One of the most important responsibilities your community's board of directors faces is effectively planning for major common-area repairs and replacements. Whether a costly expenditure is needed in a few years or not for 20, it’s the board’s fiduciary duty to make sure your community association has adequate funds when the time comes. That’s where reserve funds come into play.
There are many misperceptions about reserve funds and the role a reserve study plays in planning your association’s future expenditures, so we’ve broken it down for you.
What exactly is a reserve fund?
A reserve fund is an account where money is put aside to pay for large capital expenses that are expected to arise over the next 30 years. This money is exclusively for common-property components that have a limited useful life. Maintaining an adequately funded reserve account ensures that your association will have the money available to replace expensive items (typically those that cost more than $10,000) and make major repairs to roofs, mechanical equipment, garages, amenities and other common areas when the time comes. Any funds available for reserves should exclude operating monies and include only cash and investments and other net assets available to pay for from reserve fund expenditures.
Your governing documents – and in some cases, state law – make it mandatory that an association maintains a reserve fund. Per the Minnesota Common Interest Ownership Act (MCIOA)
, “the association shall include in its annual budgets replacement reserves projected by the board to be adequate, together with past and future contributions to replacement reserves, to fund the replacement of those components of the common interest community which the association is obligated to replace by reason of ordinary wear and tear or obsolescence…”
What are the risks of underfunding your reserves?
Underfunded reserves can impact your community’s property values, the safety of residents and the integrity and appearance of your structures and grounds. In spite of these, research conducted by Association Reserves found that more than 70 percent of the associations they reviewed were less than 70 percent funded! As a result, these communities do not have the money to pay for all of the major expenditures they are expected to face. Why is this the case?
According to CAI (Community Association Institute)
, “Uninformed homeowners perceive reserves as increased financial burdens rather than financial protections.” Additionally, many homeowners and associations still have not financially caught up from years of slow economic conditions. As a result, association boards continue to seek ways to minimize assessments/dues, both for existing homeowners and for buyers looking to purchase within their community.
Unfortunately, this only delays – and most likely increases – the financial burden on homeowners. The only options for completing projects when an association is underfunded are to significantly increase assessments immediately, impose a special assessment or take out a loan. What frequently happens, though, is that the work simply doesn’t get done. “Communities that are underfunded often end up deferring needed repairs,” says Jacque Martin, director at Reserve Advisors, a reserve study company that has worked with many FirstService Residential communities.
How does a board allocate money to reserve accounts?
The amount of your annual dues that should go toward a reserve fund can vary significantly. Factors such as the age and type of property, the number of common structures, how recently the association had major work done and the size of the community will all affect the amount of money you need to set aside each month.
You may hear that associations should allocate between 15 and 40 percent of their assessments toward their reserve fund, but Martin cautions against using fixed numbers as guidelines. “You can’t simply decide to allocate a percentage of your fees toward reserves,” she says. You need to base the amount on an up-to-date reserve study.”
How does a reserve study help?
First, it’s important to note that the state of Illinois has not adopted any specific statutes related to reserve studies. However, it is common practice in Illinois that an association perform periodic reserve studies as prudent business practice. A reserve study, preferably performed by a professional and reputable company, helps your homeowner association board to best predict when capital expenditures will be necessary. It identifies predictable common-area repair and replacement projects so the association can at you can prepare financially to meet those costs. It usually looks at common elements that require major repairs or replacement within the next 20 to 30 years.
The reserve study consists of two parts:
- A physical analysis, which involves an onsite inspection of the components on your property and an estimate of their expected useful life (most states with reserve study statutes require a physical analysis every 3 or 5 years)
- A financial analysis looks at how much you currently have in your reserve fund and determines how much money you need to collect each year to adequately cover the cost of making repairs or replacing those components (best practice says associations should update numbers every year as part of their annual budget process)
It’s important to have your reserve study conducted by a qualified third-party specialist with a background in multiple engineering disciplines and proper credentials from a recognized accrediting organization. In the United States, this means being accredited by CAI or the Association of Professional Reserve Analysts (APRA). Be sure that the provider is also familiar with components in your specific region since useful life can vary due to weather and other regional conditions.
How often should you update your reserve study?
The Minnesota Common Interest Ownership Act (MCIOA) requires that this be done at least every three years. Martin says that many associations choose to update their reserve studies more frequently. “Getting an update every two to three years lets the provider re-evaluate the components and your funding needs,” she explains.
Some of the factors that might alter previous recommendations include inflation, changes in the condition of individual components or how they are being used, unexpected situations such as weather and your level of compliance with the previous recommendations. An experienced community management company can help you determine when you should get an update.
For an association’s largest
capital projects, we recommend that boards seek bids from vendors on completing the scope of the project. Be upfront, and tell them the project is several years out and you will contact them when the association is ready tackle the project.