Avoiding Future Special Assessments

By Drew Sleezer, Project Manager

Life is full of risks. You may be stuck with your current circumstances, but you have surprising power to influence many future risks. As a manager or board member, you are responsible for the care of common area assets enjoyed by many homeowners. Understanding your association’s current risks and knowing what action you can take to minimize future risks is an important part of your responsibility.

As a part of every Reserve Study, we calculate the association’s Percent Funded, a measure of the association’s Reserve cash-on-hand compared to common area deterioration. It’s no surprise that special assessments are much more common among associations with relatively little cash compared to the value of common area deterioration (having a low Percent Funded). Data from over 40,000 Reserve Studies prepared over the last 30 years has allowed us to prove the clear relationship between Percent Funded and Special Assessment risk.

We know that associations in the 0-30 Percent Funded range should expect special assessments almost 50% of the time (once every other year, on average), because the association has no cash margin for events that don’t go according to plan. Take a look at the Baseline (designed to keep the Reserves cash-positive) Reserve funding plan shown below for the association’s next 30 years. The association is currently 54% Funded, in the 30-70% range where special assessments occur about 12% of the time (about once every eight years). Let’s say the board is comfortable with that level of risk, but no more. So why would we counsel them that Baseline Funding isn’t a good decision for their association? They are projected to have “enough” cash, aren’t they?

The reason is that special assessment risk is additive. It is like flipping a coin, where half the time you get “heads”. So after two flips, it is likely you’ll get one “heads”. After 10 flips, it is likely you’ll get five “heads”. You can see in this association’s Baseline Funding plan that over the course of 30 years they are projected to be in the (red) 0-30% range nine years. This means the association will likely have four or five special assessments during the years their Reserves are in the red 0-30% range. That’s too often for this Board! So they’re going to have to increase their contributions a bit, to prevent their Reserve Balance falling into the high-risk 0-30% range.

It’s all a matter of funding Reserves appropriate to your risk tolerance. Don’t let today’s “acceptable risk” drift to tomorrow’s “unacceptable risk”! The future is uncertain, but that is different from unpredictable. The budget decisions you make today will affect your association’s special assessment risk in future years.Funding Plan - Baseline

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How Much are Adequate Reserve Contributions?

by Steven Beltramo, Project Manager

At Association Reserves we understand board members face a big challenge to budget for the maintenance and replacement of their association’s major common area assets. Boards typically have little knowledge of project costs and when those costs are expected to occur. Looking to the Reserve Study for guidance, most members will review the document and exclaim, “We’re supposed to put THAT much in?” Such a realization often brings a chill to the budget process.

For board members, the size of adequate Reserve contributions are regularly viewed as dark and mysterious. Board members often tell us they feel as though they are moving forward in the dark. They know they’ll face the wrath of their members if special assessments are needed because of past low Reserve contributions, and they know those same owners will be upset if Reserve contributions are “too high”. The path to budget success can appear very narrow.

In order to answer, “What is normal?” We randomly selected 120 different associations to study from more than 4,000 we served during 2016.  We compared our recommended Reserve contribution rates to the association’s total assessment rate.  From this data, a clear story began to emerge.  In the Figure shown below, you can see that about 90% of associations need to set aside 15% to 40% of their total homeowner assessments towards Reserves in order to offset deterioration and minimize their risk of a special assessment.

The cost of unchecked deterioration is expensive and unrelenting. Associations able to get by with Reserve contributions under 10% of total budget are rare.  Most associations with Reserve contributions under 10% of total budget are headed for special assessments in the future.

So from all of us at Association Reserves, we hope this study sheds some light on the dark mystery, “How much are adequate Reserve contributions?”reserve contribs

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Change to the FHA “10% to Reserves” Rule?

FHA approval is a status condo associations can attain, allowing unit owners/buyers to receive FHA insurance on their loans which make those loan more attractive to lenders. Depending on your location, as much as 30% – 40% of all residential loans are for people who enjoy FHA insurance. Without your association on the FHA’s “approved” list, you are instantly reducing the buyer pool for units at your association by a significant fraction. If your association is FHA-approved, significantly more buyers can afford to shop for homes in your association because of more favorable loan terms. Current owners benefit by lower time on the market and stronger sales prices. Read more about FHA approval in general here and here.

But the FHA, in order to provide these favorable terms, needs the association to “toe-the line” and meet some minimum standards. For the last few years, these standards have included such things as owner-occupancy ratios (must be at least 50%), and Reserve funding (must be at least 10% of total budgeted income).

On 10/26/16 the FHA came out with a revised set of standards so associations could become approved with owner-occupancy as low as 35%. In their eyes, to accept this higher risk they needed to lower the risk level somewhere else. They chose Reserve funding. So for associations seeking FHA approval with owner-occupancy between 35% and 50%, the FHA will consider them for approval if their Reserve contributions are 20% of total budget. Since adequate Reserve contributions for most associations are 15%-40% of their budget, this indeed stiffens up Reserve funding requirements but doesn’t constitute an insurmountable obstacle.

So when you hear the FHA has doubled its Reserve funding requirement up to 20%, know that this only applies to associations with owner-occupancy between 35% and 50%. The “10% of budget to Reserves” rule still applies to associations with an owner occupancy ratio over 50%.

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Is a Reserve Study Required Annually in California?

In a word, yes.

California Civil Code 5550 requires a Reserve Study based on a “diligent visual site inspection” at least every third year, but requires the Board review that Reserve Study annually and “consider and implement necessary adjustments”. That’s called an annual Reserve Study update.

California Civil Code 5300 and Civil Code 5560 together require that every association annually adopt and disclose their Reserve Funding Plan. Most Reserve Studies have a 30-yr Funding Plan. But if it is two years old, then the association doesn’t have a current plan. Time has marched on, and the plan is out of date. Get your updated 30-yr Funding Plan, every year, when you update your Reserve Study. Then adopt it and disclose it!

That same Civil Code 5300 requires a full Summary of the Reserve Study be included in the annual budget report. That “summary” is defined in Civil Code 5565. You’ll note throughout 5565 the word “current” with respect to Reserve Study information. That can have only one interpretation… the “current” year (not information from one or two years ago).

California Civil Code 5570 defines the annual Assessment and Reserve Funding Disclosure. The only purpose of this form is to provide owners with a disclosure of current information. And the only way one can report current Reserve Balance, current Reserve Contribution rate, current Percent Funded, and a projection forward of at least five more years of that same information, is to have a Reserve Study prepared/updated for the current year. In case you haven’t seen one, an example completed form looks like this.

But what if you don’t care about what the law says? Who’s going to “call you on the carpet” and make you comply? On a practical level, adequate Reserve contributions, required by almost every association’s Governing Documents, comprise 15-40% of the association’s budget. This means Reserve contributions are one of an association’s largest budget line items. Being so large means it is fiscally irresponsible to disregard such a large budget line item for years at a time. Tip: failing to update your Reserve Study for years at a time is a key reason for special assessments. That’s the practical benefit. Save your homeowners from that headache!

For further reading, see this article focused on the topic of preparing the annual Assessment and Reserve Funding Disclosure Form in California.


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Make your Association 35% Better!

We all know that scarcity causes conflict and stress. Scarcity of Reserves causes deferred maintenance and special assessments, drags down property values, and causes other related problems. How can an association avoid these problems and emerge with sufficient funds to maintain the community, maximizing property values and pride of ownership?

Simple. Update your Reserve Study, don’t let it grow useless on the shelf. In a review of 19,111 of our most recently completed Reserve Studies, we found that special assessments (an easy-to-measure event) dropped by 35% when an association updated their Reserve Study more frequently than every fifth year. The improvement was 35.1%, actually! In addition, year-to-year variations in Reserve contributions in those associations dropped by 9%.

It’s not surprising really. Associations who pay attention to their financial situation have demonstrably fewer special assessments (disruptions), and more stability to their budget. They tend to be on-track, setting the right amount aside towards Reserves, with owners all paying their fair share (the true cost of home ownership). The result is their association is significantly more likely to have the necessary Reserve funds on-hand when they are needed to perform those major, predictable common area repair and replacement projects.

So… want to make your association a better place to live and own a home? Pay attention to your budget. Update your Reserve Study regularly (every year, or at least every third year). The payoff, 35.1% fewer special assessments, is very real. It’s in your control to make this type of change at your association!

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Setting our Industry Up for Success

After 30 years preparing Reserve Studies, helping associations make wise decisions about their capital budgets to avoid surprises and the high cost of deferred maintenance, Robert Nordlund of Association Reserves has joined the national “Think Tank” of the Foundation for Community Association Research (FCAR) to help the industry on a broader spectrum. Watch a brief video introducing 2016 Think Tank members and projects here.

Robert joins distinguished leaders from other national companies serving on the “Think Tank” with insurance, legal, financial, maintenance, management, and other areas of expertise to chart a successful path for the future of the community association industry. FCAR is primarily known for its national “Fact Book”, updated every other year, which provides a baseline of information for our industry. Think Tank members are investigating how technology can be embraced and harnessed for the benefit of homeowners, boardmembers, and managers, and finding how managers and boards can be more effective working with homeowners who are advancing in age.

Robert is also serving as part of a team to determine how effective Reserve Studies are in helping associations budget responsibly, minimize their special assessments, and maximize property values.

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Does our Association Need to have Healthy Reserves?

A good answer is both “yes” and “no”. Let me explain.

Yes: Typical Governing Documents and the uniform legal expectations of Boardmembers  across the country require Boardmembers to maintain and protect the assets of the corporation on behalf of the owners. In a community association, this means the Board is chartered with the responsibility to budget for the ongoing care of the physical assets of the association. There is no wiggling around that responsibility. That’s a Boardmember’s job, and there’s no one else to blame if community spirit suffers and home values fall due to special assessments and deferred maintenance.

No. Only Hawaii, to my knowledge, has a specific state-wide Reserve Fund requirement standard, and even that standard is low.

So are Healthy Reserves required? I argue for “yes”, but don’t look for it clearly written in a law somewhere. Reserve expenses don’t go away. If you wish to perform Reserve projects in a timely manner and avoid disruptive special assessments and costly deferred maintenance, the best way is to make healthy (adequate) Reserve contributions which build a healthy Reserve Fund. Reserve expenses, not the law, are at the root of the need for Healthy Reserves!

Healthy Reserves maximize well-being in the community, minimize boardmember liability exposure, and maximize property values. They may not always be articulated as a requirement, but Healthy Reserves are the smart thing to do!

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Reserve Contributions – They’re Not About the Future!

One of the biggest misconceptions about Reserve contributions I hear, even more than “they’re too much” or “we can’t afford them” (which I’ll address in another post), is that they are for the future. I don’t know how I can be any more clear on this matter. Reserve contributions are not for the future. Reserve contributions offset ongoing, day to day, current deterioration.

Reserve contributions offset the current deterioration that is occurring each month while the current owners are enjoying those assets. The owners using these assets should pay for their use. It’s only fair. If every owner pays their fair share of deterioration, on an ongoing basis, the future takes care of itself. While big Reserve expenditures arrive infrequently, the cost accrues slowly and regularly on a daily basis. This is not a game of “musical chairs” the Board plays, hoping to dodge or defer a big expense when it occurs. Those big bills come about due to deterioration that occurred slowly, steadily, usually in plain sight and on a very predictable schedule, for years.

Reserve contributions are not charity for some other owners in the future. The ongoing cost of Reserve deterioration is as real as any other bill the association faces. Appropriately sized Reserve contributions pay that bill on an ongoing basis, so future owners don’t have to pay the bills you left unpaid!

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Can Reserve Funds be used for Drought-Friendly Landscape Renovations?

In the middle of a major drought, many of our California clients are asking this question as they try to be both “good citizens” and financially responsible. The answer is yes, but…

Landscape renovations can be classified as a Reserve Project if they meet the National Reserve Study Standard four-part test:
1) The project is a common area maintenance responsibility
2) The project has a well-defined Useful Life interval
3) The project has a predictable Remaining Useful Life
4) The project is above a minimum threshold cost of significance.

Many associations already have landscape-related projects in their Reserve Study, the most common being tree trimming. Many others have other periodic landscape renovation projects to periodically freshen up the appearance and health of their greenscape. If your association currently has a landscape renovation Reserve Component, those funds could be used for re-planting and re-designing with drought-tolerant species. If you wish to add such a line item, get some guidance from your Reserve Study and landscape professionals to select an appropriate Useful Life, Remaining Useful Life, and scope. Remember, such an addition will result in an increase to your Reserve contribution rate.

Another strategy here in CA would be to borrow from Reserves for a landscape or irrigation renovation, with these borrowed funds expected to be recouped by savings from lower water usage. While Civil Code requires borrowed Reserve funds to be repaid within 12 months, the following clause allows the association to delay repaying the funds over a longer period of time: “…the board may (delay repaying the borrowed Reserves), after giving the same notice required for considering a transfer, and, upon making a finding supported by documentation that a temporary delay would be in the best interests of the association.” See CA Civil Code 5515(d). So if you find that a $50,000 landscape renovation project would result in a projected $50,000 water savings over 3.5 years, and if your Reserve balance can support that magnitude of an expense without delaying necessary Reserve projects, an updated Reserve Study can provide your necessary documentation. The result is a zero-interest loan from Reserves to Operating to execute that project. Just let us know, and we’ll work that funding into your next Reserve Study update.

A few additional points:

  • Make sure the project meets your architectural requirements. You don’t want to replace grass in your greenbelts with artificial turf if you’ve been denying homeowner requests to do similar projects in their front yards!
  • If you are installing artificial turf (or something else that will need renovation or replacement), remember to add it to your Reserve Component List!
  • If you make design changes to your landscape, think 10, 20, or 30 yrs into the future. The current drought may be temporary, and because of its cost you’ll want to enjoy your new landscaping for decades into the future.
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Is 10% of Budget to Reserves a Law?

Click here to see a list of laws we compiled from across the country with respect to Reserves. While 30 states have some legal requirements, the “10% of budget to Reserves” is not a law. But it’s something you want to do.

Due to the financial meltdown that began approx 2008, more lenders are particular with respect to making loans. Fannie Mae, Freddie Mac, and FHA have enacted a requirement that Reserve contributions comprise at least 10% of total budgeted assessment income (Note: this only applies to condominiums, it does not apply to planned development or home-owner associations). So if your association dues are $200/mo, Reserve contributions need to be at least $20 of that $200, or you’ll need a Reserve Study justifying a lower number. Such a lower number would be exceedingly rare, as most associations require 15-40% of their total dues going towards Reserves to offset ongoing deterioration. If enough Reserves are not set aside on an ongoing basis to offset deterioration, there will be insufficient funds to pay for a new roof (or whatever major common area assets your association has), and owners will need to kick in funds via a special assessment. Such a special assessment could be very destabilizing for an owner barely making their mortgage payments. “10% of total budget” Reserve contributions are likely inadequate, but it’s what lenders have chosen to lower the chances a special assessment will occur that would cause a homeowner to default on their mortgage payments! That’s just the reality of the lending situation at this time.

Our firm is the largest provider of Reserve Studies in the country. We help our client associations avoid surprises and become prepared for their inevitable major common area repair and replacement projects. If you don’t know how much to be setting aside to adequately offset ongoing deterioration, click this link and request a proposal. We can tell you with confidence what to Reserve for, what your current risk of a special assessment is (based on how much you presently have in Reserves), and how much you should be responsibly setting aside at this time.

If you don’t want to hire a Reserve professional, change your budget so Reserve contributions are at least 10% of the total. That will get you into the ballpark and significantly increase the “sale-ability” of units in the association. Trust me, an increase in a few thousand dollars in sales price nicely offsets a few bucks a month of increased dues! It is without question the right thing to do.

You’re just fooling yourself if you think it is advantageous to keep dues low by avoiding Reserve contributions. The pain, disruption, cost, and unfairness of a special assessment typically is something boardmembers don’t want to do twice.

Either you pay Reserve contributions on an ongoing basis, or you’ll pay it later by way of a special assessment or lower property values. It’s cheaper and financially in the best interests of all homeowners to make appropriately sized Reserve contributions an ongoing basis. Click here for an article on the topic.

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