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Establishing Your Reserve Funding Plan: Considerations & Strategies
Association approaches to preparing for major repair and replacement projects have varied widely over the years—from completely ignoring, to detailed analysis of building components and their related costs, and all variations in between. While next year’s operating expenses and the resulting regular assessments are rarely viewed as “discretionary,” reserve expenses and the offsetting Funding Plan often are, particularly when projects are slated more than a few years away.
Sarah Anderson, PCAM, Director of Marketing & Operations of EMB Management, Inc., AAMC, discusses some of the challenges of reserve planning with industry veteran Jim Talaga, RS, President of the Association Reserves – Washington regional office. Their goal is to present some new ways to view and approach this important task and establish some best practices.
Best Practice 1
Because of the havoc of special assessments and their disruptive effect on the community, boards should address the reserve funding plan early in the annual budget process. Being overly optimistic about a monthly landscape budget, for instance, rarely causes financial challenges. But years of underfunding Reserves will almost certainly result in the need for a Special Assessment.
Sarah: Why do you think it has been difficult for many associations to increase their reserve contributions and follow the recommendations within their Reserve Study?
Jim: There are three reasons for this in my view. First, many associations began their lives in an era where little to no reserve planning was ever undertaken. The misconception among board members and homeowners (that continues to this day) is that the Reserve Fund is for some far off future expense. In reality, funding reserves is necessary to offset ongoing common area deterioration as it occurs. The second reason is that addressing the reserve contribution is often left until the end of the budget process and board members are often unprepared to make wise funding plan decisions. In most instances, the reserve contribution is one of the largest budget line items, and an increase in the rate often means an increase in overall assessments, which is always viewed as unpopular. Finally, we have found there is a general misunderstanding of how to read and use the Reserve Study.
Although there is a statutory requirement in Washington for a 30-year reserve funding plan, the expense projections can and should be broken down into five- and ten-year action plans. With simple addition and subtraction, an association can clearly see how much reserves they currently have in the bank, and what expenses they need to prepare for in the near term. There is also confusion and emotion surrounding the concept of “% Funded” and “Fully Funded”—industry terminology that should not get in the way of a simple planning task.
Sarah: Can you suggest some other ways for association boards to explain what their reserves are for and, if an increase is necessary, how to get them moving in the right direction?
Jim: Boards can use the information in the Reserve Study to create a summary of specific projects that will be completed during the next five or ten years. It will become much clearer to homeowners when, for example, they see there is a need to paint the buildings, replace the fence, and reseal the decks. This makes the expenses tangible, not just a list of meaningless numbers on a page. When we have clients facing a special assessment in order to afford timely repairs, we often counsel that those funds be allocated to specific projects, or a combination of specific projects and rebuilding their reserves. People like to know how their money is being used.
The current budget disclosure requirements that were implemented within the RCW (both the Condominium and HOA Acts) in 2011 for budgets adopted on or after January 1, 2012 are also a wonderfully illustrative tool. The disclosures clearly show the cash flow path the community is on by comparing their current budgeted reserve contribution rate to the funding levels recommended in their Reserve Study.
Homeowners need to appreciate that reserve expenses are inevitable and should be a question of when, not if. There are only four ways to pay for the expenses listed in the Reserve Study: 1) set aside sufficient reserves (many Declarations actually require this) 2) levy a special assessment 3) obtain a bank loan 4) endure deferred maintenance and the decline in property values associated with doing nothing. When you include compounding interest over time with regular reserve contributions, properly funding reserves is always the least expensive funding option by a significant margin.
Best Practice 2
Provide access to the entire Reserve Study to each owner, along with links to video tutorials, webinars and articles. You’re all in this together, sharing expenses and creating your community. Also, have your studies prepared and therefore available for distribution well in advance of the budget process, allowing time for owners to digest and formulate questions.
Sarah: But what if the Funding Plan in the Reserve Study requires a large increase, which the association cannot financially tolerate?
Jim: The Funding Plan is based on a scope and schedule of reserve expenses, as determined by the actual condition of each item on the component list. The repair and replacement costs won’t go away, and in fact are likely to increase during the life cycle of the association. Remember that all reserve components are inflating over time, and the lower the association’s current reserve fund strength, the harder it will be for them to meet those expenses if they don’t get going now.
With many of our client associations, we are able to craft a strategy of lower initial increases followed by some periods of time with larger than typical (e.g., 5% to 10%) annual increases. This type of “ramping” as we call it can get an association moving in the right direction more effectively rather than trying to implement a large leap in assessments. If some combination of reserve contributions and Special Assessment is inevitable, the earlier in the process the board can communicate the funding strategy to the homeowners, the better.
Because Community Associations are volunteer organizations with comparatively high turnover of board and committee members, financial transparency and basic education will likely always be at the center of successful communities. Many boards do not provide homeowners with a copy of the Reserve Study, nor utilize many educational resources and tools. We see this as a huge mistake.
Sarah: We have seen Washington state go from little or no guidance for Reserve issues, to requiring mandatory Reserve Studies and disclosures. What do you think the future may hold?
Jim: Well, the trend has clearly been for more scrutiny of an association’s financial health, not less, and more encouragement for the board to “do the right thing” on behalf of the homeowners. This trend is a good thing in my opinion. There is no reason for homeowners to be surprised by a repair or replacement expense that gradually approached over many years, often in plain sight! Association-governed communities are most successful with owners who are a good fit, including their ability to afford the “true cost of ownership.” If they can’t, delinquencies and foreclosures can result in major impacts to the cash flow and financial wellbeing of the association. We review association budgets every day, and often see “collection costs” as one of the largest line items in the operating budget.
I think it will continue to be important to educate and create a system where good financial stewardship of an association is rewarded, not punished. There has been a misperception in the real estate world that lower monthly assessments are, by themselves, very attractive, and is often a selling point in a buyer’s purchase decision. However, if a comparable property nearby has higher monthly assessments but sufficient reserves and a solid Funding Plan in place, the property with the lower monthly assessments may not be the better deal financially. Reserves “% Funded” is a fair way to compare property to property. Washington could follow the lead of California, where one of the mandated disclosure requirements is to show a per-unit reserves deficit or surplus.
I recently presented an educational seminar to an influential group of real estate professionals in the downtown Seattle core to illustrate these concepts. They warmly embraced the message, knowing that the ability to provide some basic financial insight into an association for their buyers would set them apart, resulting in happier customers and referrals. Board members and Managers should do the same—make sure you understand basic Reserve Funding concepts and that real estate agents and prospective homeowners are aware that you have a current Reserve Study, a strong reserve fund, and are pursuing a reasonable Funding Plan. That will set your association apart from competing properties in your market area.
You should be continually recruiting volunteers— those who take time to read and understand the Reserve Study may be your next community leaders.
Sarah: To circle back to the beginning, and put you on the spot a little, what Funding Objective should an association pursue: Baseline, Threshold, or Full Funding?
Jim: Most people who debate this issue are unaware that reserve contributions associated with the higher-risk “Baseline” objective and the more conservative “Full Funding” objective averages only a 13% difference. Having said that, this is a question that will likely be debated until the end of time!Unfortunately, it’s been our experience that people who get caught up in this funding plan detail often miss the bigger picture.
After establishing a well-conceived budget and disclosing the association’s complete financial picture to the homeowners (of both current and future needs) the board will want to be sure that their decisions and actions comply with their Declaration and state law, as well as fall under the protection of the Business Judgment Rule: Made in “good faith,” in the “best interests of the association as a whole,” and “with reasonable inquiry.” That’s the bottom line.
Co-Authored By Sarah Anderson, PCAM
Director of Marketing & Operations, EMB Management, Inc., AAMC
Co-Authored By Jim Talaga, RS
President, Association Reserves