Reserves for Common-Interest Developments

Reserves for Common-Interest Developments

Common-Interest Developments (abrev. CID) is the fastest growing form of housing in the world today. They are commonly known and seen as condominiums, timeshares, planned unit developments along with other titles and descriptions. The ownership benefits of a CID are to have rights to an undivided interest in common areas and amenities which might prove to be too expensive to be solely owned. For example, an owner would like to have a pool but cannot afford one on their own. But if buying a condominium with a pool in a CID of one hundred units, an owner would have use of that pool for basically one-hundredth the cost due to sharing this cost with the other 99 owners. Timeshare, or Vacation Ownership, is the same concept. Where buying a second home for vacation purposes might not be financially possible, buying a week or two can be when sharing the overall costs with other participants.

When a CID is developed, the developer is required to incorporate (in form) a Homeowners' Association (abrev. HOA) prior to any property sales. The role of the HOA is to manage the CID once control is transferred from the developer. The HOA governs the CID based upon the incorporated Covenants, Conditions, and Restrictions (abrev. CC&Rs) which were recorded when the property for the CID was subdivided. The CC&Rs will outline the financial budgeting guideline for the HOA in determining the dollar amount in maintenance fees for assessing the owners. In a wholly-owned CID, maintenance fees would normally be assessed on a monthly basis.

The HOA is operated by an elected Board of Directors (abrev. BOD) of the existing owners. The BOD performs its duties based upon the CC&Rs. As outlined in the CC&Rs the BOD is responsible for producing budgets for the maintenance fees to be assessed to the owners. Maintenance fees consist of two functions being the daily, monthly, and annual operations and the long-term maintenance or replacement of the common areas and amenities. Daily, monthly, and annual operation expenditures for a HOA would include common area maintenance of the grounds, water for landscaping, electricity for general lighting, heating the pool, pool maintenance, etc. Long –term maintenance or replacement of common areas would consist of paving streets and parking lots, replacement of roofs, re-plastering pools, painting buildings, etc. When these individual budgets are completed, they are combined and per the CC&Rs allocated and assessed to the owners for payment. When the payments are received they will be deposited based upon the budgets to the appropriate HOA operation bank account and the long-term maintenance or Reserve bank account.

Funds collected for the long-term maintenance or replacements of the common areas are deemed Reserves. They will accumulate until they are needed for such. The budget process and what is to be reserved for by the HOA should be outlined in the CC&Rs. The CC&Rs should outline where the responsibility ceases for the HOA and becomes the responsibility of the owner for the long-term maintenance or replacement of the individual units. For example, plumbing might cease being the responsibility of the HOA once the main water pipe enters the unit wall. This would place the financial burden on the owner if a pipe was to start leaking inside the unit and it would have to be repaired.

When dealing with Reserves, the following objectives for planning, budgeting and managing of Reserves should be considered:

  1. Fiduciary responsibility of the BOD
  2. Protect the property condition and value
  3. Meet requirements of governing and legislative bodies, and the CC&Rs
  4. Common Area management for tracking and administration
  5. Optimized investment plan for available Reserve Funds
  6. Reserve Studies

A Reserve Study is a coordinated effort between HOA management, BOD, contractors/vendors, interior designers, architects, engineers, accountants, investment counselors and sometimes lenders for producing an overall reserve plan. The process begins with the identification of the individual common area items (or reserve items) which need to be reserved for in the Reserve Study analysis.

Fortunately, there is a standardized four-part test for determining if an asset is appropriate for Reserve designation: 1) The asset must be a common area maintenance responsibility 2) The asset must have a Useful Life 3) The asset must have a predictable Remaining Useful Life, and 4) The asset must be above a minimum threshold cost.

Once the reserve items have been identified and established as the "Reserve Component List", the following information will then be determined for each item by the professionals outlined above:

  1. Project Description (Fence - Paint or Fence - Replace)
  2. Description/Quantity (including measurement basis such as Linear Ft, Sq Ft, etc.)
  3. Useful Life (Yrs)
  4. Remaining Useful Life (Yrs), where 0 is the initial planning year
  5. Current Replacement Cost (includes installation, salvage, disposal, etc.)

Additional useful information such as:

  1. Cost Basis (current cost by square yards, linear feet, each, etc.)
  2. Freight and labor (costs to receive and install)
  3. Salvage (estimated value of the item when replaced, if any)
  4. Date placed in service or the date last maintained or replaced

The information above now can be used to produce a reserve financial plan and budget to determine the amount to be assessed to the owners in their maintenance fees. While producing the financial plan and budget the following factors should be considered:

  1. Funding Objective (Full Funding, Threshold Funding, Baseline Funding)
  2. Inflation
  3. Contribution annual increases
  4. Interest earned
  5. Taxes on interest earned
  6. Contingencies

Full Funding means attempting to maintain a Reserve balance equal to the deteriorated value of the assets. Baseline Funding means attempting to maintain a Reserve Balance that never falls below zero (without the help of special assessments or loans). Threshold Funding is a value chosen by Board or Management typically somewhere in-between Full Funding and Baseline Funding. Full Funding is a more conservative objective, where special assessments and deferred maintenance are rare. While a Baseline Funding objective technically provides sufficient Reserves, in actual practice special assessments are common among these associations due to lack of any "margin" for unanticipated expenses.

The most professionally recognized and accurate reserve plan is reflected in a cash flow projection taking into account the above factors. The national standard four Funding Principles dictate that a Reserve Plan should consider and effectively meet the following four objectives: 1) Sufficient funds for anticipated expenses 2) Budget Stability from year to year 3) an Equitable Distribution of the contribution burden over the owners, over the years, and 4) Fiscal responsibility.

Well implemented, a multi-year Funding Plan smoothly provides sufficient funds for the naturally irregular maintenance or replacement expenses associated with the individual reserve items, from the initial (zero) year to approximately 30 years away. In essence, a stable rate of Reserve contributions are designed to offset an irregular array of Reserve expenses, such that every owner pays "their fair share" over time in direct proportion to the amount of time they have an ownership stake in the association. An effective Funding Plan, developed in an annual Reserve Study, ensures that major maintenance and replacements at the association can get done on time, leaving only true "surprises" to be handled by special assessment.

References

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