The main purpose of a reserve study is to analyze the overall components of an HOA to try and determine how long it will be before assets will need repair or replacement and estimate the cost of such upkeep.
Reserve studies also serve to enable the board of directors to analyze the overall strength of the reserve fund. The reserve study is vital in assisting the board with funding reserves – that is, the ability to closely estimate the amount of funds that will be needed to keep the association in good repair without having to impose special assessments or gain outside funding.
Reserve studies are critical in helping the board avoid financial emergencies within the HOA. When that large expense finally happens, the HOA will have planned accordingly and will avoid the need to secure special financing to fix the problem. Instead, they will utilize the reserve fund to cover large expenses. Ultimately, a little financial pain up front translates to fewer costs in the future.
Reserve studies are also vital because they create equality between the current and future members of an association. For example, if the current members of an association are using the HOA’s physical resources, such as the clubhouse or a pool, they are creating wear and tear on that property. Eventually, in 10 years or so, something will happen – i.e., clubhouse carpeting will need replacing or a leak will occur. If there is no reserve – or if that reserve is inadequate – the future members would then be responsible for financing all, or a large portion of, damage or use that they did not personally cause.
In short, a reserve study is a valuable tool you can use to preserve the financial health of your homeowners’ association by ensuring that the association’s reserve fund is properly maintained. The reserve study is designed to identify the current status of an association’s reserve fund and create a plan to improve the situation for the association.
Before contacting a reserve study specialist, “the board should have a general idea of what reserve studies are … and what they are not”, according to Steve Jackson, Owner/Consultant of Advanced Reserve Solutions, Inc. headquartered in Orange County, CA.
Jackson continues, “Our job is to assist the board in developing a budget – to be used as the reserve allocation in the operating budget – which helps the association with their next year. Additionally, the reserve study advises the association as to their reserve fund status (percent funded) and provides projections to assist the board in developing their long-term reserve funding goals and objectives.”
To better understand the benefits of a reserve study, one must first understand deterioration costs and the basics of the reserve fund.
Deterioration Costs Explained
With each passing day, association assets are aging, which means they will eventually need to be repaired, replaced, or refurbished in some manner. Your HOA’s deterioration cost is determined by the size and asset mix of the association. In time, deterioration costs will increase due to inflation. If your HOA board has not planned properly and has contributed less than needed to the reserve fund, they will likely be forced to implement a special assessment on homeowners to cover a large expense. It is the board’s duty to avoid this! This is why your association’s reserve funds should be adequately maintained.
Reserve Fund Basics
A homeowners’ association typically has two funds: the reserve fund and the operating fund. The operating fund is maintained by the association for keeping up with day-to-day expenses and maintenance, such as vendor invoices and routine monthly expenses.
The reserve fund is essentially a savings account for the HOA. Funds in this account are used to offset the association’s ongoing disrepair and projected future costs. When an HOA has less than 70% of a funded reserve, they risk having to implement special assessments or raise association fees to cover costs; this puts undue burden on homeowners by forcing them to come up with money on short notice. It is the board’s obligation to properly plan and prepare for unforeseen emergencies and expenses in order to avoid such a scenario. Ideally, the association will have a fully funded reserve in which to draw from when future unplanned expenses occur.
This begs the question: how does one differentiate between a maintenance expense and a reserve expense?
Expense Differentiation: Maintenance or Reserve Expenses
Maintenance expenses should be paid for from the association’s operating budget because, in general, a maintenance project is considered as an ongoing, or normal, cost of having a particular asset.
Reserve expenses, coming from the reserve funds, should be used to extend the life of an asset, rather than for normal maintenance of said asset.
How Much Does my HOA Need to Have in Reserve?
According to the International Capital Budgeting Institute (ICBI), “a reserve study funding plan should be prepared on the cash flow basis.” However, it’s important to bear in mind that cash flow analysis is concerned with actual transactions, and because cash flow is linear while inflation is not, this makes it mathematically difficult to plan for future costs that change with time (inflation or actual changes).
Because every property is unique, there is no one set answer as to how much your HOA needs to have in reserve. There are multiple factors involved, such as the age of the property, the size of the property, the amenities offered, expected use/wear and tear of assets, etc. A good rule of thumb is to have 70% or more of the property’s calculated deterioration be covered by the reserve fund. This will lower the risk of any future board having to level a special assessment.
Percent Funded Explained
The National Reserve Study Standards define percent funded as “the ratio, at a particular point in time (typically the beginning of the fiscal year), of the actual (or projected) reserve balance to the fully funded balance, as expressed as a percentage.”
Fundamentally, percent funded can be found by comparing, on a particular date, how the current reserve fund matches up to the HOA’s reserve needs. To calculate percent funded, divide the actual reserve fund balance by the computed fully funded balance. For examples of this, check out these examples by Capital Reserve Analysts.
Ideally, a reserve fund balance will be 100%. By figuring out the percent funded, the board can gauge the reserve balance at a given point in time. If your association has less than 70% funded, there is a higher risk of needing special assessments; the reserve fund is considered weak under such conditions. This is why a minimum of 70% funded is always advised.
Capital Expenses vs. Reserve Expense
Capital improvement projects occur when a new asset is added to a community. Once completed, a capital improvement project will create operating and future reserve expenses.
Reserve fund expenses come with replacing and/or repairing existing components. Reserve funds should be held in a separate banking account that is specifically designated for such expenses.
Basic funding plan goals include baseline funding, threshold funding, and full funding. The level of risk increases between categories.
Baseline funding carries the greatest risk due to the many variables associated with the timing of component replacements and repair/replacement costs.
Threshold funding typically establishes a reserve funding goal of keeping the reserve balance above a specific dollar or percent funded amount.
Full funding is the most conservative funding goal, which involves setting a funding goal to attain and maintain reserve funds at (or near) one hundred percent funded.
It’s important to be aware of the percent funded of your HOA’s reserve, as this could provide insight into any possible future assessment increases and the financial stability of the association.
Two Types of Analysis
A reserve study is comprised of two parts = the physical analysis and the financial analysis:
The Physical Analysis is an evaluation of the physical state and repair or replacement costs of common area components that an HOA is obligated to maintain.
The Financial Analysis is an evaluation of the association’s income, expenses, and reserve balance.
The Physical Analysis and Financial Analysis help predict the projected reserve income and expenses. Using these analyses, the board can strategically plan for future expenses and incorporate any special assessments and budgeting.
What is a Reserve Component List?
According to the Community Associations Institute (CAI), a component is defined as “the individual line items in the reserve study, developed or updated in the physical analysis … these elements form the building blocks for the reserve study and … comprise the common elements of the community.”
To obtain a better understanding of the components, the National Reserve Study Standards has comprised a four-part component list that serves as a guideline for associations in determining whether an expense is covered by the reserve fund. To ascertain whether the expense is to be covered by the reserve fund, the board must decide if the expense is:
- life limited,
- a common area maintenance responsibility,
- have a predictable remaining useful life, and
- is the cost above a minimum of significance?
Types of Reserve Studies
In general, there are four types of reserve studies that can be conducted, based on levels of service, according to the National Reserve Studies Standards. Let’s take a look at what these various levels entail:
Full Reserve Study
A full reserve study is generally conducted for those associations that have not yet had a reserve study on their property, or for a board that seeks a second opinion to validate the accuracy of a previously conducted study. In other words, this type of study is only required once, or initially, under most circumstances.
A full reserve study will require time to inspect the site and measure any common area(s). This will allow the inspector to create a component inventory and a condition assessment. Life and valuation estimates, fund status, and a funding plan will also be developed during a full reserve study.
Reserve Study with Site Visit/On-Site Review (WSV)
This type of reserve study is less expensive than a full reserve study because it is less time-intensive and a component list simply needs to be updated/verified. Typically, a Reserve Study WSV is conducted every 3 to 5 years for the inspector to document any component changes. During this time, a condition assessment based on onsite visual observations will take place. Life and valuation estimates, fund status, and a funding plan will be updated/reviewed during this time.
Reserve Study with No Site Visit (NSV)
Generally meant to be conducted in the years between WSV-based reserve studies, this type of study does not include a site inspection; therefore, it is the least expensive type of reserve study. Component information is still updated, but this is based on observations and conversations with HOA board, vendors, and maintenance staff. Life and valuation estimates, fund status, and funding plan will be updated/reviewed.
Generally used for budget estimates before construction of a community, this type of study is based on architectural documents and engineering plans. A preliminary study includes a component inventory, funding plan, and life and valuation estimates.
The type of reserve study that will be conducted in your HOA will depend on the current need of the association.
How Often Should a Reserve Study be Conducted?
It’s best practice for an HOA to have a reserve study conducted on a regular basis – at least once every few years. While not every state has laws requiring reserve studies, it is still recommended that the association hire a professional to conduct a reserve study in order to evaluate the condition of HOA amenities and major assets.
Who Conducts Reserve Studies?
Reserve studies should be conducted by professionals who specialize in the preparation of reserve studies. Certification criteria has been created to identify those who have been trained specifically in the creation of reserve studies. For instance, the Community Associations Institute (CAI) offers certification of a Reserve Specialist (RS). In order to achieve this certification, candidates must have prepared/conducted a minimum of 30 reserve studies in the past three calendar years, hold a degree related to architecture, engineering, or construction management, and comply with various rules and codes of conduct. Alternate credentialing is available through other industry sources, such as the Association of Professional Reserve Analysts (APRA).
A reserve study should be conducted by a credentialed professional, no matter the level of study sought.
When searching for a firm to conduct your association’s reserve study, “the consultant’s experience is very important”, says Steve Jackson of Advanced Reserve Solutions. He continues, “The job of the reserve analyst, in my opinion, is to work as an independent third party, providing a professional opinion on as to how the association is doing and what they ought to be doing. It’s important to review sample reports from various reserve study companies and compare the information presented. Look at specifics – do they provide detailed inventories/counts, square footage, etc.” Jackson stated that many companies have great marketing efforts, but their reports are lacking pertinent information that allows for future reserve study updates.
Cost of Reserve Study
There are multiple factors that affect the cost of a reserve study, most notably:
- Size of Property – size, acreage, number of units, number of amenities, etc.
- Location of Property – close proximity to a site inspector to eliminate travel time and expense
- Complexity of Property – HVAC units, number of stories, scope of repairs, etc.
It’s worth mentioning that the time of year may also affect the cost of the reserve study. This is because reserve study specialists typically consider their “off season” to be January through May, as the majority of associations end their fiscal year on December 31. Generally, off season studies may be less costly.
Finally, another factor that may affect the cost of the reserve study is turnaround time. As with most anything, cost increases as turnaround time becomes tighter. Longer turnaround time can equal less money spent on a reserve study. It’s important for the board to plan ahead for the type of reserve study needed. By regularly scheduling and keeping up with the reserve study, the association will benefit in the long run.
Are Reserve Studies Required by Law?
Reserve funding legislation varies by state. At the time of this writing, 30 states, such as Hawaii, Nevada, California, and Virginia, require community associations to budget for homeowner disclosure or preparation purposes. In Nevada, specific statutes related to reserve studies were set forth in NRS 116 which require that reserve preparers be registered with the state’s Department of Real Estate. Other states have similar laws in place. Check out this article the San Diego Union-Tribune published June 1, 2019 regarding the Davis-Stirling Act and requirements regarding reserves.
In some states, HOA’s are not legally required to conduct a reserve study. However, this does not negate the board’s responsibility to budget and prepare for future expenses. To see reserve requirements by state, visit the Community Associations Institute. Associations should refer to their governing documents and contact legal counsel for specific questions regarding reserve study requirements.
Next Steps: What to do With Your HOA’s Reserve
So, your association has had a reserve study completed …. now what?
The first thing to do is to contact your HOA accountant and establish a formal reserve policy. An accountant can review the components and decide which expenses will be designated as capital and non-capital expenses. An investment strategy should then be established to maximize interest on the HOA’s reserve account.
Don’t let your HOA’s finances affect your personal finances! Remember John and Sue? Don’t find yourself uninformed or unprepared like they were! As a homeowner, you have the right to know the status of your association’s financial condition, even before purchasing a home in that community! Below are some helpful tips to get you started:
- Ask for a resale disclosure. (Your real estate agent can help!)
- Be sure to read and review all documents and information in the resale packet.
- Review and understand the terms of the HOA’s governing documents. For instance, if the board does need to impose a special assessment, is there a cap?
- Request copies of the association’s financial documents and review posted financial packets. (In some states, such as Arizona, it’s mandated that the HOA provide balance sheet information to homeowners each year. (*Keep in mind that new developments often do not have reserves.)
At SpectrumAM, our goal is to inform and assist homeowners in all things HOA. The financial health of a homeowners’ association is vital to happy homeownership. A home is one of the biggest purchases of a lifetime – be sure that your home is a part of a stable and financially secure HOA!