Serving on an association board carries significant responsibility for any community association’s long-term financial health. While often viewed as a compliance document, a reserve study is actually a strategic tool that, when actively used, guides informed decision-making, responsible budgeting, and long-term success. So, how exactly should boards use their reserve study report?
What is a Reserve Study?
First, let’s review what a reserve study is. A reserve study determines how much to collect in annual reserve contributions so the board can afford capital projects when they are needed. The reserve study consists of two parts, as defined by the Community Associations Institute (CAI) and the Association of Professional Reserve Analysts (APRA): the Physical Analysis and the Financial Analysis of common elements.
Physical Analysis
- Component Inventory – Identification of the common elements and their quantities.
- Condition Assessment – Evaluation of the current condition of each component based on the observation of the engineer or reported characteristics.
- Life and Valuation Estimates – The engineer’s team determines a finite useful life, the remaining useful life, or better stated, how much longer it will last before needing replacement, and the anticipated future cost of repair or replacement for each component.
Financial Analysis
- Fund Status – The current amount of money in reserves when the engineer conducts the reserve study. It will be as of a specific date, often the beginning of the association’s fiscal year. This is the starting point for the engineer as they develop the funding plan.
- Funding Plan. This is the plan that assesses the unit or homeowners’ monies that go into the association’s reserve account to offset the anticipated future expenditures, allowing the community to pay for those capital projects as they become necessary. The funding plan goes out at least 20 years into the future and, more commonly, is developed as a 30-year forecast.
How To Use Your Reserve Study Report
Because reserve studies contain what may seem like an endless amount of information about your association, they can be understandably intimidating to digest. While all the details provided are valuable, reading and utilizing a reserve study report doesn’t have to be an overwhelming task. If you’re looking to get to the meat and potatoes of your report, here are the key elements to review.
Reserve Fund Status
Review your association’s current financial conditions. This is the starting point for the rest of the report’s details and is found in the executive summary.
Reserve Expenditures
Review near-term and capital-intensive reserve expenditures. The reserve expenditures table details each reserve component, including its quantity, useful life, remaining useful life, and reserve expenditures over the next 30 years. This detailed component inventory presents a prioritized replacement schedule including itemized costs, with expenditure placement generally reflecting recommended project prioritization or order.
It can be helpful, when initially reviewing the report, to focus on expenditures over the next five years and, subsequently, on capital-intensive expenditures during years 6-30. Report narratives detail the condition of each component, including photos, to help you understand the condition of your association.
Reserve Funding Recommendations
Once you have reviewed the expenditures table, you can begin diving into the recommendations to help you follow the expenditure plan. The executive summary and reserve funding plan both contain funding recommendations and information. The executive summary presents written recommendations, a recommended reserve funding table, and a graph. The graph presents reserve contributions, expenditures, and balances throughout the study’s duration. The initial reserve balance and the projected capital expenditures forecast determine the recommended funding levels.
It is critical to review the reserve study’s funding plan, as the recommendations for the next several years reflect an association’s financial status.
- A properly funded association can generally expect consistent annual reserve contributions with inflationary adjustments over time.
- Overfunded associations likely experience annual reserve contributions that are relatively flat, or in extreme cases, decreased for several years.
- Underfunded associations generally experience stepped increases (i.e., $15,000 annual increases for x years, which are designed to get funding back on track) followed by inflationary adjustments thereafter. In extreme cases, associations may see contributions double (or more) than their current budgeted amounts.
Understanding Reserve Funding Adequacy
A common scenario amongst associations is assuming their funding status is “healthy” because of a high reserve balance.
For example, “we have $600,000 in the bank and minimal expenditures, so we do not need to increase annual reserve contributions for several years”. Without a current reserve study, the reserve balance is not necessarily a clear indication of overall financial health.
Are critical projects being deferred? Does the association have a clear understanding of both near-and long-term replacement needs? In the chart below, year-end reserve balances are projected to peak at $724,646, followed by more than $1,350,000 of major projects over the next six years. Ignoring inflationary increases would result in a $120,000 reserve shortage by 2028.
This scenario can only be properly assessed with the assistance of a current reserve study. Without one, the association does not know what truly awaits around the corner in terms of replacement projects and associated costs. Furthermore, the lack of a current reserve study limits the association’s ability to adequately address potential shortfalls and ensure the association has a clearly defined path to long-term success.
Associations that lack long-term planning and do not implement an appropriate funding strategy guided by a reserve study will almost certainly run short of reserve funds at some point. Without sufficient reserves, associations face two choices: defer replacement or increase cash flow.
Deferred Replacement
This is a common choice amongst those facing a shortage of reserve funds. If the funding gap is small, the deferred project is non-critical (e.g., aesthetic items such as pool furniture or common-area carpeting), and the association has a short-term plan to improve funding levels, the deferral is unlikely to be a critical issue.
However, time and time again, many associations in this position face significant reserve shortages during years of relatively high expenses, often leading to the postponement of critical projects and accelerated deterioration, with potential safety concerns.
Increase Cash Flow
Special Assessments
Special assessments are very burdensome to homeowners. This option puts financial strain on residents, especially those with fixed incomes. Depending on the volume of assessments required, the additional assessments are likely to span several years.
Bank Loans
While bank loans do not require immediate contributions from homeowners, they have the added expense of interest. Homeowners certainly have more time to assess and adjust their personal finances, unlike that of special assessments, but that convenience comes at a cost.
The above options address near-term funding shortages. However, these ‘band-aid’ type fixes only address the symptoms of insufficient reserves, not the real problem… a lack of establishing adequate reserves moving forward.
Utilizing Your Reserve Study to Achieve Long-Term Success
The long-term success of a community association is measured by its ability to operate like a successful business. The association must be fiscally responsible, able to invest in itself, and improve the value of the organization as a whole. Although the reserve study is a professional recommendation, it is a snapshot in time. Over time, priorities and project needs change, but one thing remains constant: the need to have adequately funded reserves.
The most successful associations use their reserve studies as a starting point and continually assess changing needs to achieve long-term success. But what does this process look like? In short, it means keeping the expenditure schedule and funding plan up to date and addressing potential financial shortfalls early. What might seem challenging can be quite simple with the right tools.
Budget Season Tasks
Before budget season, the reserve study should be updated. Minor adjustments can be handled internally using Excel spreadsheets, whereas complex changes may warrant an updated reserve study.
Begin by updating the current year’s expenditures and reserve contributions. Next, review each deferred project and determine if it needs to be completed in the upcoming year. Update the timing of any deferred expenditures accordingly.
Once this is complete, the updated expenditure tables and funding plan can guide next year’s budget process. Furthermore, updated numbers enable one to evaluate changing needs over time and address potential year-end reserve shortages years in advance.
Keeping the schedule of expenditures and funding plan current provides management and the board with the most complete picture of the association’s near-term project needs and long-term financial status. Surely most associations will, at some point in the future, find themselves deferring projects and/or not meeting their reserve studies’ recommended level of reserve contributions.
Ultimately, their success is measured by the ability to weather such differences while adjusting the long-term funding strategy to ensure reserves are adequately funded, and common property is maintained in excellent condition for decades to come.