HOA Reserve Funds: Common Questions and Best Practices
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HOA reserve funds are designated sums of money set aside for future expenses, such as building repairs or replacements. It's important for HOAs to have a healthy reserve fund in order to prevent unexpected financial burdens on individual homeowners. The size of the reserve fund should be determined by a study known as a reserve study, where an outside professional assesses the current condition and projected future costs of common area assets. To ensure the HOA's reserve fund remains healthy, it's important for the board to regularly review and update the reserve study, as well as establish a budget that sets aside enough funds each year to cover expected expenses. Overall, having a solid reserve fund allows the board to maintain the community's property values and provide a comfortable living experience for all homeowners.
What Percent Should HOA Reserves Be Funded?
HOA reserves should be funded as close to 100% as possible for its “ideal funding level”. The ideal funding level represents the funds an association has stored to replace reserve components as they are due over time. For instance, if an association has 75% of its ideal funding level, they can only replace 75% of their reserve components as they become due. The further away from 100% you are, the more likely your HOA will need a special assessment to make up the difference. Reserves that are funded at 70% or above are not in danger of a special assessment. As you drop below 70%, a special assessment becomes increasingly likely; however, for reserves that fall at 30% or lower, a special assessment will almost assuredly be needed.
The key to avoiding a special assessment is to set aside adequate reserves on an ongoing basis. But how much is enough for your association?
Robert Nordlund, the founder and CEO of Association Reserves, explained that determining a reserve fund percentage is "relative" to your specific association needs because it requires a comparison of the reserve fund size and the reserve requirements size. A ratio known as "percent funded" is used to find the reserve fund percentage by comparing how the current reserve fund balance matches up to the association's reserve needs (also known as the fully funded balance).1 By design, a reserve account grows over time through regular funding from a percentage of your assessments.
What Can HOA Reserve Funds Be Used For?
HOA reserve funds can be used to pay for the replacement of a reserve component or asset that is already in existence, such as replacing asphalt streets. You cannot use reserve funds to pay for the creation of something new like building a playground where one did not previously exist. Essentially, HOA reserve funds protect the stability of your association’s finances from naturally irregular, yet predictable, future expenditures for the replacement of reserve components.
The funds in your HOA reserve account should not be used for maintenance. In other words, reserve funds are used to pay for the replacement of a reserve component, not to offset on-going deterioration. Oftentimes, boards think of reserves as a general savings account; however, that is not the case. Reserves are for reserves only, not for capital improvements or routine maintenance.
The Reserve Study: A Living, Breathing Component of Your Success
A reserve study assists with an association's long-term financial plan by considering the current status of the reserve fund and determining a regular funding contribution that will allow you to replace reserve components as needed. This study comprises two things - a comprehensive physical analysis of the current condition of your community's assets and detailed financial analysis.
Your community's reserves are important for ensuring that common-area assets like clubhouses, lobbies, and pool areas can continue to serve their function. A reserve study specialist will assess the condition of these areas in your community with an eye towards identifying future replacement costs and will recommending how much should be contributed annually so you have funds available when they're needed most!
It is essential to treat your reserve study as a living, breathing document that should be regularly reviewed and updated annually, in compliance with California Civil Code 5550. It is important to remember that a reserve study only serves as a budgeting guide for current and future boards to use; however, ultimately, your board has the power to adjust wherever you see fit.
“For example, your reserve study may indicate that a roof should be replaced in 30 years. If you are 28 years in, it still is in great condition, and you've done all the preventive maintenance, inform your reserve analyst that you believe the remaining life of the roofs can be extended because of the routine maintenance that you have done to your roofs over the years. If your reserve analyst agrees that the life can be extended, you can decide to get another few years out of it and adjust that component accordingly in the study." - David Rainer, vice president of community management at FirstService Residential.
Important! FirstService Residential recommends conducting regular reserve study reviews and on-site inspections with reserve and engineering specialists to ensure that you're not missing any new developments or crucial upgrades.
What is the biggest (and common) reserve blunder? Watch a quick video clip below to hear what Kirk Kowieski, vice president at FirstService Residential, said.
Determining Maintenance Vs. Reserve Components
Properly categorizing your community's common area components is one of the challenges that come with managing reserves. For example, some items will require regular maintenance, such as pressure washing sidewalks and window cleaning whereas others, such as infrastructure items like roofs and mechanical equipment, will need to be replaced as time passes. It's important to know the difference between maintenance and replacement costs. Maintenance items can be done on a regular basis and are included in your annual operating budget. On the other hand, replacements will require additional funds from HOA reserve funds so that their expense is postponed over time. This way you don't get stuck paying full price twice: once during installation and once again in the future.
More and more associations, especially communities that are decades old, are starting to address infrastructure components as part of their budget planning process. As associations address the need for infrastructure components in their budget planning process, it is important to include those items that will last a very long time and may not be seen as often - like roofs or asphalt. A good practice to follow is to add infrastructure items to your reserve components list when their eventual replacement becomes reasonably predictable.
Every component has a useful life given to it by the manufacturer. "Useful life" refers to the length of time that a component serves its original purpose. While the manufacturer may estimate the expected useful life of a component to be a particular number of years, many factors can affect that estimate, such as environmental effects, wear and tear, revised regulations or obsolescence. Inadequate maintenance will reduce a component's useful life. As a result, the component will need to be replaced much sooner – usually before the association has set aside enough money in its reserve fund.
Did you know? There are several ways to test the useful life of a component, including vibration analysis, thermal imaging, laser shaft alignment, trends analysis, and oil sampling and analysis. Work with your management company and engineer or maintenance team to explore these options and more.
Ultimately, your board should aim to budget appropriately for costs that you may not have anticipated to avoid the risk of imposing a special assessment or taking out a loan. If you need help determining whether an item should be included in your operating budget or reserve inventory, consult with your reserve study specialist or management company.
What other assets and components are commonly missed? Fill out the form on this page to get a complimentary guide, 6 Reserve Fund Regrets to Avoid.
Your community's property values will always be a top priority for any board and staff. The best way to ensure that you're meeting everyone’s needs, while also maintaining pride in your neighborhood is to have fully funded reserves!
A well-prepared reserve study with key details about each unit ready at all times can help keep things running smoothly during difficult times. So, when life does happen – whether good or bad! – you won't have worry as much because there is enough money set aside in your HOA reserve funds.
Nordlund, Robert. 2011. "What Exactly is Percent Funded?". Reservestudy.Com. https://www.reservestudy.com/resource/article/what-exactly-is-percent-funded/