Association Reserves: Beyond the Basics and Maximizing Funds
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"Save for a rainy day" – it's a classic idiom, but it still rings true in all aspects, especially when it comes to your association's reserve funds. However, a rainy day will be the least of your concerns if your community requires a special assessment for a leaky roof that your board and management company didn't adequately prepare for.
Building and securing a long-term budget while maintaining the association's property values are two expectations of board members that go into a thriving community. You can do this while operating on a structured budget with a solid reserve fund and reserve study. By working with your management partner and reserve specialist to adequately fund your reserves, your association can avoid (as much as possible) imposing special assessments. But first, let's go back to the basics and define a reserve fund and study.
A reserve fund is a community savings account that offsets ongoing deterioration – protecting the stability of your association’s finances from naturally irregular yet predictable future expenditures. By design, a reserve account grows over time through regular funding from a percentage of your assessments.
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 offset ongoing wear and tear. The reserve study comprises two things - a comprehensive physical analysis of the current condition of your community's assets and detailed financial analysis.
What Is Percent Funded and How Much Is Enough?
The key to avoiding a surprise special assessment is to set aside adequate reserves on an ongoing basis. But how much is enough?
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
Percent Funded = Reserve Fund Balance (actual) / Fully Funded Balance (computed)
If your percent funded percentage is 30% or less, your reserves are considered "low," and if it is 70% or more, it is considered "high" and exactly where you want to be. For further explanation and an example, watch a quick video from Kirk Kowieski, vice president at FirstService Residential.
What are the Benefits of Having a Strong Reserve Fund?
While the recommended percentage for a fully funded reserve is 70% or higher, your board and management team are responsible for spending it wisely on projects that benefit the community in the short- and long term. Here are three distinct benefits that residents and board members can expect:
Peace of mind: A reserve fund gives association members greater confidence and comfort in knowing the money will be there when it is needed.
Market value preservation: If your community has a strong reserve fund for support, the market value of shared assets and properties could be preserved (or potentially increase). Just like all the good things in life, the higher the value, the better chance at resell.
Equitable cost participation: You can take pride in your neighborhood and know that you've contributed to the shared amenities that many generations to come will benefit from, including your children or family!
Ultimately, having a strong reserve fund allows your association to go beyond the minimal maintenance and repair, allowing your community to attract more potential buyers. Future homeowners often research an association's financial strength and reserve funding to find their potential home's property values before deciding to purchase.
How Can Incremental Assessment Increases Benefit Reserves?
Contributing to your reserves is not as easy as it sounds because it's an indefinite goal that often requires more funding each year. Naturally, most boards want to avoid being the "bad guys" that raise assessments. As a result, roughly 72% of associations have underfunded reserves,2 so many require special assessments when a last-minute project arises, or alternative options (like the one below) don't pan out.
"Associations run into the risk of miscalculating assets while trying to figure out their reserve fund budget. For example, if boards tried to save on reserve fund contributions by requiring every homeowner to manage their own garage door, sure, their monthly contributions will be less, but they have to pay out of their pocket for the door. Also, the association's property values will go down tremendously due to a few negligent homeowners or those who don't care to upkeep their garage door." - Robert Nordlund, Founder and CEO of Association Reserves
So, what is the best way to increase assessments? Nordlund recommends that most associations follow the "$10 solution," which requires each homeowner to pay an additional $10 a month to the reserve contributions and increase it by $10 every year. To learn more about incremental assessment increases, read our latest article, Inflation, Insurance and "In Case Of…": Why to Consider Raising HOA Assessments.
A good association management company will offer sound guidance on establishing, maintaining, and maximizing your reserves' funding. FirstService Residential provides this essential support to the communities we serve so that associations are empowered to create successful, long-term financial plans.
Determining Maintenance Vs. Reserve Components
Deciding whether items require maintenance or replacement (or both) will determine if they should be listed in your annual operating budget or as part of your reserve inventory. 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. Others will need to be replaced, like roofs and mechanical equipment. Additionally, some will require both, such as pools and carpeting. Less expensive items are typically included in the operating budget. Costlier items are assigned as reserve components so that their replacement costs can be financed over an extended period.
More and more associations, especially communities that are decades old, are starting to address infrastructure components as part of their budget planning process. These are components that last a very long time, are generally out-of-sight and are not often thought of — 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.
"Useful life" refers to the length of time that a component serves its original purpose. Every component has a useful life given to it by the manufacturer.
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.
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.
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.
The Reserve Study: A Living, Breathing Component of Your Success
How will you determine which items to develop, upgrade or replace and their expected cost? A healthy, professionally conducted reserve study will point you in the right direction.
A reserve study specialist will assess the condition of common-area assets within your community (like clubhouses, lobbies and pool areas), identify future replacement costs and recommend an annual contribution amount for your reserve fund. By partnering with a solid reserve study specialist and reviewing your study regularly, you'll have a strong foundation for your association.
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. But remember, it only serves as a budgeting guide for current and future boards to use. 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 looks great, and you've done all the preventive maintenance, you can decide to get another five years out of it and adjust that component accordingly." - Bobet Bennett, Senior Vice President of Financial Services 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.
To Invest or Not to Invest Your Reserve Funds?
Generally, it's a good idea to invest a portion of your savings and let it grow over time. A reserve fund is no different! If your reserve study predicts that you won't need any immediate big-ticket project within the next few years, short-term or long-term investments are great to keep your funds growing. As a rule of thumb, the IRS does not consider reserve funds and homeowner assessments as taxable income, as long as they are in a separate account from your operating funds.
Keep in mind that earned interest could potentially be taxable in California. We recommend consulting with your association's CPA for best practices and legal advice on this matter.
FirstService Financial can leverage its existing relationships with more than 30 banks to provide FirstService Residential clients with higher rates on money market accounts. On average, FirstService Residential clients earn rates that are 4 to 5 times higher than the national average.
For example, FirstService Financial partnered with a master-planned community in Escondido, California to help increase their portfolio’s average interest earned by over $5,900 (10% increase).
Like an effective maintenance plan, a thorough reserve study and fully-funded reserves can help maintain your community's or high-rise property values throughout board and staff changes and allow your residents to feel proud of their association. Life can be unpredictable (in good and bad ways), but your association's financial goals don't have to be.
Nordlund, Robert. 2011. "What Exactly is Percent Funded?". Reservestudy.Com. https://www.reservestudy.com/resource/article/what-exactly-is-percent-funded/
Nordlund, Robert. 2020. "How Much Should an HOA Have in Reserve?". Reservestudy.Com. https://www.reservestudy.com/resource/blog/how-much-should-an-hoa-have-in-reserve-2020/