Reserve contributions typically comprise 15-40% of an association’s total budget, making it one of the association’s largest, if not the largest, budget line item. In the annual budget process, it makes no sense fussing about the little line items (just a few percentage points each) if you neglect reviewing and updating your Reserve contribution line item.

From a liability exposure point of view, the Business Judgment Rule dictates that boardmembers need to act within their area of authority, after reasonable inquiry, in the best interests of the association. For a budget line item as large as Reserve contributions, that means looking at, and adjusting it as necessary, annually.

Fundamentally this is necessary because each year reality creeps into an association’s best laid plans. The Reserve balance is never quite what one presumed it would be, deterioration is often not exactly at the rate one presumed it would be, and repair/replacement pricing is always moving more (or less!) than you presumed it would move, and sometimes in the wrong direction. So the whole situation is in a state of constant change… the cash available, the timing of the expenses, and the size of the expenses.

Bottom line: it is appropriate to update your Reserve Study, which means review your Reserve components, your Reserve Fund strength, and your Reserve contributions annually as part of the annual budget process.

Special note – the individual asking this question was from California, where the law says that Reserve contributions must be evaluated and adjusted annually, that key figures (Reserve balance, Reserve contributions, and Reserve Fund Strength) must be reported annually, and that the annual update process must be based on a “diligent visual site inspection” at least every third year. Most of this can be found in California Civil Code Sections 1365 and 1365.5.

The bottom line is that the Reserve Study should be performed according to reliable and repeatable National Reserve Study Standards. There is a four-part test to be used, guiding associations about what is (and isn’t!) an appropriate use of Reserve Funds. For a project to be funded through Reserves, one must be able to answer “yes” to each of the following four questions:
1) Is the component the maintenance responsibility of the association?
2) Is the component Life Limited?
3) Does the component have a predictable Remaining Useful Life?
4) Is the anticipated repair/replacement cost above a minimum threshold of significance?

In many cases, you can see that a significant landscape upgrade is appropriate for Reserve designation. It is common area, it is life limited (plants/shrubs get old and need to be replaced), it can be anticipated on a predictable schedule, and for many associations a landscape renovation project can be a significant expenditure of funds.

So if it passes the four-part test, it is appropriate to be handled through Reserves. We even had a “Dude Ranch” association that defined their riding horse stock as a Reserve component… they were assets maintained by the association, they got “old” and therefore had a limited Useful Life, they aged in a predictable manner, and a herd of horses (or a significant fraction of the herd) is a significant expense!

http://www.reservestudy.com/replacement-reserve-costs-vs-total-insurable-value

Now today someone asked if the Reserve Study provider should be held accountable (liable!) if construction defects were not revealed in the Reserve Study. So please, refer to the prior blog entry as a basis for this answer.

A Reserve Study should be expected to provide three things: the Reserve Component List (the scope and schedule of upcoming Reserve projects), an evaluation of Reserve Fund strength (Percent Funded), and a recommended multi-yr Funding Plan. National Reserve Study Standards allow us to stay within our area of specialty, stating that in the process of preparing a Reserve Study we can presume a component is “properly constructed”. This is not a shield we hide behind, it simply describes of our line of work. A Reserve Study should not be expected to reveal construction defects. That is the realm of a forensic engineering study.

Let us prepare a Reserve Study for you to help you prepare for your association’s inevitable capital expenses, so you don’t have special assessments, deferred maintenance, political tension, boardmember liability exposure, mortgage financing difficulties, and declining property values. A roof that gradually failed, in plain sight, over the course of 20 years should not be the source of a cash flow surprise at your association!

We continue to hammer the point that per National Reserve Study Standards (not just my opinion), one gets three results in a Reserve Study:
1) A Reserve Component list that establishes the scope and schedule of upcoming Reserve projects
2) An evaluation of Reserve Fund Strength
3) a Recommended multi-yr Reserve Funding plan.

So that’s what one should expect to receive in their completed Reserve Study. One should therefore not expect to find in a Reserve Study an evaluation of the building envelope, articulating strengths and weaknesses of its design or its construction. If an association wants such an evaluation, they should commission such an investigation. A building envelope evaluation is by definition not part of a Reserve Study.

At Association Reserves we don’t do construction consulting, we don’t redesign decks, we don’t prepare maintenance plans, we don’t prepare insurance appraisals, and we don’t prepare building envelope evaluations. We leave those things to experts in those respective fields.

We are Reserve Study providers, problem solvers with respect to association capital budgeting. We help our clients get out of trouble with respect to their Reserves, and we help them stay out of Reserve trouble. We are very good at what we do, and to excellently provide independent counsel to our clients in this field we believe we can have no interest in doing other work for the association (painting, construction consulting, or building envelope evaluations), as any other work has at a minimum the appearance of being a conflict of interest. And because any of these possible conflicts dent the credibility of the Reserve Study provider’s findings and recommendations, any potential conflict of interest must be clearly disclosed to the client per National Reserve Study Standards. Click here to see for yourself (see p7, item #1).

Get a great Reserve Study, and if you need one, get a great building envelope analysis. But don’t expect them to be one and the same document!

In a word, no. A Reserve Study is an important tool to be used by the Board of Directors and Management as they protect, maintain, and enhance the major common area assets of the association. A Reserve Study is not a vision-casting document, helping the board dream of a broad spectrum of fascinating options available in their future. A Reserve Study is also not a (re)construction specification document, that can be copied and handed out to contractors for bidding purposes. Per National Reserve Study Standards, a Reserve Study helps the Board of Directors learn the scope and schedule of upcoming Reserve projects, the strength of their Reserve Fund, and a multi-yr Funding Plan to provide for the timely repair or replacement of their anticipated expenses. Keep in mind what a Reserve Study is supposed to do, and it helps you avoid expecting it to be something different.

While the Board of Directors may ask their Reserve Study professional for input as they consider cost vs benefits for different materials (it costs more but it’s supposed to last longer… is that a wise move?), the default expectation should be that the Reserve Study will help the Board repair or replace the association’s assets with similar assets, with normal technological or aesthetic upgrades. Where differences are suggested or warranted (upgrading one type of roofing system to a different type that is more cost-effective), a disclosure is recommended for the sake of communication, but is not mandated by National Reserve Study Standards.  Typically that may be as simple or as clear as the cost and Useful Life appearing in the Reserve Component List, such as moving from a 20-yr life roofing material, to a 30-yr life roofing material. We don’t need to necessarily be discussing brands, just that the next roof will be more expensive but it will last longer (and be worth it).

Note that the recommendation for effective communication goes both ways… what we recommend as a wise move to our clients, and what colors, finish materials, or redesign options an association is thinking about implementing when their current component needs replacement. We are in this together as planning partners, we both need to be on the same page.

Most of us have a mortgage. Some of those mortgages have a “balloon” payment at a future point in time. That is a future expense. Some of us with small kids in the house are anxious about college bills. That is a future expense. But physical deterioration goes on every day. One day a roof is new, the next day it’s not. After being installed new, it is a gradual, daily, observable progression towards the day it will fail. You don’t write the check for that deterioration until a future point in time, but the deterioration is accumulating on a daily basis nonetheless.

This is a theme you’re going to hear more from us about this year. It is the concept of making wise (not foolish) decisions, and the concept of an association’s “deterioration cost”. That cost of deterioration is as real as the electricity bill or the landscaper’s bill. If you don’t pay it one month, it doesn’t go away. It just gets added to the next month’s bill. And similarly, if you don’t pay it on time, you get a late fee. That is often the same with doing Reserve projects. If you don’t perform a Reserve project in a timely manner, it doesn’t go away, and it often gets more expensive (due to deferred maintenance).

So what’s your association’s “deterioration cost”? It is based on your size and your asset mix. Every day, all those assets are getting older, marching gradually towards needing to get replaced (or refurbished or repainted…). If you are contributing less than the deterioration cost, you have unfairly paid less than your share, and some poor sap in the future will be faced with paying your bill. That “deterioration cost” will float upwards in time over the years due to inflation, but it should remain relatively constant through the years. It’s just plain part of the cost of home ownership in your association. Associations that have historically underfunded their Reserves will likely need to contribute higher than their “deterioration cost” to play catch-up and prepare for a large roofing or painting expense. Associations with surplus Reserves should contribute less than their “deterioration cost” to gradually bleed off their surplus. But if an association is regularly contributing less than their “deterioration cost”, they are headed to special assessment land.

It’s not about Reserving for the future. It’s about keeping up with bills due to ongoing deterioration.

But back to the question: Can a Board Choose to Under-Reserve? Yes. It is their association, they can set the budget as they see fit. But just because they can, doesn’t mean it is a correct, or safe, choice.

Typically a Reserve Study will clearly articulate the Reserve contributions necessary to offset the ongoing deterioration and “set the association up for success”, preparing them to have enough cash for upcoming expenses without reliance on future special assessments. Armed with this knowledge, if a Board chooses to fund the Reserves to a lower amount, they run the risk of putting the association on a course towards deferred maintenance and special assessments. Ongoing deterioration is occurring. That “bill” is as real as any other cost facing the Board. If that “bill” is not being offset with appropriately sized Reserve contributions, that “bill” will eventually be paid by future owners in the form of a special assessment.

This last week we presented a webinar on D&O Insurance and Reserve Studies, with guest expert Kevin Davis of Kevin Davis Insurance Services (the country’s largest provider of D&O Insurance coverage for community associations). If you missed it, you can watch the webinar by clicking here. Kevin clearly describes the financial decisions Boards make as wise, casual, or foolish. A Board can be sued for any of their decisions, but they significantly increase the risk of being sued if their decisions on financial issues are casual or foolish. In addition, defense of casual or foolish decisions are much more difficult and time-consuming than defending a wise decision. Finally, if a decision can be shown to be willfully in disregard for the association’s Governing Documents or State Law, those Boardmembers are at risk of not being defended by the association’s D&O insurance.

So Boardmembers seeking to run the association according to their Governing Documents and desiring to keep their personal liability to a minimum need to fund the association’s Reserves adequately. As I like to say, there is no “oops” in being a Boardmember. Running the association responsibly is the job of a Boardmember. As a Boardmember you are playing with other people’s homes and their money. They will be upset if you run the financial ship of the association into the rocks.

So don’t be foolish. Don’t under-Reserve.

So the first criteria for a Reserve component is that it exists. If it does not exist, it is a new asset to the community, and therefore a Capital Improvement. But what about a black-and-white closed circuit camera system? Can it be replaced through Reserves with a color-digital system with a one-week digital video backup system? Such a system is obviously new (of course), and different (color, and now with storage), but I would argue that it continues to serve the intended purpose of the original asset, with current technology.

What if the asset is listed as “B&W Camera System” in the Reserve Study? I would argue that is only a description, not a limitation. The essence, the reason the component exists at the association, is to provide a visual record of what is happening. At this time, while a color digital system with digital backup is “new”, it is truly just doing what the old one did, but with current technology. Adding a gate system where one previously did not exist would be a capital improvement, but replacing an old camera system with a new camera system sounds like a Reserve project to me.

The same case can be made for new roofing materials, pool and spa surface materials, computers (and software and printers) in on-site management offices, decking systems, furniture in the rec rm, etc. If the asset existed, and if the old asset can be replaced with new assets that perform the same underlying function, such projects pass the test as being a Reserve Component.

In addition to the comments made by an independent community-association attorney and the California DRE, there is the underlying reason that making adequately sized Reserve contributions is simply the fair thing to do. Making Reserve contributions less than the rate at which the association’s common area assets are deteriorating means the current owners are paying less than their fair share, and forcing future owners to pay more than their fair share. In this common situation, Boards are essentially “self-dealing”, giving themselves lower assessments at the cost of future owners who will be forced to play “catch-up” when the roof fails or the elevator fails. I wonder how long it will be until that liability exposure becomes more commonly discussed!

Common area deterioration, the reason for Reserve contributions, is as real as any other “bill” at the association. Some day, the reality of that ongoing deterioration will rear its ugly head. The only choice facing an association is if that bill will be spread out fairly over the owners who enjoyed the use of those common areas, in direct proportion to the # of months they owned a home in the association, or if those expenses will collapse on some future owner who gets caught “holding the bag”. Someone is going to pay the bill.

Spread it out. Pay your fair share.

By the way – stay tuned for our November Webinar (sign up for our company’s email newsletter here to get the announcement of date/time), when we’ll discuss this very issue with respect to the Board’s D&O insurance coverage.

If you’ve hired Association Reserves, we believe we have been hired for our independence, expertise, and experience, for the purpose of providing you with budget advice and accurate disclosures. We destroy our independence and fail to provide you the results we were hired to provide if we distort the truth. And that is the key.

We see the preparation of a Reserve Study like a three-legged stool – very stable. Those three legs are the Reserve Study professional, management, and the Board. When those three parties are involved, the results tend to be reliable and effective. Each correcting the other leads to accuracy. For instance, a Boardmember providing us updates on the latest projects done at the association may report the recent painting was accomplished for $50,000, but management later may correct that ($50,000 was just the 50% progress payment!). Management may suggest to us that the special assessment required to get ready for the asphalt project should be spread over the next three years, but the Board may reply that politically the association is ready, and it is best to do one special assessment and get it over with. And both management and the Board should be involved proof-reading the Reserve Study, finding any glaring typos (a Remaining Useful Life of 0 instead of 10!).

But when it comes to distorting the truth, that’s when you’ll see our heels dig in. If we are asked to change a Remaining Useful Life of an ironwork repaint project from 0 to 2 “just because you don’t think you’ll get around to it”, when it is currently rusty and the paint coverage has failed, we will keep it at zero because that is the truth of the situation. Readers of the Reserve Study need to know the truth, both physically and financially. No funny-business. Prospective buyers are reading the Reserve Study to get a sense of what they are getting into, and current owners are reading Reserve Studies to get a status report on their common areas and their financial preparedness for future projects.

Can you argue the size of the recommended Reserve contributions? You can complain (we’re used to that & don’t take offense at it), but there’s typically not much we can do. Our job is to get you prepared for future expenses, and we don’t accomplish that by being overly optimistic.

Our job is not “to keep the dues low”, or to “validate the Reserve Study done last year by the treasurer (or another Reserve Study firm)”. Our job is to present the truth of the situation to Reserve Study readers. Ask your questions, and you’ll see where we dig our heels in. The logo on the cover is ours. We welcome your insights, clarifications, and corrections, but we won’t stray from the truth for you.