Question: I am looking to purchase a condominium unit in a fairly large complex. The seller has given me a large package to review, and I only have a few days in which to wade through this material and decide whether or not to purchase.

I have looked at the budget, and it does not appear that the Association has a lot of money in their reserve account. Is this something I should be concerned about? Is there any law which requires how much money an association should keep in reserve?

Answer: Yes, you should be very concerned about an association which does not have sufficient reserves. If the roof or the boiler or the elevator goes bad after you become an owner, and if the Association does not have enough money in reserve to pay for this problem, each owner -- including you -- may be faced with a special assessment, and this may cost you a lot of money.

A reserve simply means that the association should have money set aside "in reserve" to cover the cost of future emergency or major repairs. Reserves are -- or should be -- an essential part of every community association.

Recently, the Community Association Institute (CAI) -- a national non-profit association created to provide education and resources to our nation's residential community associations, issued a publication entitled "A Complete Guide to Reserve Funding & Reserve Investment Strategies" (GAP Report 24). This publication should be on the bookshelf of every community association Board member and property manager. Copies are available on the website or by calling 703- 548 8600.

According to CAI, "adequate reserve funding means more than just providing funds for roof replacements. In the long run it can contribute to the rise and fall of property values. For instance, if an association is in debt or has no reserve fund, educated home buyers may not want to invest in the community."

It is clear that you are an "educated" potential home buyer. I wish more people would be concerned enough to carefully review the package of documents when they are in the process of purchasing into a condominium association.

In many parts of the Country -- potential purchasers must be given what is called a "resale package". This package contains the legal documents which govern the Association (such as the Articles of Incorporation, Declaration and Bylaws) as well as the most recent audited budget of the Association.

Often, the contract which the potential purchaser signs allows the purchaser only a very short window of time in which to read and digest a large amount of documentation and information. It is highly recommended that potential purchasers change this time period to a more reasonable one -- such as 15 days -- so that the material can be reviewed, carefully and without pressure.

The CAI publication contains an analysis of State laws impacting on reserve requirements. In the District, for example, there are no laws regarding reserves. In Maryland, the Condominium Act requires that the annual budget shall provide for reserves -- but does not require any level of funding. Virginia law also does not contain any mandatory requirement as to the amount of reserves which an Association must carry on its books.

Although many community association property owners may not realize it, a community association 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, water bills, trash collection, insurance premiums, and payroll taxes. In order to project 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.

In addition to general operating expenses, Boards understand that at some future point in time, they will have to make major repairs, alterations and even improvements to the common areas within the Association. The elevator must be refurbished, the driveway must be paved, and the roof must be repaired or replaced. All this costs money, and these additional expenses must come from somewhere. And all of these projected expenses 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 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:

This is but an example; obviously every Association has different needs and different concerns. But the bottom line is that in order to properly plan ahead, the Association in our example must add to the annual budget the sum of $15,371 toward reserves. 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.

There is 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.

If reserve funds are not available if and when money is needed, what can the Board of Directors do? Oversimplified, there are three other ways to raise money in a community association:

1. Increase monthly assessments: The Board could increase the assessments. However, if the Association needs the money immediately -- and it is not there -- the regular assessments will not come in fast enough to raise the needed money.

2. Special assessments: In most associations, the governing legal documents authorize the Board of Directors to impose a special assessment on all owners. In our example, if the Board immediately needed $75,000 to replace a defective roof, and if there are 90 owners in the complex, this would require each owner to pay $833.33 immediately. Keep in mind that assessments are usually calculated based on the percentage interest that each owner has in the association. Thus, while the amount of the special assessment will vary; the fact remains 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 banks have started making loans to Associations. 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.

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.

There are two additional reasons why adequate reserves are important.

First, if you want to sell your unit -- or refinance it -- most lenders will want to review your Association's reserve situation. If they are inadequate, the lender may reject the loan application.

Second, as has been discussed earlier, potential purchasers, such as yourself, may be turned off if the level of reserves in the Association does not appear adequate.

According to the CAI Report:

Owners are often reluctant to contribute to reserve funds because they think the funds are costing them extra money. To convince these owners of the need for reserves, the Association must make them understand that a reserve fund is not an extra expense -- it just spreads out association expenses more evenly. Equipment and major components must be replaced, whether the expense is planned or not.

Boards of Directors have a fiduciary obligation to the owners who elected them to make sure that the budget they prepare is adequate --which must also include appropriate reserves.

For more articles by Benny Kass, please press here.

Published: November 12, 2001

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