Condo and HOA Management

The Perils of Underfunding Your HOA Reserves

| 5 min. read

Adding money to your HOA reserves is a tough sell to association members. It feels like throwing money down a hole, and every individual resident would certainly rather spend the money on their own needs than have it sitting in someone else's bank account, waiting for a rainy day.

However, the reality is that many HOAs—as many as 70% of them—are woefully undercapitalized. They can pay the day-to-day bills as long as nothing unexpected happens—but something always comes up. An undercapitalized association with inadequate HOA reserves will have no choice but to hit owners with a nasty special assessment; increase contributions substantially; borrow money to meet the cash flow shortfall; or some combination of these three ugly options.

Meanwhile, inadequate HOA reserves make it hard on homeowners. Buyers may shy away from a home in an HOA that has been in existence for a while, but has not yet established a meaningful reserve. Alert buyers will use this to negotiate a lower purchase price.

What's more, adequate reserve funding is a requirement for buyers who want to take out FHA loans. If your HOA reserves fall below 10% of total budgeted income, your owners can no longer sell to the entire FHA population. What's more, if owner occupancy ratios are below 50%, your HOA reserves have to be double that amount—20% of total budgeted income—for your development to qualify for FHA funding. Your prospective buyers may have trouble with Fannie Mae funding as well.

As if that weren't bad enough, a poor fiscal situation inevitably distorts your board's decision-making process: Repairs are deferred, then maintenance issues grow more expensive, further straining an already inadequate reserve.

So when you take the negative impact on sales into account, how much does the association really save by being soft on building up your HOA reserves? Not much.

So how much should you have saved up, exactly? Here's what you need to know.

HOA Reserves: Arriving at the Ideal Number

First, what are HOA reserves designed to cover? Ideally, your HOA reserves should be capable of covering all known liabilities that the regular annual budget doesn't specifically cover.

A thorough reserve study will get you close to the target number. Make a list of everything that could break or wear out—from roofs to garage doors, scheduled paint jobs to road and parking lot resurfacing. List everything on the property, along with an estimated date for repairs or replacement.

Calculate the net present value of all of your future anticipated repairs, using a conservative interest rate. As an example, the average 1 year CD is generating 1.25%, while the average money market is generating 0.71%. (Savers recently got a little bit of a boost when the Federal Reserve hiked interest rates by 25 basis points. Last week, money markets were only generating 0.56 percent!)

Add to that the sum of your insurance deductibles and copays. If a tornado tore through the property tomorrow and you lost nearly everything, what will your organization have to come up with to cover it all?

If your deductible is $100,000, your copay is 20%, and your worst reasonable case loss scenario is $5 million, you will need current HOA reserves of $5.1 million to cover the whole shortfall.

To that amount, add the discounted present value of all planned improvements and additions; start setting that aside, too, though those projects shouldn't normally fall under the reserve heading. These are capital improvements.

Not fully funded? Don't feel bad: Few developments have full reserve coverage. 70% of association-governed communities are under-funded by 70% or more. However, you don't want to be glaringly below your ideal number for too long—especially if you're not a brand-new development, and you've had a few years to accumulate reserve funds.

Note: Your board should examine both your operating budget and your reserve budget closely. Any given project should be accounted for only once. If you have something counted on both sides, then you'll have a hard time catching up!

Keep Your Reserve Study Updated

Too many boards make the mistake of putting their reserve study and capital budget in a binder and letting them gather dust for years on end. However, a recent study from Association Reserves found that it pays to keep your finger on the pulse of your association's fiscal situation, updating your capital budget and reserve study on a regular basis.

The company reviewed over 19,000 recently completed reserve studies. They found that if a condo or HOA updated their reserve study more often than once in 5 years, their average subsequent special assessments were 35% lower. What's more, they also enjoyed more consistency in year-to-year reserve contributions.

That's a major improvement, particularly when you consider the havoc that an unexpected special assessment can play with some of your struggling association members.

What's a Reasonable Reserve Contribution?

The best amount to contribute is an amount that your residents can afford. If they can't afford it, you won't sustain the contribution level, and you'll go bonkers constantly trying to collect their payments.

The bare minimum is 10%; fall below that level, and lenders will start black-listing you. For most associations, the reality is that they must consistently contribute between 15 and 40% of their operating bid to their reserve fund. The average contribution percentage is around 25 percent. Those with reserve contribution rates of 10% or less can expect special assessments in the future. (Also, if your residents can't afford to contribute 15-40% of their operating budgets to your HOA reserves, they sure as heck can't afford a major special assessment.)

HOA Reserves: Additional Tips

Don't go it alone: Your reserve study should be closely tied to the actual, real-world depreciation of your association's facilities, appliances, and equipment; and it should be done in close consultation with an architect or a structural engineer. For smaller associations, this can be costly, but it's usually worth the effort; after all, you won't have to hire the engineer often.

Don't rely on gimmicks: Forgo things like a "13th month" assessment. Call it what it is, and level with your members.

Don't rely on borrowing to solve your problems: First, the interest eats a hole in your budget. Second, banks aren't always very eager to lend—as many associations found out during the recession. Condo and HOAs that had a cash flow crunch in 2009 and 2010 were caught between inadequate HOA reserves and members who were facing job losses and other economic hardships, and banks failed to close the gap.

Jason Van Steenwyk
Writing about personal finance and investments since 1999, Jason Van Steenwyk started as a reporter with Mutual Funds Magazine and served as editor of Investors’ Digest. He now publishes feature articles in many publications including Annuity Selling Guide,, and more.
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