HOA Detective™ – April 22, 2025: As we delve deeper into the mathematics underpinning reserve studies, it’s crucial to understand the two primary funding methodologies employed by most commercial reserve study software:
Cash Flow Funding Model (CFFM): The Cash Flow Funding Model projects future expenses and adjusts reserve contributions to ensure that the reserve fund balance remains above zero over a specified period, typically 20 to 30 years. This method allows for flexibility in contribution amounts, often resulting in lower short-term funding requirements.
Component Funding Method (CFM): The Component Funding Method, also known as the “straight-line” method, calculates reserve contributions based on the individual components’ remaining useful life and replacement costs. This approach aims to accumulate funds proportionally to the actual depreciation of each component, promoting a more equitable distribution of reserve funding responsibilities among unit owners.
The Mathematical Dichotomy: CFFM vs. FFB: The Fully Funded Balance (FFB) metric represents the ideal reserve fund level, calculated by summing the accrued depreciation of all components. While the FFB provides a benchmark for assessing reserve adequacy, its application within the CFFM framework can be misleading. CFFM often results in funding levels below the FFB, potentially obscuring the true financial health of the reserve fund. It is no accident that the FFB formula goes hand in glove with the CFFM as both serve as effective tools that can help to justify faulting reserve planning.
CFFM: Extending the Maintenance Budget: CFFM can be viewed as an extension of the HOA’s annual maintenance budget, projecting expenses beyond the current fiscal year without necessarily aligning contributions with actual component depreciation. This approach may lead to underfunding, as it prioritizes short-term affordability over long-term financial stability.
The Pitfalls of “Kicking the Can Down the Road”: By deferring adequate reserve contributions, CFFM aligns with a “kick the can down the road” strategy, postponing financial obligations to future unit owners. This practice can result in significant funding shortfalls when major repairs or replacements become necessary, leading to special assessments or deferred maintenance.
The “Musical Chairs” of Condominium Ownership: In older condominium buildings utilizing CFFM, new buyers may unknowingly inherit disproportionate reserve funding responsibilities. As early owners sell and exit the community, remaining and incoming residents are left to address the accumulated underfunding, akin to a game of “musical chairs” where the last ones standing bear the heaviest burden.
At which point does the lack of reserves in a 20-year-old condominium impact the market value of the units when the first generation of owners decide to sell?
In older condominium communities, particularly those employing the Cash Flow Funding Model (CFFM) for reserve accumulation, several conditions can detract from the market value of individual units:
- Increased Special Assessments: Underfunded reserves often necessitate unexpected special assessments to cover major repairs or replacements. These unplanned expenses can be substantial, placing a financial strain on current owners and deterring potential buyers concerned about future liabilities.
- Deferred Maintenance: Insufficient reserve funds may lead to postponed maintenance projects, resulting in visible deterioration of common areas. This neglect can diminish the property’s overall appeal and perceived value, making units less attractive in the real estate market.
https://welchllp.com/insights/knowledge/condominiums-value-reserve-fund
- Financing Challenges: Lenders often scrutinize the financial health of condominium associations. Associations with low reserve funding levels may face difficulties securing financing, and prospective buyers might encounter obstacles obtaining mortgages for units within such communities.
- Market Perception: Properties with underfunded reserves can develop a reputation for financial instability. This perception can lead to decreased buyer interest and lower resale values, as informed buyers may anticipate future financial burdens associated with ownership.
https://clarksimsonmiller.com/underfunded-hoa-reserves/
- Regulatory Compliance Risks: In regions where laws mandate adequate reserve funding, associations failing to comply may face legal consequences. Non-compliance can result in fines, forced assessments, or other penalties, further impacting the financial standing and desirability of the property.
These factors underscore the importance of proactive and adequate reserve funding strategies. Potential buyers and current owners should be vigilant in assessing the financial practices of condominium associations to safeguard their investments.
Because You’re Buying More Than a Home!
