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What Is a Reserve Study In Your HOA?

Written by on Tuesday, 09 April 2013 7:00 pm
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The Reserve Study analyzes repair and replacement needs like roofing and painting that happen every year and provides a funding plan for accumulating money to perform this work when its needed. It is more a budgeting function than a construction or building analysis, although there is an element of that. The study is usually based on visual observations as opposed to forensic or destructive testing (tearing walls and roofs apart to see what's underneath). The Reserve Study assumes that regular and adequate maintenance is being done to prevent premature repairs or replacements. There are several parts to the Reserve Study process:

  • All HOA maintained building and grounds components are identified that have useful lives of (typically) 2 to 30 years, the recommended projection period for a Reserve Study.

  • The condition of each component is carefully evaluated and an estimated remaining useful life applied to each plus the useful life when the asset is new.

  • The repair or replacement cost of each component is estimated based on current bids or reliable construction cost estimating sources (available from RS Means, Craftsman Book Company and other similar sources). The information for each component is applied to the formula: Cost ÷ Remaining Useful Life = Money Needed Yearly for Reserve Fund Totaling the results for each component will produce how much money should be reserved yearly.

    For example, if roof replacement costs $100,000 and the remaining useful life is 25 years, then $4,000 is required yearly to pay for the work when it's needed. Doing this procedure for each component will show the total money needed yearly to fund reserves. Each year, the reserve fund needs to be adjusted by area inflation and the interest earned on the invested reserve funds.

  • Since the recommended projection period is 30 years, the inflation rate and yield on invested funds at the time of the study need to be factored in to ensure the fund keeps pace with reality. Adding inflation will increase future year costs and interest yield on invested funds will reduce the amount of owner contributions.

    How should the Reserve Study recommendations be funded? A Reserve Study with no funds is a car with no gas: It'll go no where. The Reserve Study should provide a recommended Funding Plan which calls for regular and adequate contributions to pay for future repairs without the need of special assessments. For common wall communities, this is accomplished monthly. For HOAs with few assets, reserve contributions can be quarterly or annual, whatever the regular assessment (fees, dues) schedule is. If each member contributes a portion monthly, all members that own there along the 30 year time line will only contribute an amount attributable to their time of ownership. And all members will pay. This is the fair approach to reserve funding.

    How should these reserve funds be accounted for? Reserve funds should be kept separate from operating funds. If your reserve plan is complete (includes all components and a plan to fund them), establishing separate ledger accounts for each component is unnecessary. The board should only spend out of reserves for items that are included in the component list.

    How should the reserve funds be invested? It's conceivable that reserves could grow to many thousands, or even millions, of dollars. Since the Reserve Study shows the board when reserve funds will be needed, funds can be placed in higher yielding long term investments. Every dollar earned in interest is a dollar less needed from the members. Increasing interest yield only one percent over 30 years amounts to tens of thousands of dollars for the average HOA. If an HOA is large and accumulating hundreds of thousands or millions of dollars in reserves, it makes sense to hire a professional investment advisor to manage the funds. Conservative investments like government securities or certificates of deposit (CDs) are recommended, however, there are other options that an advisor can recommend.

    When should a Reserve Study be performed? All homeowner associations, regardless of size, should have a Reserve Study done, the sooner, the better. The study will compare what reserve funds you currently have versus what you should have. The concept is called the Percent Funded. Along the 30 year Reserve Study timeline, there is an ideal amount of money the HOA should set aside known as 100% Funded. The Percent Funded function shows how the HOA is doing relative to the ideal. For example, it is not uncommon for older HOAs that have not been properly funding to be 20% Funded or less. Knowing the Percent Funded is critical to chart a funding plan to catch up. You need to know where you are to know where you need to go. If your HOA is newer, the sooner you perform a Reserve Study and begin funding it, the sooner you will reach the 100% Funded ideal.

    How often should the Reserve Study be updated? Once the initial Reserve Study is completed and the funding plan is in place, yearly updates need to be performed. Even if no reserve projects are done, the rate of inflation and the yield on invested funds always change year to year. Even a 1% change in either of these factors causes a huge impact on the thirty year projection due to interest compounding.

    What happens if reserves are under funded? It depends. If the HOA has inadequate reserve funds to begin with, the Reserve Study will show the need for "catch up". How fast the HOA catches up depends on how soon funds are needed. If there is an expensive and urgent repairs like roofing, a special assessment may be needed to address it. If major repairs are some years off, the funding plan can usually accrue the money through regular assessments (fees, dues). Or, using a combination of both special and regular assessments may be the way to go. Whatever course of action taken, the goal should be to reach "100% Funding".

    What sorts of financial problems can homeowner associations encounter with inadequate reserve funds? Without adequate reserves, HOAs rely on special assessments. Special assessments are unfair because owners that have bought and sold in the past fail to pay their fair share and current owners end up "holding the bag". Special assessments are a hardship on owners and some may be uncollectible if an owner's equity is small, he is foreclosed or declares bankruptcy. Also, since special assessments are unpopular, the tendency of the board is to postpone major renovations. This deferral accelerates the deterioration process, detracts from curb appeal and erodes home market values. A reserve funding plan with regular monthly contributions from each owner is both fair and permits major work to be done when it's needed.

    Can poorly managed reserve funds affect the sale of units? Absolutely. Smart buyers and lenders look closely at how reserve funds are handled. Lack of reserves is a red flag for inevitable and costly special assessments (a sign of poor planning). If given the choice between a well maintained HOA with healthy reserves and one with little or none, which would be the wiser investment?

    Which types of repairs and replacements must be paid for by HOA funds? The governing documents define what are the HOA's responsibility. In common wall communities like condominiums, the HOA is usually responsible for items like roofing, landscaping, siding, painting, paving, sidewalks, pools, clubhouses, signage and fencing. But there are many more components. The average condominium has between 15 and 50 reserve components that should be considered. High rise co-ops and condos can have hundreds.

    Bring in the Experts. If there are particular problems like dryrot, structural, soil or drainage, an independent specialist study should be incorporated with the Reserve Study.

    What kind of qualifications should a Reserve Study provider have? Besides years of experience doing reserve studies and a long list of satisfied HOA client references, a qualified Reserve Study provider should have industry credentials, good budgeting skills, extensive knowledge of construction and homeowner association operations. Professional Reserve Analysts (PRAs) are members of the Association of Professional Reserve Analysts and hold the highest credential in the industry to perform this work. See www.apra-usa.com for a list of PRAs.

    How much does a Reserve Study cost? Costs to perform a Reserve Study vary based on the size of the HOA, the number of components and the time needed for field work and report compilation. The initial Reserve Study costs the most since it involves the time needed to gather the component data. The typical Reserve Study with 15 to 50 components usually costs $2000 to $5000. High rise condominiums and HOAs with numerous reserve components are more costly.

    How often should a Reserve Study be updated? Annual updates are required to keep the study accurate and much less costly than the original since they involve only tweaking. It is highly recommended that a site inspection update be performed at least every three years to verify the condition and remaining useful life of the components.

    A properly funded Reserve Study is an invaluable tool for maintaining value and promoting harmony. When HOA member assets are properly maintained, members profit from higher market values of their homes. Since major maintenance is done consistently and uniformly, no one is getting a better deal then anyone else. The HOA is more livable and improved curb appeal engenders community pride. When the members like living there, they stay longer and are more willing to volunteer. Oh, one other amazing benefit: No More Special Assessments! Hooray!

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      About the author, Richard Thompson

    Individual news stories are based upon the opinions of the writer and does not reflect the opinion of Realty Times.