replacing the roof, and the Association has a clearly delineated plan confirming that some portion of the reserve funds is earmarked to pay for replacement of the roof, then the value of the condominiums in the building is not adversely affected.
The impact of worn out building components like roofing,windows and siding is much more immediate and direct than the impact of having an outdated, 30 year-old clubhouse located in your community.
It’s not that the clubhouse isn’t an asset or that the Association shouldn’t be reserving money to pay for the maintenance and renovation of the building, but the impact of a worn out roof is something that will affect every condominium unit that is protected by the roof. Whereas an aging clubhouse building may be of little concern to a buyer who doesn’t plan to make use of the facility.
The goal of offsetting the value of community-owned assets that is lost through depreciation, by accumulating reserves to pay for the eventual replacement of the assets, is one of the primary objectives of the reserve planning process. Over the years the connection between funding the reserves at a rate that is commensurate with the rate at which the assets depreciate has been steadily weakened due to something call cash flow funding…
In our next post on this topic we will address the concept of cash flow funding and how it undermines one of the most important objectives of the reserve planning process.