Capital planning is one of the most important, if not the most important, responsibilities of an HOA board. Going beyond the day-to-day routine operation of the community, capital planning focuses on the long-term physical and financial health of the community, as well as proactive planning for the replacement of major community assets. From roads and roofs to elevators and amenities, responsible capital planning ensures that the association’s components are maintained in a timely and cost-effective manner.
Understanding Capital Planning in HOAs
Capital planning is the process of identifying, forecasting, and funding large-scale repair or replacement projects within the HOA. These projects typically exceed the scope of regular preventive maintenance and require financial preparation for years in advance.
At the heart of effective capital planning is a reserve study – a professional evaluation of the condition of common assets that estimates the cost and timing of future capital projects. Reserve studies provide a blueprint for reserve funding, helping boards determine how much money should be set aside each year to meet future project needs.
Reserve studies also guide boards in creating their annual HOA budget, providing expert guidance on prioritizing capital projects year by year. By conveying capital planning needs to current and future boards, reserve studies support the board’s fiduciary responsibility to maintain and enhance the association’s value.
Importance of a Long-Term HOA Funding Strategy
A well-crafted, actionable reserve funding plan helps HOAs not just anticipate future expenses but ensures that adequate reserves are available to complete projects promptly and avoid deferred maintenance. By forecasting these costs and building up reserves equitably, HOA boards can also avoid hefty special assessments or emergency loans. Long-term planning also enables boards to make informed decisions about projects, providing them with greater purchasing power.
Without a long-term funding plan, boards are essentially leaving the physical and financial health of their HOA to chance, which historically never turns out favorably. The most significant risk is that the HOA becomes underfunded, leading to:
- Deferred maintenance that turns minor issues into expensive emergencies. What seems like a minor issue today will almost always become a more significant one tomorrow.
- Declining property values as HOAs without well-maintained infrastructure and adequate reserve funds are not as attractive to potential buyers
- Significant, sudden increases in reserve contributions that put homeowners in an unfavorable financial position, especially in HOAs with residents on a fixed income
- Special assessments or bank loans become necessary to tackle emergency projects, creating tension between the board and homeowners
With increased scrutiny from lenders and insurers, maintaining a long-term funding plan has become even more critical. Lenders have begun requiring greater transparency and accountability from associations, with Fannie Mae and Freddie Mac blacklisting specific associations that have structural issues, deferred maintenance, underfunded reserves, and that have failed to conduct reserve studies.
Similarly, insurers gauge an association’s ability to cover potential claims without resorting to special assessments. If an HOA is underfunded and has deferred critical maintenance, components are more susceptible to failure, leading to an increased likelihood of insurance claims. Properties that fail to demonstrate sufficient financial preparedness for current or future repairs and maintenance may face higher premiums or coverage restrictions to account for increased risk exposure. In the worst-case scenario, insurance providers may opt to drop the property and not renew coverage.
HOA Funding Strategies
There are four funding strategies available to HOAs, each of which involves identifying the reserve contribution rate for each year while maintaining a predetermined reserve fund balance. Choosing a strategy generally comes down to analyzing and weighing the risk tolerance and best interests of the community, which should be done in tandem with your reserve study provider.
- Full Funding
- This strategy focuses on maintaining a 100% funded reserve balance, which is the equivalent of the sum of the fully funded balance for each component. The fully funded balance of a component is the replacement cost relative to the component’s useful life. For example, if a component has a $100,000 replacement cost and is halfway through its useful life, the fully funded balance would be $50,000. While full funding is the most conservative funding strategy, there is typically no reason why an HOA would need to be fully funded at any given time. Because most projects are dispersed over time, this strategy often results in unnecessary funds being set aside.
- Threshold Funding
- This strategy is the most recommended by reserve study providers and involves keeping the reserve balance above a minimum amount. By looking at cash inflows and outflows to the reserve fund over time, a minimum reserve balance can be determined. Reserve contributions can be stable and equitable while ensuring the reserve balance doesn’t drop below the threshold, even in critical funding years.
- Baseline Funding
- Baseline funding operates similarly to threshold funding; however, the reserve fund will hit $0, or the baseline, at some point over the length of the reserve study. Generally only acceptable in times of distress, given there is no cash flow cushion, this is the riskiest funding strategy.
- Statutory Funding
- Statutory funding refers to the amount of money required in reserves to comply with state statutes, making this funding strategy non-negotiable in certain states. For example, in Michigan, associations are required to maintain a reserve fund that, at a minimum, equals 10% of the annual budget. This strategy simply requires associations to follow specific state funding laws. For more information on state statutes regarding reserve studies and reserve funding, click here.
The benefit of multiple funding strategies is that there is almost always a viable plan for associations to follow to attain and maintain adequate reserves. Whether an HOA is severely underfunded or in a solid financial position, boards can solidify a strategy by working alongside their reserve study provider to weigh risk versus affordability.
Common Mistakes in HOA Financial Planning
The challenges that HOAs face in capital planning often boil down to short-term thinking, inadequate forecasting, and poor communication. Many HOAs rely on outdated reserve studies or fail to conduct a study at all, leading to insufficient reserves when major expenses arise. If future repair or replacement costs are underestimated, HOAs may defer maintenance to avoid increased dues or special assessments, which can result in more costly projects down the line.
Another frequent mistake is a lack of transparency between the board and homeowners. When boards make funding decisions without clearly communicating their reasoning or the long-term benefits of such choices, it can lead to resistance from residents. Additionally, some boards rely too heavily on special assessments or loans rather than building a sustainable homeowners’ association reserve fund through equitable contributions, which can strain homeowners financially and create tension in the community.
To avoid these issues, HOAs can take the following actions:
- Conduct regular reserve studies and update them on a 3–5-year basis to reflect current costs and project timelines
- Adopt and follow a proactive maintenance strategy to extend the useful life of community components and minimize the chance of costly emergency repairs
- Build reserves gradually and equitably through consistent dues rather than relying on special assessments or loans
- Communicate openly with homeowners about the HOA’s financial status and needs, funding strategies, and the benefits of adequate reserve funding
- Engage financial professionals, including collaboration with your reserve specialist, to guide long-term planning and ensure compliance with fiduciary duties
The Bottom Line
Capital planning is a commitment to the long-term health and stability of your HOA. By understanding the importance of reserve studies and working alongside your reserve study provider to adopt a strategic funding approach, boards can proactively manage infrastructure and avoid financial surprises. Whether your association is just beginning to build reserves or is reevaluating its current strategy, there is always a path forward. With the right tools, expert guidance, and willingness to learn, HOAs can meet future needs confidently and equitably, ensuring the community thrives for years to come.