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Preparing the annual budget and overseeing a community association's finances
are perhaps the most important responsibilities of the association's board
members. It is a primary business duty of a community association to maintain
and preserve market values of both the residential and common area property.
To do so properly, directors must develop funding plans for future repair
or replacement of major common-area components, such as swimming pools, decks,
asphalt surfaces, concrete areas, fencing, monument signs, and much more.
Using annual operating budgets and reserve budgets assist in reflecting the
plans and goals of the association as well as in setting the level and quality
of service for the community association's activities in the months and years
ahead.
Community associations have several funding options, including
periodic assessments over the life of the assets, special assessments
at the time of the actual replacement, borrowing funds when needed,
a combination of the above, or the most common practice of setting
aside funds in a special category commonly called reserve
funds, replacement reserves, replacement funds, or
simply, reserves.
Owners are sometimes reluctant to contribute to reserve funds
because they feel that these “surplus” funds are an added cost
of living. These same owners often forget that the overall appearance
of their community translates directly into its property value,
which has been documented as the leading factor in members' satisfaction
with their community. Additionally, one must remember that lenders
look for signs of financial health when reviewing mortgage applications.
Communities with inadequate reserve funds may find themselves at
risk for mortgage denials. Equipment and major components must
be replaced, whether the expense is planned or not. Today's boards
of directors must educate their membership in understanding why
property owners should invest in reserves now, even though the
money seemingly might only benefit future owners. Reasons to be
shared with the members for creating and adequately maintaining
a reserve fund should be: (1) Fulfillment of legal, fiduciary and
professional requirements (2) Requirements of the secondary mortgage
market as dictated by Fannie Mae, FHA, VA and Freddie Mac (3) Deterioration/Depreciation
of common assets from which current owners have benefited (4) It
minimizes the need for unforeseen special assessments, especially
for those on fixed incomes, (5) A replacement fund or reserve enhances
resale values, and (6) Accounting standards require proper attention
be paid to the reserve/replacement fund, given the depreciable
nature of certain assets over time.
Before establishing a reserve/replacement fund, the community
association should discuss its financial needs with its professional
manager, CPA, engineer, or other trusted advisor. Community association
reserve funds account for nearly $5 billion U.S. dollars today.
With so many reserve advisors available, association leaders often
encounter difficulties in selecting the best one for their association.
Due to the technical details involved, the community association
should hire a qualified, experienced person to prepare its reserve
study and any of the above professionals can typically point the
association in the right direction. Additionally, a board may begin
by talking to other association boards, learning about industry
trends, and checking references.
Typical Reserve Studies are comprised of two parts, the Physical
Analysis and the Financial Analysis.
- Physical Analysis - During
the physical analysis, a reserve specialist typically performs
a site inspection evaluating information about the physical
status of the association and the repair/replacement cost
of the major common area components. The reserve specialist
conducts an inventory of the association's assets, renders
a condition assessment, and completes a life expectancy evaluation.
The component inventory should be relatively stable from
year to year.
- Financial Analysis – The
financial analysis is made up of a finding of the client's
current reserve fund status (measured in cash or as a percent
funded) and a recommendation for an appropriate reserve contribution
rate.
Of course, standard operational expenses continue
to occur annually and can be effectively budgeted
each year. Such expenses should include all minor expenses which
would not adversely affect an operating budget from one year to
the next. Examples of operational expenses are:
- Utilities
- Services: landscaping, street sweeping
- Administrative: management fees, copies & postage
- Repair Expenses: equipment repairs, minor concrete
repairs, fence & gutter repairs
There are three categories that describe the various types of
reserve studies, from an exhaustive to minimal in reference to
the level of service.
First , a Full Reserve Study is one in which
the following study tasks are preformed: (1) Component inventory
(2) Condition assessment based on visual observations (3) Life
and valuation estimates (4) Fund status (5) Funding plan
Second , an Update, with site visit/on-site review
where all of the above noted study tasks are performed as an update
to the previous study.
Finally , an Update with no site visit and/or
observations in which only the following tasks are performed: 1)
Life and valuation estimates 2) Fund status 3) Funding plan
In establishing the component inventory, one must review the documents
and statutory requirements to determine which components are to
be included in the common elements. Once common elements are established,
you then must review the maintenance contracts to determine the
appropriateness of including all or portions of a component for
proper funding. One should then review the budget for components
such as fences and sidewalks, which are generally replaced in small,
low-cost increments. Next, confirm that the component funded in
the overall budget is not also funded in the reserve. Identify
all mechanical equipment. Generally, moving parts should be included
and reviewed for their longevity. Then determine if the component
will be normally excluded for repairs or replacements of the association's
assets which have an estimated useful life expectancy equal to
or exceeding the estimated useful life of the community itself.
Not all common-area components require on-going preventive maintenance
and therefore may not be required to be on the reserve schedule.
Selecting a Funding Method is the final step of the reserve planning
process. Community associations typically set aside a separate
section of the budget for the reserve. The study is normally prepared
prior to the fiscal year end for use in the budget preparation
process. There are four primary funding strategies, known as Full
funding, Baseline funding, Threshold funding and Statutory
funding.
Full funding is to attain and
maintain the reserves at or near 100 percent.
Baseline funding is an approach
to keep the reserve cash balance above zero at all times. This
means that while each component may not be fully funded, the
reserve balance should not drop below zero during
the projected period.
Threshold funding is based on
the baseline funding concept, but allowing a minimum reserve
cash balance as the threshold. It relies upon a predetermined
dollar amount as the threshold.
Statutory funding is based on
local statutes which set aside a specific minimum amount of
reserves as required by law.
Each community association has the task of devising a plan to
provide income to a reserve fund to offset anticipated expenditures
from that fund. No matter what funding method is used, the community
association should always remember to review the fund balance over
a period of time and or as it adds or deletes components that will
affect the fund. Consequently, adjustments to the annual contribution
rate should be made from time to time in order to assure adequate
replacement funds are available when needed.
A reasonable methodology in reviewing a reserve study
for purposes of assuring informative content, both now and into
the future, is to gather the following:
* A summary of the community association's number
of units, physical description, and reserve fund financial
condition.
* A projection of reserve starting balance, recommended
reserve contributions, projected reserve expenses, and projected
ending reserve fund balance for a minimum of 20 years.
* A tabular listing of the component inventory,
component quality or identifying descriptions, useful life,
remaining useful life, and current replacement cost.
* A description of methods and objectives utilized
in computing the fund status and development of the funding
plan.
* Sources utilized to obtain component repair
or replacement cost estimates.
* A description of the level of service by which
the reserve study was prepared.
* Fiscal year for which the reserve study is
prepared.
Reserve Studies can be very complex
and sometimes difficult to read. However, the board of directors
should feel confident and knowledgeable with the study provided
to them. They should have a clear and concise understanding of
the components identified and analyzed for proper funding before
they provide their membership with the report. Asking questions
of the preparer should be a standard part of any review. As the
saying goes, “there are no dumb questions.”
It is suggested that a summary of
the reserve study be provided for general distribution. Such a
summary should be as simple as possible for the board members to
relay to the membership. The summary can be as basic as providing
an Annual Expenditure Detail which generally provides the following
summary:
- Lists the replacement year i.e. 2002, 2003, 2004 etc.
- Lists the repair/replacement required for that particular
year i.e. wrought iron painting, and
- Provides the amount of reserve expenditures to be paid
out in a specific year.
Careful planning for future repairs and replacements
allows the membership to know that the board of directors is taking
its fiduciary responsibility seriously and that the directors are
truly being good stewards of the association's money. There are
professionals readily available to assist community associations
in protecting the physical and fiscal needs of their communities
for all the years ahead. That said, such safeguards always commence
with the proper development and maintenance of sufficient reserves.
Vicki Ward
PCAM®, CMCA®, AMS®
President
Principal Management Group of Houston
Houston, TX
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