STEPS IN CALCULATING RESERVES
By: Gary Porter
Considerable support exists for the position that an association prepare a reserve study and fund its reserves. This support may be in the form of specific sections of the association's controlling documents, such as it's by-laws and CC&R's, or it may be in the form of state law, such as California's Civil Code Section 1365 or Florida's Administrative Code Section 718. It could also be in the form of case law, such as California's Ravens Cove Townhomes vs. Knuppe Development. Even if none of the above existed, prudent business practices would require that an Association analyze it's reserves and prepare a funding program. An association, even if it is a non-profit organization, is still a business.
Community associations generally are responsible for the repair, maintenance and replacement of their common area facilities regardless of whether title is held in the name of the association or if commonly owned by the members of the association. The association should analyze it's funding needs and set aside adequate funds from its annual budget to meet its long term obligations. This is necessary because the common area facilities of any association age, and, as they age, they will deteriorate. Each of the components of the common area facilities have separate life cycles, and some may never require replacement or major repair. The association is charged with the responsibility of adequately maintaining the common area facilities and, in the author's opinion, this includes providing for a replacement funding program that considers the aging process, anticipates future costs, and provides a method of meeting those future costs.
Preparation of a reserve study permits the association to comply with its obligations. The steps that an association should go through to ensure that it is preparing a thorough study would consist of the items discussed below. The reserve study should be prepared by someone who is competent and capable of preparing the report, and willing to assume responsibility for the accuracy of it.
1) ANALYZE ASSOCIATION DOCUMENTS AND LEGAL REQUIREMENTS. The first step in establishing a reserve study is to analyze the Association documents to determine the exact responsibility of the Association in caring for and maintaining and replacing the common area components. Further, the Board of Directors should look at the statutory legal requirements and the jurisdiction in which the Association resides to see if there are overall considerations regarding the preparation of the reserve study.
2) ESTABLISH RESERVE POLICIES. The Association should establish policies with respect to the items to be included in its reserve study. These policies should be adopted to keep the work of preparing the reserve study to a minimum amount without jeopardizing the funding of the association. Simply stated, the Association should set materiality limits for items to be included in the reserve study. For instance, the purchase of a $50.00 item, whether new or replacement, while it may properly be includable under other criteria, should be excluded from any reserve study on the basis of immateriality. Since a reserve study is a projection, or forecast of future financial events, it necessarily includes assumptions, many of which are very material in nature. The setting of a scope limitation to be included in the reserve study is a necessary step.
3) IDENTIFY, INVENTORY AND MEASURE COMPONENTS. The Association, through examination of its legal documents or the initial budget as filed by the developer with the local Department of Real Estate, should give the preparer of the reserve study excellent guidelines for identifying the common area components of an Association and may also provide extensive measurements of those components. The Association must then decide what level of detail it wishes to disclose in its reserve study. For instance, the Association could simply list swimming pools and provide a blanket reserve or it could break the swimming pool into further component categories which might include periodic acid wash of pool, periodic re-plastering of pool, replacement of pool, replacement of pool equipment, and replacement of pool decking. Further, the preparer of the reserve study must perform a walk-through of the entire complex being alert for components that exist that have not been included in prior reserve studies, and also paying attention to the possibility of hidden components. Hidden components consist of any item that is not readily visible to the preparer (or any other person) that could have a significant impact on the reserve study. Common items which might be considered in this area will include components that were previously excluded due to their estimated remaining life that have now, through the passage of time, fallen within the category of items that should be considered. A second possibility is the much faster than anticipated deterioration of items previously considered to be permanent or lifetime components. Still another possibility is that items never contemplated in the reserve study may become issues with which the Association must deal. An example here would be a sewer line which generally would be estimated to have a life in excess of thirty years, and being buried below ground would not be visible to or considered by the Association. However, if the sewer line were to become broken and overgrown by extensive tree rooting systems thereby requiring replacement, it is likely that the Association must bear the cost of replacing this item even they have not previously reserved for it.
Complete, accurate measurement of all components should be obtained and retained in the files of the reserve study preparer.
4) ASSESS AND INSPECT CURRENT CONDITION. The reserve study preparer must next assess and inspect the current condition of each of the common area components. The preparer may wish to engage a specialist such as a consulting engineer or a contractor in this area to assist in evaluation of the common area components and offer estimates as to their remaining life. The Board of Directors, Association employees and vendors, and the Association property manager, if any, can also be consulted.
5) ESTIMATE TOTAL LIFE, AGE, AND REMAINING LIFE. The Association should always maintain permanent records of the common area components that are acquired by the Association, but should also maintain records of the common area components received from the developer that are not recorded on the books of account. A study should be made of the estimated total lives of these assets, which should then be reduced by their age to determine the estimated remaining life of the asset. This is a crucial factor in preparing an accurate reserve study, and will depend to a large extent upon the maintenance given to the common area components.
6) ESTIMATE RE-PLACEMENT COST. One of the most difficult questions that exists for a reserve study preparer is whether to use current estimated replacement costs, or use inflated costs based upon the anticipated length of time between the present date and the date the component will require replacement.
It would generally be considered prudent to provide for the estimated replacement cost at the anticipated time of replacement. However, the estimated life and change in costs will heavily influence the ultimate estimated replacement cost. A review of the inflation index for the past 30 years demonstrates the wide variations of inflation that may be experienced in a relatively short period of time.
7) CONSIDER VARIABLES, ALTERNATIVES, SUBSTITUTES. One method by which the Association can maintain control over the common area assets is to provide routine maintenance to offset the deterioration process as much as possible. In addition, however, the Association may have to consider substitute products and their impact on cost as well as other alternatives. An example here might be that in certain areas of California where there is damage to a roof, the Association cannot replace the roof with that type of wood roof because it is a violation the fire code. Consequently, an Association in that circumstance would be required to change to a substitute product.
The Association should always be alert for new products and processes that may eliminate or substantially reduce the wear and tear on the Association property. For instance, even though on a single structure with a north and south facing roof, the two sides of the roof are the same age, the southern facing roof in most of the sunbelt states will experience much higher deterioration rates than the north facing roof simply due to increased exposure to the sun. On a wood shingle roof an Association may be able to apply chemical treatments to the roof to enhance its life and thereby prolong the period in which the Association is able to accumulate funds to pay for the replacement of its common area components.
8) FUNDING RESERVES. In developing a funding program, the association should consider the following:
Inflation Assumptions. Inflation assumptions may be built into a table of replacement costs in an attempt to account for the estimated replacement cost at the time the component is scheduled to be replaced. Others hold that the introduction of inflation into a reserve study can be misleading. The author agrees with this standpoint. As long as the reserve study is updated on a regular basis the Association will be forced to reevaluate costs each time, whereas, if an Association is relying upon inflation built into its analysis to anticipate the future increases in replacement costs it may be rudely awakened at a future date. If an individual were preparing a reserve study and applying the inflation theories in the late 1970's they would have to have included assumed inflation rates of approximately 20%, which have long since proved unrealistic. A scant five years later inflation rates dropped down to three percent.
Interest Income. Many Associations accumulate interest income in their reserve funds as a means of either one, accumulating additional funds, or two, attempting to offset the impact of inflation.
Income Taxes. Income taxes of the Association should be recognized and paid out of the fund that has incurred the income tax liability. Therefore, if interest income from reserve cash balances is retained in the reserve or replacement fund, then that fund should be responsible for the payment of taxes on such earnings.
Level or Revolving Funding. Using this method, an Association may for assets with differing life cycles may be able to borrow from one component category on a temporary basis to fund another component category on a temporary basis.