The recent front page Washington Post article on the financial problems condominiums are facing prompted me to write this column about the absolute necessity of maintaining adequate reserves. And it is especially timely since associations are starting to prepare next year's budget.
Every community association should have money set aside "in reserve" to cover the cost of emergency or major repairs. Reserves are -- or should be -- an essential part of every community association.
The Federal Housing Administration (FHA) is the dominant lender for condominiums -- both sales and refinances -- and under their rules, an association must demonstrate to the mortgage lender that the "funding of replacement reserves for capital expenditures and deferred maintenance" represents at least 10 percent of the association's annual budget.
Although many property owners may not realize it, their community is a business, and must be run just like any other business. Indeed, many associations are very big businesses, with large incomes and equally large expenses.
Every year, the Board of Directors -- working through its management company if there is one -- must project its income and expenses for the next year. Often, this projection is speculative, based on previous years experiences. However, there are on-going operating expenses which must be paid, such as insurance premiums, water bills, trash collection, payroll taxes, and even legal bills. In order to determine the next year's expenses, the Board has to know approximately how much money will be available during the coming year. It should be obvious that the Board cannot plan to spend more money than it will receive. Associations are not the Federal government.
In addition to general operating expenses, Boards will have to make major repairs, alterations and even improvements to the common areas within the Association. Many buildings are old and not in the best of shape. The driveway must be paved, the elevator must be overhauled, the piping and the roof must be replaced. All of this costs money, and these additional expenses must come from somewhere. And all of the numbers must be incorporated into an annual budget.
How does the Board project reserves? Over the years, the concept of a "reserve analysis study" has been successfully developed, whereby qualified engineers perform an "A&E (Architectural and Engineering) Study" of the entire complex. These professionals will report to the Board something that looks like this:
|Item||Projected Useful Life||Cost to Repair||Annualization|
This is but an example and does not include every possible component; obviously every Association has different needs and different concerns. But the bottom line is that all Associations -- in order to properly plan ahead -- must add to the annual budget the sum recommended by the reserve study. This money should be collected from the owners as part of the overall monthly or quarterly assessment, and deposited in a secure, interest bearing investment -- such as a Treasury bill or other government insured fund.
In light of the ridiculously low interest rate currently being paid by banks, there are those who advocate getting a greater return on these reserve accounts. Some want to invest in stocks and bonds. I cannot recommend that; the money belongs to all owners and unless all owners agree -- in writing -- to invest in non-secured funds, they must be protected and insured by the federal government.
In the past, there was no magic formula to determine how much is adequate. However, a reserve analysis study -- performed at least once every five years -- will guide the Board as to the level of reserves which are required.
In the Washington metropolitan area, only Virgina has addressed this issue -- and only after a major scandal involving a property manager who stole lots of moneys from its community association clients. The law in Virginia requires that a board of directors conduct, at least once every five years, a study to determine if reserves are sufficient.
But no dollar figure or percentage of the budget was required.
Now, with the new FHA requirements, if the mortgage lender is not satisfied that the reserve requirements are adequate, the lender –according to FHA -- "may request a reserve study to assess the financial stability of the project. The reserve study cannot be more than 12 months old. When reviewing the reserve study, consideration must be given to items that have been replaced after the time that the reserve study was completed."
If reserve funds are not available if and when the need arises, what can the Board of Directors do? Oversimplified, there are three ways to raise money in a community association:
1. Increase monthly assessments: However, if the Association needs the money immediately -- and it is not there -- the regular assessments will not be coming in fast enough to raise the needed money. More significantly, many owners can no longer afford their current assessment, let alone any higher number.
2. Special assessments: In most associations, the governing legal documents authorize the Board of Directors to impose a special assessment on all owners. For example, if the Board immediately needed $56,000 to replace the roof, and if there are 80 owners in the complex, this would require each owner to pay something in the range of $700 immediately. Keep in mind that assessments are usually calculated based on the percentage interest that each owner has in the association. Thus, the amount of the special assessment will vary; the fact remains, however, that each owner may be required to pay up immediately. Wouldn't you rather pay a few dollars toward reserves each month instead?
3. Get a Loan: Many associations are taking advantage of this approach, and some banks are willing to make such loans. However, there are a lot of legal and financial hurdles that the association has to overcome, and it takes time for a bank to commit to a loan.
As nice as all these methods sound, if your owners are delinquent with their mortgage and condo payments because they have lost their job, there will not be enough money to do those important and necessary repairs and replacements. The net result: the complex will deteriorate, and market values will go down. And that is exactly why FHA has implemented the reserve guidelines.
A well managed community association must have a long range plan for major repairs and replacements. Dollar figures will be included in these plans, and these dollars will (or should be) added as "reserves" to the budget adopted each year by the Board.
Boards of Directors have a fiduciary obligation to the owners who elected them to make sure that the budget they prepare is adequate -- including reserves.