Funding Your Reserves Banking Against Surprises

Bill and Martha Jensen bought a new condominium in Brockton in 1995 and lived there for 19 years. In 2014 they sold the unit to Max and Rita Diaz. A year later, the condominium association’s board of directors voted to replace the building’s roof and imposed a special assessment to pay for the project. “That’s not fair,” the Diaz’s complained, insisting that they shouldn’t have to pay the full assessment to replace a roof that sheltered the Jensens for 95 percent of its life. 

It wasn’t fair—but major components and systems don’t last forever, and big assessments are what happens when a board doesn’t set aside funds on a regular basis to update those components and systems. 

“The number one mistake a board can make is characterizing such things as future expenses,” says Robert Nordlund, founder and CEO of Association Reserves, Inc., a Calabasas, California-based, reserve study firm with clients in every state. 

“It’s human nature to worry about future things at a future time,” he explains, “but if you characterize reserve expenses as offsetting ongoing deterioration, the future takes care of itself. Associations that don’t pay this ongoing bill doom themselves to deferred maintenance, special assessments, and declining property values.”

What Deserves Reserves

Nordlund says that for an item to warrant reserve funding, it must be a common area maintenance responsibility, exceed a minimum threshold cost, and have a limited and predictable useful life.

In addition to roofs, long-lived common assets meeting that criteria include masonry walls (which may need concrete restoration or repointing to renew the mortar between bricks); chillers, cooling towers, and other parts of a building’s climate-control system; elevators; the fire-alarm system; interior décor in common areas such as administrative offices, hallways, lobbies, and recreation rooms; sidewalks, streets, parking lots, and garages; balconies and decks; and  swimming pool surfaces, pump motors, and filtration systems. 

In cooperatives, the building’s underlying mortgage should be a reserve item, too, says Annette Murray, a certified public accountant and a shareholder with Wilkin & Guttenplan, PC, an accounting firm with offices in New York City and East Brunswick, New Jersey. 

“The board needs to monitor and plan for a mortgage, especially when it’s coming up to be refinanced a couple of years ahead,” she says. “Many co-ops pay interest only and just keep refinancing the same dollar amount. If they need more money, they increase their mortgage. A best practice would be to have a mortgage that amortizes, paying interest and principal.”

More Than Just Smart...

In most jurisdictions, common-interest associations conduct a periodic reserve study—a budgeting tool that assigns an approximate useful life to each major building component, estimates its replacement cost, and sets aside funds each year so replacement funds will be adequate when replacement time comes. 

Associations update their reserve study annually or every few years to account for inflation and product enhancements. “Reserve studies should prepare the association for material and technical upgrades such as new pool surfaces and more efficient elevators and boilers. You buy the new appropriate thing, not a like-for-like replacement,” Nordlund says. 

Many states—including Massachusetts―require reserves, and some even specify the minimum acceptable percentage of the budget that an association must set aside in reserve. 

“Massachusetts Mass. General Law chapter 183A, Sec. 10 (i)  states: ‘All condominiums shall be required to maintain an adequate replacement reserve fund, collected as part of the common expenses and deposited in an account or accounts separate and segregated from operating funds. The requirements of this subsection may be modified pursuant to subsection (m) of this section,’” says Pamela Jonah, an attorney at Goodman, Shapiro & Lombardi, LLC, in Dedham, Massachusetts.

“However, what is ‘adequate,’ is not defined,” she adds. “Therefore, there is no specific amount required by the statute.”  There is, she notes, a section in the law that allows owners to vote to modify the reserve fund requirement, but, “In my experience we do not often see unit owners voting to rescind the requirement of having reserves, as most understand that there will be necessary capital projects as an association ages.” 

“In New Hampshire, associations may maintain reserves pursuant to the terms of their own governing documents,” adds Gary M. Daddario, partner in Winer & Bennett in Tyngsboro, Massachusetts.

In other markets—New York City being one major example—no such requirement exists, and consequently many associations do nothing. “Others perform a capital-needs assessment, which states what will need replacement within the next five or six years and how much that will cost, but doesn’t set up a funding plan,” says Mitchell H. Frumkin, president of Kipcon Inc., an engineering consulting firm whose headquarters are in North Brunswick, New Jersey. “It just assumes that the board has money, which may come from savings, a special assessment, or a loan.” 

Whether or not their state requires it, many boards are beginning to embrace reserve studies to make people buying into their buildings eligible for Federal Housing Administration (FHA) financing. 

“Oftentimes associations use the FHA, Fannie Mae, and Freddie Mac requirements as a threshold on how much to place into reserves; all currently require 10% of the budget be set aside,” Jonah says. “The other and probably more prudent thing to do is to have a reserve study conducted by a professional, such as an engineer to determine the useful remaining life of larger capital projects, such as the roofs, and siding and then plan from there,” she adds. “If an association ever wants to take a loan, the banks will often require a certain amount of funds to be held in a reserve account.”

A typical Reserve Study set-aside, enough to offset ongoing deterioration, commonly is 15-40% of an association's total budget, Nordlund says. Thus, buildings that rely on the FHA reserve percentage requirement will usually collect insufficient reserves from the owners, causing a future reserve cash flow crisis. 

“Attorneys, as far as I know, all advise clients to maintain reserves,” Daddario notes. “The appropriate amount differs by community but, other than the FHA standard, one standard is enough to sustain at least one to two major projects. 

“This leads to the concept of reserve studies.  Reserve studies are not required but are highly recommended.”

The Right Team 

A reserve study that yields useful information should be a team effort, beginning with the board and its property manager or management firm. “The manager is the primary communicator between the board and its vendors,” says Matthew Grobert, vice president, capital reserves/development transitions, for The Falcon Group, a New Jersey-based engineering firm that has offices nationwide.

“Every association should have a good attorney well-versed in common-community law,” he continues.

In selecting a professional to perform the reserve study, a board should employ an engineer who is a reserve specialist (RS) and/or a professional reserve analyst (PRA). A board’s own in-house engineer may help with specific property knowledge, but probably won’t have the expertise of a consultant with reserve credentials. 

CAI administers the RS designation. The PRA credential comes from the Association of Professional Reserve Analysts, the reserve-study industry’s own trade organization. Grobert is a reserve specialist; Frumkin and Nordlund hold both credentials as well.

However, “Some firms doing reserve studies don’t even have a professional engineer on their staff,” Grobert cautions. “They use some other way to gather costs. Using a firm with architects and engineers doing replacements and restorations helps me to perform a very accurate reserve study, because I have up-to-date costs.”

Tolerance Level

Once the reserve study is complete, the board and owners must decide on a funding plan based on their tolerance for risk and their willingness to set money aside each month for the reserves.

Some associations strive for full funding, collecting enough money to replace each component at the end of its useful life, without charging residents any additional assessments. In the interim, the stored funds yield interest and serve as an inflation hedge. This sounds good, but many owners disapprove of a fully-funding approach because it increases their monthly assessments.

At the opposite extreme is baseline funding, which reduces annual contributions, eventually dropping the reserves to zero. This strategy lowers the monthly assessments, “But if a component has to be replaced early, or costs more than expected, you can run into trouble,” Frumkin warns.

Threshold funding strikes a middle ground between full and baseline funding. “Most associations do threshold,” Frumkin says. “They’re maybe 60 percent to 70 percent funded,” and if a big repair or replacement is needed, the budgetary shortfall will be made up with a one-time assessment of all residents.  

Where the Money Goes

A building or association’s accountant and banker or financial advisor should be part of the reserve-study team to help the board decide where to invest the reserves until they are needed. The accountant’s main role is to sort out these capital contributions (which are not taxable and can be carried forward from year to year) from taxable interest on investments.

Whatever investments are selected must be extremely safe, enabling the board to fulfill its fiduciary responsibility, says Abdullah Fersen, chief executive officer of Newgent Property Management in Yonkers, New York. Fersen says acceptable investments include certificates of deposit (CDs), money-market funds, and U.S. Treasury securities—bills, notes, and bonds—with varying degrees of maturity. 

“When you set up your investments, make sure they’re laddered,” Frumkin advises. “Don’t put it all into long-term investments. Look at the reserve study and plan, so your investments come due when they’re needed, and so you don’t run into penalties when you have to spend money to replace something.”

“In general, associations that do not plan and place money into reserves will be left with no choice, but to have huge increases in common fees to fund capital projects — or worse, large special assessments, that do not have priority in Massachusetts as to mortgagees and therefore can cause problems when  unit owners do not pay,” Jonah cautions.

And that, in a nutshell, is the takeaway from any discussion of reserves and long-term planning for any size community: planning now for tomorrow, next year, and even the next decade is the duty of a proactive, conscientious board-management team, and to the good of the community at large.         

To learn more about reserve studies, see Reserve Funds: How & Why Community Associations Invest Assets, edited by Mitchell H. Frumkin and Nico F. March, CAI Press, Falls Church, VA.                                  

George Leposky is a freelance writer and editor, and is a frequent contributor to New England Condominium.

Correction (11/10/16): This article has been revised to clarify a point made by Robert Nordlund about how much an association's budget is set aside for a reserve study.

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Comments

  • Great article but one unfortunate miscommunication should be noted. Typical Reserve contributions are 15-40% of an association's total budget, so associations that only fund to the FHA "10% of budget" level will regularly find themselves underfunded.