Has your association completed a reserve study?
Reserve studies are used by homeowner associations to estimate the remaining useful lives of each common area structure and amenity under their jurisdiction, calculate the cost of maintaining them over the remainder of their useful lives, and then estimate what it will cost to replace them at the end of that time frame.
Too many boards fail to do reserve studies or hamstring their creation by not delegating the process to an experienced expert who is either on the board or, if need be, by hiring an outside firm to help.
Formal reserve studies are so important that some jurisdictions, including the State of California, require HOAs to perform them.
What to Include in Your Reserve Study
A reserve study doesn’t need to be hugely complex, at least not for smaller developments. However, reserve studies should be as detailed as possible because they are vital for matching expected expenditures – both long-term and short-term – to the means available. Your reserve study should address the following factors:
- Planned repairs or desired replacements of common area facilities
- New construction projects
- Routine, recurring maintenance costs
- Reserves for natural disasters, unforeseen events, etc.
- Insurance in place
There are two components of every reserve study: the physical component and the financial analysis. The physical component tells you the ends – it estimates when you’ll need to replace each major common area component or item and when. The financial analysis tells you what you should have on hand now, earning a reasonable and prudent investment return based on current market realities, in order to get there.
An HOA board member’s job as a fiduciary, someone appointed and authorized to ethically handle others- money, is to invest HOA reserves prudently so that there is enough cash available to handle these expenditures at the time you need to spend the money.
This last bit is important. Not only must you manage a pool of money, but you must also manage it in such a way that there is liquidity in your assets at the time you need it, without having to sell at a big discount if the markets happen to have moved against you right before you have to replace that roof on the clubhouse.
Some reserve studies are more extensive and detailed than others, but it is vital that every association board go through this process, because if you don’t, you run the risk of getting blindsided by a major expense – forcing you to blindside other members with a huge and possibly unmanageable assessment.
Updating an Existing Reserve Study
If you have an existing reserve study, you need to dust it off and review it once per quarter or after any major expenditure or repair/maintenance event.
Look carefully at the assumptions your existing reserve study contains! Here are two examples of assumptions that should be questioned:
- Are your rate of return assumptions still valid? Many pension plans have recently run into trouble assuming their investments would return 10% annually when in actuality they returned 7% or even less. This came back to bite them when they found that they were unable to meet their pension obligations.
- Were previous assessments of the useful life of common area facilities, amenities and structures valid? Sometimes buildings and structures deteriorate faster than expected. You could discover plumbing or roofing issues that force you to bump your timeline up.
Investment Planning in Reserve Studies
Once you have completed a good reserve study that dovetails closely with your capital expenditure plan, it will make your job of directing investments much easier. This is because you can then allocate your investments based on planned expenditures and match up their timelines.
For example, you could use a money market for contingency reserves, just to get a few basis points’ return without taking any market risk. This still provides you liquidity in emergencies.
You could then employ a number of other strategies, including:
- Laddering CDs. With this strategy, have each CD mature shortly before you expect you will need to commit the money.
- Laddering zero coupon bonds. These bonds don’t make interest payments. Instead, you buy them at a discount from par, and the issuer guarantees payment of the lump sum on a scheduled date. They are very useful for funding planned expenditures years in advance, and will generally give you a higher return than a CD or money market alternative.
- Laddering investment grade bonds. These are government issues and higher-quality corporate bonds that are rated BBB- or better by Standard and Poor’s or Fitch or Baa3 from Moody’s.
All in all, reserve studies are a complicated issue, and you can never be too educated about investment management. The more you know, the better you will be able to live up to your responsibilities as a fiduciary.
If you’re at all unsure about your ability to properly manage your association’s finances, we strongly urge you to get one or more quotes from local property managers to learn how they can take over those responsibilities from you. The penalty for failing to do so could be severe; HOA board members who poorly manage the funds under their control can find themselves being sued for breaching their fiduciary duty.