Common Interest Developments contains areas and facilities that are owned “in common” by the members. For the purpose of this article that common ownership may be in undivided interest, it have been conveyed to the association as common area in fee title, or it may be privately owned but the association has maintenance responsibility through the governing documents. As the elected governing body of the association, the board of directors is responsible for ensuring the association’s sound management and operation. One of the primary duties of the board of directors is the review and preparation of an annual budget.
The annual budget process must address two areas: operating funds and reserve funds. California Civil Code Section 1365 requires that the association review its reserve fund annually. Additionally, the board of directors must attest in the budget notes to the adequacy of the reserve fund. The budget notes must clearly state, in bold type:
The estimated replacement cost, estimated remaining / useful life of each component as of the end of the fiscal year for which the study is prepared:
- The current estimate of the amount of cash reserves necessary to repair, replace, restore or maintain the major components.
- The current amount of accumulated cash reserves necessary to repair, replace, restore, or maintain major components.
The percentage the accumulated cash reserve is of the estimated required reserve.
In addition, the Civil Code requires that the board of directors state in the budget notes whether they have “determined or anticipate that the levy of one or more special assessments will be required to repair, replace, or restore any major components or to provide adequate funds therefor.”
Lastly, specific disclosures must also be made under Civil Code Section 1365.2.5 in a prescribed format.
Your reserve study should assists the board of directors in complying with Sections 1365 and 1365.2.5 of the code by providing the information required by the code in order that the board of directors may carry out their fiduciary responsibilities in this budget process. Specifically, it provides:
- The legally required data to estimate properly the useful remaining life for each component;
- The financial information necessary to determine Reserve Fund requirements, percent of required funding currently on hand;
- A recommended minimum monthly reserve contribution.
Not only should your reserve study provide the information necessary for the board of directors to make informed budget decisions, but it should also contain the preparer’s best professional judgment concerning the minimum reserve funding necessary for operating, maintaining and repairing the property. We point out that budgeting is not an exact science because the budget analyst cannot foresee or control the future acts of the association, its members, its board, its management, or of nature.
The ultimate budget decision (i.e., approving the budget) rests with the board of directors (or when the increase is over 20 percent, the decision rests with the members unless the documents impose more stringent standards). We believe this decision should be made after reviewing the professional advice contained in the reserve study and acting in a proper fiduciary manner to ensure the association is adequately funded.
In preparing this study, a comprehensive list of major components is developed and data is compiled concerning the age and costs of the components. The results of that compilation are found in various charts and tables within the study. Certain assumptions are made concerning future inflation, current and future component costs, interest earnings, future aging, and other future events. Some of these assumptions may not materialize and unanticipated events and circumstances may occur in the future. Therefore the actual replacement costs and remaining lives may vary from your and the variations may be material. Therefore, the association is required by Section 1365 of the California Civil Code to review this funding plan annually and consider and implement necessary adjustments.
Each major component item should be accounted for independently in regards to the date placed in service, current replacement cost and the remaining useful life. Once this information has been accumulated, the future replacement costs are calculated and all the reserve items are grouped together to calculate the future reserve fund balances, reserve funds required, and projected monthly contribution amounts.
What is the Current Status of your Reserve Fund? (“Percent Funded”)
A general concept behind reserve funding is that over time owners will pay their fair share for the wearing out of the components, or at least that deviations from that concept are disclosed. While the State of California does not require that common interest developments maintain reserves, it does require that the association disclose to homeowners (and homeowners in turn to potential buyers) the current status of the fund. This disclosure must include the amount of money expected to be “set aside” in the reserve fund, as well as the amount of reserve money “necessary”, at the end of the fiscal year. The amount of reserve “necessary” has generally been interpreted to be the amount of money that would be on hand if owners were paying their fair share over time for the wearing out of the components. For the purpose of this article, we will refer to this figure as the “Desired Balance”.
Mathematically, there are two generally accepted methods of calculating the desired balance. One simple mathematical model which will give a reasonably accurate estimate is to take the current replacement cost of each component, divide it by its total life, and then multiply that figure by the current age of the component. Mathematically, this is represented by the following formula:
Desired Balance = Current Cost/Useful Life X Current Life
For example, a $100,000 component with a 10 year life, if it was 2 years old should have $20,000 in the reserve fund:
$20,000 = $ 100,000/10 years X 2 years
The calculation indicated above is made for each component, and then added together to determine the “Desired Balance” for the fund.
While this simplified method of determining the desired balance is easy to understand, mathematically it suffers from some inaccuracies because it does not take into account the fact that the reserve fund earns interest or that inflation will also impact the reserve portfolio over time. Simply stated (and using our 2 year old, $100,000 component with a 10 year useful life), we would not need to collect $10,000 each year because that $10,000 will earn interest. The amount of money that would need to be placed in the fund annually to offset the wearing out of this component will increase each year because that year’s contribution will have less time to earn interest before the end of the component’s useful life. At the same time, however, inflation is working on our economy and at the end of the component’s useful life we will need more than $100,000 in order to pay for its replacement, repair, restoration or maintenance. Fortunately, it is quite easy to make computations that take the expected effects of interest and inflation on each component into account using the following formulas:
or using 5% interest and 3% inflation:
This calculation is run for each component in the portfolio and the results then added together in order to calculate a more precise “Desired Balance” for the fund.
The State of California also requires that the association disclose to homeowners the relationship between the amount of money set aside in the reserve fund and the amount of money that should be on hand in the reserve fund as a percentage. Specifically, it is the amount of money that is on hand divided by the desired balance for the fund. Both figures are as of the end of the fiscal year. Unless the after tax interest rate and the inflation rate are the same, there will be a difference in both the desired balance and the percentage of funding. Typically, after tax interest is slightly greater than inflation and therefore the desired balance is lower and the percentage of funding is greater. Occasionally, we find an association that does not put interest into the reserve fund, and in this case the desired balance may be higher and the percentage of funding lower than in the simplified method. In the latter case, the desired balance we recommend is more accurately reflected by the more complex formula and is our recommendation concerning what disclosure you provide homeowners.
While the preceding narrative indicates the status of the fund, the impact of that status is another issue entirely. One caution about disclosing “Percent Funding” calculations is the fact that the uninformed often try to compare associations against other associations using this percentage disclosure. Unfortunately, the “Percent Funding” calculation does not indicate the impact on current and future owners. It is possible for an association have a very low percentage of funding, and the impact is only a few dollars or cents per door per month. Conversely, it is possible for an association with a very high percentage of funding to still need significant special assessments in the near future. These anomalies can be caused by a variety of factors including the number of homes compared to the size of the reserve responsibilities or the length of time available to replenish the fund, or both.
On the other hand, the closer any given association is to 100 percent funded, the better off it is because the “Percent Funded” calculation does disclose whether homeowners are paying their fair share over time. The extent that the “Percent Funded” disclosure is below 100 percent indicates the extent that current and past homeowners have not yet paid their fair share towards the wearing out of the components. The extent that the fund is greater than 100 percent funded indicates the extent to which current and past homeowners have paid more than their fair share of the reserve obligation. In either case, the association will eventually either need to raise the funds to do the repairs by increased regular assessments and/or by special assessments, or it will need either to reduce assessments or to hold them steady for some period of time to allow for the impact of inflation to offset the excess balance in the fund.
We can measure the impact of the status of the reserve fund by comparing it to some normalized notion of what the assessments should be if the fund happened to be exactly 100 percent funded. Using the simplified approach indicated above, this notional ideal assessment can be determined by taking the current cost of the component and dividing it by its useful life.
How Are Your Reserve Assessments Calculated
There are three general theories of funding:
Full Funding: The association wishes to move from its current position to a position where the amount of money on hand in the reserve fund is equal to the amount of money it should have on hand at that point in time as determined by one of the methodologies discussed earlier.
Threshold Funding: The association wishes to ensure that the balances on hand in the fund over some number of future years (generally thirty) remain above some threshold to allow some safety for estimate variations that will always be inherent in this type of estimating. We recommend a minimum threshold of ten percent of any given years expenditures.
Baseline Funding: The association wishes to maintain positive balances in the fund over the next thirty years. (In essence, a threshold of zero.) We never recommend this funding plan as we feel it does not provide adequate margins for the variations which are inherent, and unpredictable, in this type of estimating.
Of special note is the fact that in many instances, threshold balance estimates may be higher than full funding balances. As a general principle, we always recommend the funding plan that will provide the higher balances between threshold and full funding. However, the final decision is up to the board of directors. There may be many reasons the association may desire, or need, to fund to balances different from our recommendation, and this is perfectly permissible as long as clear disclosure is provided to the members.
The terms full funding, threshold funding, and baseline funding all represent a goal to be reached in the future. Without regard to which goal the association reaches, the assessment is determined by projecting expenditures across future years, and then projecting assessments across the same period in order to achieve that goal. There is much flexibility here, and the variations which may be adopted are almost limitless. There is no right answer.
What is a Major Component?
There are often questions concerning which components should be included in a reserve study. This is in part because the law does not define a major component, and boards of birectors are allowed wide latitude in determining what items are to be included in their reserve fund, which items can be planned for in the operating budget, and which items can wait for future years before collecting monies for future repair or replacement. Basically, in order for a component to be included in a reserve study it should:
- Be a common area component (i.e., the governing documents for the association indicate that the association is responsible for the maintenance, repair, or restoration of the component.);
- Have a limited life;
- Have a reasonably defined life.
If the component does not meet all three of these qualifications, it does not qualify. For example, we do not normally reserve for total concrete replacement because it is considered to have an unlimited life (although we may reserve for partial replacement if the circumstances so indicate.) We also do not reserve for light bulbs or sprinkler heads because most replacement is due to random failure, breakage, or vandalism, and although a limited life may be assumed, timing and the extent of breakage problems are difficult to quantify.
Additionally, there is often concern over how we establish the useful life and useful remaining life for a given component, as well as questions pertaining to the accuracy of our predictions. In fact, these questions are related. Basically, components can be placed into one of five categories:
- Cyclic Regular -Items like asphalt sealcoating or wood painting fall into this category. Such components have a very predictable life cycle. That life cycle may vary based upon local climate, usage, exposure to weather, or similar issues, but it will generally stabilize for the components of a given property and have a reasonably high degree of predictability concerning both useful and remaining life.
- Cyclic Irregular -Items like deck surfaces and roofing fall into this category. These items have a normal life span great enough that climate, level of preventive maintenance, owner care, and other issues can materially affect the actual life.
- Predictable but Irregular Non-Catastrophic Failure -This category includes pool pumps, spa heaters, and other items that can be expected to wear out with some predictability (regular or irregular) but do not need to be replaced until failure. With these items the association may well have accumulated the money for repair or replacement and then actually wait for failure to spend this money. This does not affect the reserve contribution prior to the expected replacement date, but once that date is reached assessments can be reduced until failure because adequate reserves are on hand.
- Catastrophic Failure -With these items waiting until failure is not appropriate. A hydraulic elevator falls into this category. In these cases, a fund is built for a general replacement time frame; then a decision is made to repair or replace before failure.
- Outdated Design/Aesthetics -This category refers to items where aesthetics are a major concern. Examples include light fixtures, window coverings, and other items that may be quite functional past the time they are desirable. They should be recognized and reserved for in order to keep the common area from appearing dated and unappealing.
These categories are not rigid, and in fact some components may fit into a several categories. Rather, these categories are used as general guidelines in order to help us reach a reasonable conclusion concerning life estimates and funding strategies.
Roy Helsing is president and CEO of The Helsing Group, Inc., a consulting firm specializing in community associations to include maintenance plans, reserve studies, construction management, association set-up, forensic engineering and construction consulting.