How to X-ray an HOA #4 – HOA Reserve Funds

Good HOA’s, like all good businesses, plan ahead.  Every HOA budget shows how much goes to the reserve fund which pays for capital expenditures as the need arises.   Whether the reserve fund balance will actually meet those needs has been a hot topic in recent years.

Reserve Studies.  The adequacy of the reserve fund is inextricably tied to the conclusions from the HOA’s Reserve Study.  Reserve Studies have two parts – the physical analysis and the financial analysis.  For the physical aspect, a specialist evaluates the condition of the HOA’s common area components (elevators, pools, roads, etc) and estimates the remaining life expectancy of each major item.  That specialist also calculates the repair/replacement cost for these elements.  A financial analyst then examines the HOA’s current reserve fund balance and recommends an assessment amount for each year to keep the fund healthy.

Review the latest Reserve Study.  It’s a red flag if the HOA has not had one done in the past 5 years.  Verify if the current reserve balance is consistent with the study’s recommendation. And check that a competent professional produced the study. Occasionally, an HOA will have only a one page summary created by the Board and whatever “experts” they could find for low or no cost.  This is an unacceptable substitute for the real thing.  Here is a sample Reserve Study Report.

 

People often ask “What percentage of the HOA budget should be placed in the reserve fund?”  This question defies any answer except “it depends”.  A new development presumably will not need to replace capital improvements for 15-20 years, giving time to accumulate enough cash.  But a 20 year old community will typically face the need for large expenditures within the next 5 years and beyond.  Therefore, the correct amount to set aside for the reserve fund is not a by-product of the operating budget.  Instead, it is a function of the community’s present financial and physical condition.  But just as an example, 30-45% of the annual assessment going into the reserve fund is not unusual when an HOA must “catch-up” after years of underfunding.  And in the worst cases, special assessments may also be necessary to stabilize the association’s finances.

The best way to measure the health of a reserve account is to see how close it is to full funding. Generally, industry specialists say the reserve fund should contain at least 70% of the projected repair and replacements costs.  A ratio of 50% funded is marginally acceptable.  If the funded rate is 40% or less, hefty assessments lie in the owners’ futures.  Caveat emptor.

It’s enlightening to examine FHA’s 2008 proposal for HOA reserve funds.  FHA proposed to not finance condo mortgages unless the reserves were at least 60% funded.  And if the developer still controlled the association, FHA’s proposal was 100% funded!  Strong reactions to these proposed rules eliminated any minimum reserve funding requirement.  The final ruling said only that the HOA budget must be viewed as “adequate” by a lender and at least 10% of the total budget must go to the reserve fund.  Even though FHA’s original proposal was badly defeated, I think it’s just a matter of time before minimum reserve fund levels will be set by lending institutions or state laws.

There’s also a cultural factor for reserve funds being anemic.  Americans have a poor track record of saving for the future.  A common refrain when HOA assessment discussions happen is “Let’s just pay for what is needed right now and let the future owners pay for whatever happens later.”  That’s a big reason why many otherwise desirable developments would flunk a 50% funding level test today.  Under-funded communities where the buildings are 20+ years of age are particularly vulnerable.  That’s because 30 years is generally the time when major building systems reach the end of their useful life and need replacement.

 

Minnesota currently requires only that the HOA reserve fund be “adequate” in the Board’s opinion, given the future replacement needs.   But the 2010 Minnesota legislature passed stricter regulations for these reserve funds, to be effective January 1, 2012.   Key parts of the amended statute are:

  • HOA’s must reevaluate the adequacy of their reserve fund at least once every three years.
  • The HOA cannot borrow from the reserve fund to pay operating expenses (but the replacement reserves can be pledged as security for a loan to the association.)
  • Reserve fund allocations can be waived for components if the HOA decided to fund those costs through future special assessments.  However, this waiver can last no longer than 4 years unless reaffirmed.

 

The Bottom Line.  Underfunding reserves causes inadequate maintenance, declining property values and the dreaded special assessment.  It also hurts the association’s reputation and penalizes sellers because savvy buyers steer clear of developments with funding problems.

Combined, FHA, Fannie Mae and Freddie Mac account for roughly 90% of approved loans in 2010.  If these entities someday decide to tighten reserve level criteria, many HOA communities will become ineligible for these mortgages.  This will cause buyers to flock to complexes that wisely planned ahead, while sellers in the underfunded areas will be stuck indefinitely.

 

Don’t forget to return for Part 5 of this series – Delinquencies, foreclosures and short sales. 

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