The Fourth Wave – Condo Finances

Condominium living offers many benefits and has become a very popular form of housing.  Those choosing to become condominium owners understand that they will pay a monthly fee responsible for funding both day-to-day operating costs as well as future major repairs and replacements (known as a reserve fund).  The intent when determining this fee is that if monthly assessments are set at an appropriate level, special assessments and bank loans will be avoided.  In my 35 years as a reserve professional, however, I have observed a very different reality.

The impact of inflation alone is enough to constantly increase operating costs and reserve funding requirements. In addition, observable trends in multiple associations over the years have indicated there are often four specific, predictable events that create “waves” of increased assessments or special assessments. While they won’t affect every association, history has shown that they will affect many.  The fourth wave is the biggest and, because it hits so long after the association’s construction, most original owners aren’t affected; instead, secondary owners feel the full impact. So, what are these four waves? 

The first wave can occur relatively early in the life of the association if developers set initial monthly assessments at the lowest possible level. This virtually guarantees significant short-term increases.  Assessments must often be raised to cover increased operating expenses and reserve funding.  Occasionally, they are often also necessary because members demand increased services such as on-site management, maintenance staff, better service providers, etc.

The second wave generally hits at about the 10-year mark.  This is often when large reserve expenses begin to occur, such as exterior building paint, asphalt treatments, pool resurfacing, carpet replacement, etc.  The scope of these costs are often unexpected for several reasons: estimated repair and replacement costs were set too low; no reserve study was ever performed; reserve assessments were kept artificially low due to developer transition; or reserve funds were diverted to the operating budget without raising the homeowner’s dues over recurring years. 

The third wave generally hits at about the 30-year mark. This occurs when an unfortunate confluence of events takes place: roofing needs replacement, exterior painting is required, and asphalt needs either a significant overlay or complete removal and replacement.  This is what is called a peak expenditure year.  When significant, large expenses do not all occur in the same year but occur close together, the process is referred to as a peak expenditure event (usually occurring over multiple years for communities aged 25 to 30 years).  The big-ticket items listed below are the ones that most associations will encounter in the third wave:

• Roofing – Depending on roof type and material, costs often range from $4,000 to $25,000 per unit, and life generally ranges from 15 to 50 years, with the majority of roofing types not exceeding 30 years.
• Siding Replacement – Some siding types may never require replacement and may be considered “lifetime components,” meaning they will last as long as the building structure. There are too many different siding materials to discuss here, and each has significant variations in life and cost.  In my experience, wood siding has the worst combination of both short lifespan and high replacement cost, but it is a widely-used product because of its aesthetic characteristics.
• Painting – Depending on underlying surface, paint quality, climate, and proximity to salt air, the lifespan of paint can vary significantly. Most associations adopt painting cycles ranging from five to 15 years.
• Asphalt – Depending on original construction quality, climate, and traffic conditions, the life of road surfaces can vary significantly. Even with interim maintenance such as slurry seal and overlay, most asphalt surfaces will require a complete replacement approximately every 30 years.
• High-Rise Associations – Additional expenses to factor in include elevators, HVAC equipment, plumbing equipment, lobby remodels, interior hallways, lighting, and fire safety equipment.

The fourth wave generally comes as a complete shock to homeowners because 1) (almost) nobody plans for it,  2) most reserve preparers ignore it, and 3) it generally includes the most expensive components in any condominium project.  What are they?  The roof, paint, siding and paving are not actually the most expensive components; instead, the pipes and utilities inside your walls are.  Natural gas piping is less likely to fail and most electrical systems are replaced only if the walls are already open for another purpose, but domestic water and wastewater pipes, vent pipes, water mains from the street, irrigation mains and lateral lines, and sewer mains to the street all fail over time.  These are the most expensive components requiring replacement in virtually every condominium project.  It is extremely rare to see funding in a reserve study for these items, or to hear any mention that they exist through disclosures educating residents about these potential major future expenses. 

When are these costs likely to occur?  Engineers have testified in construction defect cases that the above utilities have a life range of 40 to 60 years; nominally, we tend to assume life expectancies of 50 years for planning purposes.  Therefore, if you’re living in a 50-year-old condominium that has not yet replaced these components, it’s prudent to investigate the current condition of your in-wall and subterranean utility lines.

There are two reasons these costs are normally not funded: standards and cost.

Standards - Most reserve specialists are following the National Reserve Study Standards established by trade organizations which allow them to ignore the most expensive component in a condominium project.  These standards even recommend that utilities be excluded until “a history of repairs exists,” and do not require disclosure of this omission.  Unfortunately, since these particular components have such a long life, by the time a history of repairs exists, it’s too late.  In contrast, our reserve study company follows the International Capital Budgeting Institute’s (ICBI) Generally Accepted Reserve Study Standards, which require either inclusion of these components or disclosure of their omission.  It’s critically important for industry trade organizations to recognize this major deficiency in disclosures to condominium owners.  Standards matter. 

Cost - On the low end, ignoring inflation, cost works out to $25 per month for fifty years. ($300 annually for 50 years is $15,000.)  It’s very difficult to convince anyone to pay $25 per month for 50 years.  Therefore, this particular item virtually always becomes a special assessment issue.  I’m not advocating that every association should be funding for this future cost, but in our reserve study reports we do insist that a disclosure is included so members are aware of the obligation if it is not being funded.

Except for those prepared by our company, I have never seen these components included in any reserve study unless the components had already started to fail.  Only once have I ever seen another company disclose the maintenance obligation, indicating it was not included in the study.  If these components are included in a reserve study only once they start to fail, it’s about 50 years too late. Disclosure of the obligation without funding for it should be the norm, as it is virtually impossible to get members to agree to a budget that has them paying that much money for that period of time, especially when many of those people will no longer be members of the condominium when the cost is incurred.

Of the more than 1,000 association clients represented by our reserve study company, only five have actually funded for utilities replacement starting when the condominium was constructed.  I have personally worked with 12 associations that have had to either completely or partially replace their in-wall and under slab utilities.  Costs have ranged from $15,000 to $50,000 per unit, resulting in special assessments.  These projects were in 35 to 60-year-old associations. 

The very large numbers of condominium associations that were constructed in the 1970s and 1980s are now reaching that 40 to 50-year age when these components begin to fail.  I anticipate that we’re going to be seeing many more associations faced with these large costs in coming years.  This will not be a wave; it will be a tsunami. Most of these associations will not be prepared for such unanticipated major costs, especially when many are not even well enough funded for their known reserve projects. 

Many associations have been relying on the wrong metric to determine the adequacy of their reserve funding, relying exclusively on “percent funded.”  Many reserve preparers promote this simplistic concept as the best means of determining the adequacy of reserve funding, which only serves to add to the confusion of funding for an aging community. The percent funded concept is a clumsy simplification that can be dangerous because people place so much importance on it without even knowing if it is an accurate calculation. (Unfortunately, in many cases it is not.) Many people have been indoctrinated to assume that if an association is 70% funded, it has a “strong” reserve fund, which virtually eliminates the possibility of a special assessment. 

While we generally disclose percent funded when our clients request it, we hesitate to place any emphasis on percent funded, as we have seen an association only 30% funded that never required a special assessment, and another that was 88% funded that needed an immediate special assessment.  A cash flow analysis is a much more reliable tool in analyzing a funding plan. Percent funded works only if all significant components are included in the reserve study, if it is properly calculated, and if it considers peak expenditure events.

Accurate planning is the answer to avoiding problems. Always remember, you can’t reserve for what you can’t see…in your report. Your “hidden” components still exist, and the replacement cost, if not properly budgeted, can lead to a political and financial disaster in your community.

Gary Porter, RS, FMP, CPA

Facilities Advisors International

www.reservestudyusa.com

This email address is being protected from spambots. You need JavaScript enabled to view it.

(877) 304-6700

Gary Porter served as CAI’s national president (1998-99), and is coauthor of CPA’s Guide to Homeowners Associations and Reserve Studies – The Complete Guide.  He is also President of the International Capital Budgeting Institute.  As a Facilities Management Professional (FMP), an experienced valuation consultant, and a CPA, he has the multidisciplinary training critical for the reserve study process.

Reserve Studies - The Complete Guide

Gary Porter and Pierre Del Rosario, the principals of Facilities Advisors International LLC, are the authors of "Reserve Studies - The Complete Guide."  This Guide, published in October 2015, is the most comprehensive analysis of the reserve study process ever compiled.

The guide is available as an Adobe document at HOA Pulse.

The table of contents is:

While some reserve professionals place great reliance on the percent funded calulation as an indicator of the "strength" of the reserve fund, we believe that this approach is both too simplistic and based upon assumptions about how the percent funded calculation is made. 

Many of these individuals continually state that if you're 70% funded, that is considered a strong level and you generally won't have any problems.     The fact is, everyone overlooks the word "generally" and the common misconception is that 70% funded is perfectly acceptable.  In some cases it may be, but it overlooks a common problem we see. "Peak expenditure year" is a concept that we developed that provides a far clearer picture of the future.  Not all associations have a peak expenditure year, but many do.  The concept is that in certain years, multiple high cost components replacement cycles converge, thus creating a "peak" in expenditures.  In extreme cases, if the association is anything less than 100% funded, it's looking at a special assessment.  We've also seen example of associations that are only 30% funded and are still able to take care of their future expenditures without a special assessment.

What is more disturbing is the fact that, other than our company, no one is disclosing HOW they calculate percent funded.  Even many reserve professionals believe that there is only one way to make this calculation, which is to divide the reserve money available (the numerator) by the calculated "100% funded balance" (the denominator).  Even assuming the most simple case for calculating the money available (it really should be "net financial resources available"), it is the denominator, the 100% funded amount, that causes the problem, because there are four different methods of making that calculation:

Current cost method

Inflation adjusted cost method

Avergae cost method

Future cost method.

The current cost method, although part of California statutes, is the worst choice of the four, as it is guaranteed to result in underfunding.  Using the current cost method, the ideal contribution for each year of the 30-year funding period would be the same, until a new current cost is established. Based on the above assumptions, using the current cost concept means that, if an association were 100% funded and remained that way each year, current association members would NOT be paying assessments based on inflated costs, and the association would end up being underfunded. Current members would not be paying the full cost of the time decay of components, the amount that they have “consumed.” This is not fair to future members, as the underpayment burden is passed on to them.

The average cost method, depending on how it is used, can most closely approximate the inflation adjusted method, which clearly is the only method that can be demonstrated to provide accurate calculations for future years.  The biggest problem with using this method is that those few using it also use an average of each given year, meaning the calculation is not tied to the beginning or ending balance, but an average of the tw.  That means the percent funded number calculated can't be tied to any financial reports.  As such, it is a meaningless number.

The future cost method is also not considered a good choice, as it results in reporting lower than actual percent funded amounts, thereby shifting assessments from future members to current members. This concept correctly applies inflation, but then incorrectly requires that you use the inflated cost for the current period 100% percent funded calculation. Since an exact definition of application of future cost calculations is not made in any state statute, anyone making a future cost percent funded calculation must also make some assumptions. For instance, is future cost the inflated cost at the first replacement cycle? Or is it the inflated cost at the end of the -30year funding study period? Future cost method calculates future total inflated costs and then averages that future cost back to all prior periods, including the start date of the study. This method is used commonly by some reserve preparers.

The inflation adjusted cost method is the only method that can be supported logically, and is the method specified by the International Capital Budgeting Institute as complying with Generally Accepted Reserve Study Standards.  This concept assumes that current cost is used for the current period only (first day of the 30-year funding period), and that future replacement costs are inflated annually for purposes of the percent funded calculation. This gives you the same calculation as the current cost method for the current date, and accounts for the effects of inflation so that future costs are properly stated. Current members are always being assessed based on the “then” current cost. This cost concept is fair for all members, both current and future. Inflation adjusted cost method uses current cost for the start date of the study, and the pro-rata future cost based on EACH year of the study, not the total cost at the end of the study. That is the method used by us in our reports, and is the method mandated by ICBI in Generally Accepted Reserve Study Principles.

"Pay me now or pay me more later."  I don't know who coined that phrase, but I’ve heard it repeated often. In my 30 years as a reserve professional I have seen the truth of that phrase demonstrated time and time again.

In many condominium developments, a few components are so large and account for such a significant portion of the reserve budget, that any remaining components can seem insignificant. The big-ticket items that seem to be universal are roofing, painting, and paving. And, yes, I have seen many examples of associations where fencing, swimming pool, landscaping, clubhouses, and fitness equipment are also significant items. But, the big three - roofing, painting and paving - make up the largest portion of the reserve budget for the majority of condominium associations.

These three components also share one feature: water is their enemy. There is no place that is more true than on the roof. Many associations will “slap a roof up” knowing that they've got a 25 or 30 - year warranty on it, and never think about it again for 25 or 30 years. Bad move. The roof should be inspected annually for any indication that things are not going as planned. The type of inspection will vary depending upon the type of roofing material that you have and whether or not you have a flat roof or a pitched roof.

Assuming you have an asphalt composition shingle roof (probably the most common roofing material in the country), your inspection will start with looking for any loose, torn, or missing shingles. If the roof was installed properly the overlay of shingles along with proper flashing and gutters should divert water away from the building. One of the most vulnerable areas of the roof is the shingles at the roof peak. Sometimes just replacing the cap shingles alone can extend the life of the entire roof by several years.

Any piercings of the roof membrane provides an opportunity for water to go where it doesn't belong. These areas should be inspected and re-sealed as necessary to avoid water intrusion. Also remove any debris that has built up on the roof. A simple guideline is that you shouldn't have plants growing in the built-up debris on your roof.

Inspect the rain gutters. You should clean up any debris in the gutter system that has built up including, leaves, twigs, or any other waste material that can stop water from draining properly. Tree limbs hanging directly above the roof should be trimmed back to avoid or reduce leaves and twigs and branches that can fall on the roof causing damage. Also check the gutters to see if any shingle granules are making their way into the gutters or onto the driveway. This is an indication that the roofing material may be failing.

Check the inside of structures for any leak stains on the ceiling. Since water can travel a long ways from where the leak is to the ceiling where it can be observed, it doesn't necessarily mean that the leak is directly above water stains on the ceiling. When you see water stains on the ceiling it is time to call a roofing expert to help you diagnose the problem.

Also, if you notice that your roof appears to be sagging at all, it's time to call an expert. If you’re going to hire a contractor to repair or replace your roof, check their credentials.  Also seek advice as to whether or not you should engage a roofing consultant who is not the contractor that would be performing the work. Often the work on your roof can entail hiring several different contractors.  Most board members don't have the expertise to make this determination.

Review your roof’s age and warranty to make sure you replace it on time. Trying to extend the life of your roof by a few extra years could end up costing you more money if you have to make numerous minor repairs in between or if you suffer water damage as a result of inadequate maintenance.

Remember, as we said at the start, pay me now or pay me more later.

This article was originally published at HOA Pulse in May 2013