A Tale of Two Reserve Studies

One of the things that we advise all of our clients is that a homeowner association’s financial situation can change quickly. Hence, it cannot be assumed that just because an Association received a relatively positive review from CIDA’s examiners it will always be a fiscally sound, well run organization. A second piece of advice that has been been the closing paragraph of virtually every CRC and CIDA Report that has ever left our office is that it is almost always in the best interest of a buyer to become involved in the governance of the Association in an effort to ensure that the financial stability of the HOA improves moving forward.

Unfortunately this last piece of advice appears to go largely unheeded, no doubt because most new home owners are busy with work, careers, family and the like and it can prove to be a challenge to find the time to serve on the Board of Directors. We suspect that this is one of the reasons why we often find that people who do serve on HOA Boards are older and many times retired. Older homeowners also tend to stay in a home longer whereas younger buyers, and especially first-time buyers, are often upwardly mobile, career oriented individuals who may own a home only a few years before selling it.

In any event, the story that the HOA Detective is going to share here, one that he calls The Tale of Two Reserve Studies, speaks directly to both of these issues. Not only does the story involve two reserve studies it also involves two condominium associations. The condominiums share a number of important similarities which make them a useful subject for a case study of what can go wrong when an Association falls down on the job of reserve planning and perhaps most astonishing, how quickly things can go awry.

Our story begins in 2015 and 2016 when CIDA’s predecessor Capital Reserve Consultants was asked to conduct a due diligence examination for two buyers. The first buyer contacted CRC in July of 2015 after making an offer to purchase a condominium in an 8 year old, five-story building that contained 49 residential condominiums and 1 commercial condominium unit. The second buyer contacted CRC in June 2016 after her offer on a condominium unit in an 18 year old, five-story condominium building that contained 53 residential units and 7 commercial/retail condominiums had been accepted.

The sellers in each transaction provided the buyers with reserve studies that had been prepared by the same firm, a large engineering consultant that specializes in providing engineering, inspection and reserve planning services to condominium associations. In the case of the 2015 engagement the reserve study that the Association provided was already two years old. As is often the case, it was as close as we could get to a current reserve study and after consulting with the buyer it was decided that we would move forward with the due diligence examination using the information that we had.

The 2016 buyer was somewhat more fortunate in that she was at least been provided with a copy of what we refer to as a current reserve study; which means that the study contained a thirty-year reserve spending and funding projection that began on the first day of the current budget cycle, which for purposes of reference was January 1, 2016. Whereas the reserve study that was provided to the buyer involved in the 2015 transaction was not current because the thirty year projection began on January 1, 2013 as opposed to January 1st of the year in which the buyer was purchasing the condominium…small details no doubt, but important none-the-less.

The results of both the 2015 and 2016 examinations were relatively positive, with the first Association receiving a CRC Score (CIDA Score) of 65 while the Association that was examined in 2016 received a score of 61. While these may not seem like particularly good scores when the potential exists to receive a score of 100, the fact is that the average and median CIDA Scores have never been as high as 65 and even the 61 that the Association received in 2016 was slightly above average at the time.

What is significant about our story is what has happened in the last two weeks at the CIDA world headquarters, which is that two new buyers have engaged the services of CIDA to examine these same two condominium associations for a second time. So to summarize, the first of these two Associations was examined by CIDA in July 2015 and for a second time in May of 2018. The second was examined for the first time in June of 2016 and again in May of 2018.

Fast-forward to 2018 and we now have two newer reserve studies which were again prepared by the same firm, which is also the firm that prepared the previous reserve studies that CIDA reviewed during the previous examination….and that’s when things really start to get interesting.

For purposes of clarity we will refer to the Association that was first examined in 2015 as Association A and the subject of the 2016 examination as Association B. So, here’s how things shake out:

In 2015 Association A provided an outdated reserve study to a prospective buyer that painted a  picture of an organization with a  well-funded reserve account, although the fund balance was only $342K at the time, the Association was a newer facility that wasn’t really old enough to require much in the way of major renovation, much less replacement of any major common area improvements. The annual reserve contribution at the time (2015) was slightly more than $112K while the percent funded levels were above 50% and projected to increase each year, eventually topping out at 97% in the last year of the funding projection. Meanwhile, the year-end reserve fund balance was projected to be at least $369K and by 2018 the minimum fund balance would exceed $500K and was projected to remain above this level for the remaining years covered by the reserve study.

Moving forward to 2016 we found Association B to be in possession of a current reserve study which, while not as robust in terms of the recommended reserve funding strategy, was still a funding projection that appeared relatively sound and responsible, at least on the surface. One of the problems with Association B and its reserve study was that, even though it was a current study and had been prepared by the same provider that had conducted the reserve study for Association A, the study that was provided by Association B in 2016 did not include a percent funded analysis. However, it did project that the reserve fund balance in all years after 2016 would be at least $150K and by 2025 the year-end fund balance was projected to be almost $600K, and to never drop below that level for the remaining years covered by the study.

Considering that Association B was already 18 years old and would soon be moving into that critical phase in its life cycle where it was approaching the tipping point of 25 years, it was all the more important to build a solid financial foundation that included adequate reserves. It appeared, at the time, that the Board had some grasp of the importance of increasing the reserve funding and the 2016 reserve study was the strategy that would be employed to make this happen.

Association B’s reserve fund balance at the beginning of 2016 had been only $66K which had prompted the need for a small special assessment of $23K in 2016, which in turn had prompted CIDA’s examiner to advise our buyer that the Association’s reserves had been underfunded in the past and that funding would need to increase significantly if the organization was to avoid the negative effects of an underfunded reserve account as it approached the 25 year milestone in the life cycle of the facility.

In Part II of this series we will reveal the outcome of the more recent 2018 examinations of these two Associations and as you may have figured out, it is not a pretty picture…

 

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