Importance of Reserve Studies

On more than one occasion an association will have to make difficult decisions regarding funding of short term and long term property repairs.  Too often I hear about property improvements needing to be funded by means of a special assessment due to lack of money in a separate capital improvement reserve account.  If you are a board member of an association imagine how much easier your job would be if there is a plan for both short term and long term repairs/replacements.  For a board to properly plan for future property improvements a Reserve Study is critical. 

A reserve study provides an estimate of the costs of repairing and replacing major common area components such as roofing and pavement over the long term. We recommend the association hire a professional consultant with proven experience in the preparation of reserve studies to conduct a reasonably competent and diligent visual inspection of the accessible areas of the major components that the association is obligated to repair, replace, restore, or maintain.  Typically, individual homeowners are responsible for maintenance of the interior of their own units. Generally this includes maintenance of the interior unit finishes such as the carpeting, interior paint, etc. In addition, each unit owner may have explicit maintenance responsibility for exclusive use common areas such as private patios, balconies, etc., or for some exterior features of the unit such as front doors and windows, etc.  The property components that are the individual unit owner’s responsibility may be described in a reserve study but costs for maintenance and repair of these items should not be included as they are not the association’s responsibility.

We recommend a reserve study inspection be performed followed by a written report at least once every five years.  Ideally, all major repair and replacement costs will be covered by funds set aside by the association as reserves, so that funds are there when needed. This requires: 

• Examination of the association's repair and replacement obligations;
• Determination of costs and timing of replacement; and
• Determination of the availability of necessary reserve cash resources  

Because the board has a fiduciary duty to manage association funds and property, a replacement reserve budget is very important. This information supplements the annual operating budget in providing owners with financial information.  The reserve study is also an important management information tool as the association strives to balance and optimize long-term property values and costs for the membership.

The following paragraph is taken from the Illinois Condominium Act:

“All budgets adopted by a board of managers on or after July 1, 1990 shall provide for reasonable reserves for capital expenditures and deferred maintenance for repair or replacement of the common elements. To determine the amount of reserves appropriate for an association, the board of managers shall take into consideration the following: (i) the repair and replacement cost, and the estimated useful life, of the property which the association is obligated to maintain, including but not limited to structural and mechanical components, surfaces of the buildings and common elements, and energy systems and equipment; (ii) the current and anticipated return on investment of association funds; (iii) any independent professional reserve study which the association may obtain; (iv) the financial impact on unit owners, and the market value of the condominium units, of any assessment increase needed to fund reserves; and (v) the ability of the association to obtain financing or refinancing.”

 For association members, reserve planning helps assure property values by protecting against declining property values due to deferred maintenance and the inability to keep up with the aging of components. A good reserve study shows a more accurate and complete picture of the association's financial strength and market value.  The reserve study should disclose the manner in which the board and outside management, if any, is making provisions for non-annual maintenance requirements. Preparing a reserve study calls for association decisions on how to provide for long-term funding, and on the extent to which the association will set aside funds on a regular basis for non-annual maintenance requirements. A good reserve study may also function as a maintenance planning tool for the association.

Many associations have not developed funding plans nor had a professional reserve study prepared. This is particularly true in smaller, self-managed associations. A good reserve study should at a minimum be a physical analysis that contains the following information:

• A description of the property components that fall under the association's responsibility to maintain beyond the typical annual maintenance items
• Identification of total cash reserves currently set aside
• The estimated costs for replacement or repairs to rectify immediate needs. Issues which may be categorized as an immediate need may include replacement of the following property components: 
• Items that have failed
• Items that are beyond their useful life 
• Items that do not meet building code requirements
• Items that are a life safety hazard
• Items that do not meet ADA guidelines if applicable
• Items that do not meet FHAA guidelines if applicable 

• The estimated useful life and estimated remaining life of the existing property components 
• The estimated replacement cost of the property components (Note: This can be shown in current dollar values plus an agreed upon inflation factor may be added to project anticipated future costs).

 

Some reserve studies may go beyond the above items by recommending funding strategies. A product of the funding analysis process is the development of a funding plan (cash flow forecast or projection) to estimate future reserve cash receipts and disbursements. It is our professional opinion that the funding analysis should be prepared with the assistance of the Association’s accounting firm.  The association should decide how much should be raised through regular assessments for the reserve account each year and how much should be raised by special assessment, if any. In addition, the association should consider how much cash will remain in the reserve account at the end of the planning period relative to the projected balance needed at that date. It is important that association members understand the difference between operations and replacement reserve activities. Boards should establish policy to distinguish between reserve expenses (funded from the replacement reserve account) and operating expenses (funded through the non-reserve operating budget). 

In a new development many homeowners assume that their reserve requirements have been adequately established because the developer prepared a reserve budget.  We recommend a transition study, which is similar to a reserve study, be performed by an independent consultant.  The developer’s reserve budget often does not identify all components to a level of detail that identifies future needs. Consequently, a new association should conduct its own reserve study before the developed property is more than a few years old.

Resolve to Have a Reserve Study

Associations will have to make difficult policy choices in determining their funding goal. Many associations are currently underfunded in reserves. This is due to a lack of attention to reserve budgets in the past and underestimation of replacement costs either by the association or by an inexperienced consultant. An ideal goal for an association is to eliminate this underfunded reserves deficit or shortage. That is, to build up the reserve fund to a level where the cash in the replacement reserve account is at least equal to the estimated value of accumulated wear of all major components. The association board should pass a resolution that a reserve study shall be performed periodically. Associations that have been operating without a reserve study, or funding plan, should initiate this process as soon as possible.

When considering which professional consultant to hire it is helpful to talk with people who have worked with any firm or consultant under consideration and to examine samples of related work.  A Board member’s decision making responsibilities could be so much simpler if they have a well written Reserve Study to use as a guide.  Failure to plan is planning to fail.

 

John Hershey, President of J. Hershey Architecture and a Licensed Architect with over 30 years of experience, specializes in residential design, consulting, and construction management.  He is a member of ACTHA, CAI, the American Institute of Architects and is a LEED Accredited Professional for energy efficient design.  Send your questions to jmh@jhersheyarchitecture.com  or visit www.jhersheyarchitecture.com