The Comprehensive Guide to Reserves

Reserve Fund Strength, Part 2 of 4

By Will Simons, RS / Published June 2016

This article represents the second in a series of four parts modeled after a popular group of e-books originally published by Association Reserves over the last several years. The series is intended to adapt these e-books specifically to the needs of Florida community associations, summarizing and explaining the key information relevant to board members and property managers in the Sunshine State. The series will cover the following subjects, progressing from basic principles to more advanced concepts: “Component Lists,” “Reserve Fund Strength,” “Funding Plans and Principles,” and “Why Reserve Studies?”

In our previous article (see the March 2016 issue of FLCAJ), we discussed the basic building block of any successful reserve schedule—the component list. For those who may have missed it, we’ll give a brief refresher here. In short, the component list is essentially a schedule of repair/replacement/modernization projects (called “components”) that a community association should expect to face over a period of time. Some examples would be roof replacements, building painting and waterproofing, elevator modernization, lobby remodeling, etc. The list includes estimates of useful life, remaining useful life, and replacement costs for each component, which can be extrapolated to compile a forecast of future expenses. Looking ahead, the forecast is then used as the basis for present-day planning and budgeting, in order to avoid surprises and allow for an association to properly assess the owners in the association for their “fair share” of the costs of these projects, even though they may not actually occur for many years.

Properly defining an association’s reserve component list is an essential first step, and if not done correctly, will render any further analysis unreliable. A thorough and accurate list will help guide the association’s decision-making processes, providing a roadmap to ensure that adequate funds will be available when necessary. However, as with any map, you won’t know the correct route to reach your destination unless you know where to begin. After establishing the component list, the second step for any association’s reserve plan begins with an honest look at its present financial position. This brings us to the subject of this installment in the series: when it comes to reserves, how can we evaluate the current strength of an association’s reserve fund?

One common way that some associations make this determination is to pick a certain dollar amount and then make a commitment to never let the available reserve funds drop below that number. That strategy may be useful for some period of time, especially early on when a community is still new and many assets are far from their next replacement date. However, if proper care is not taken to look down the road and budget realistically for future expenses, the association may one day realize it has inadvertently backed itself into a corner with a large expense coming soon and no time to accumulate adequate funds through routine contributions to the account. At that point, the only realistic option may be to try and pass a special assessment—clearly not the ideal outcome, and one that could have been avoided through a different way of evaluating reserve fund strength.

To introduce another option, let’s walk through a simple exercise. An acquaintance tells you she’s the treasurer of her homeowners association, and she’s just been reviewing the prior year’s accounting audit. Her association has more than a million dollars in its reserve account, and as treasurer, she’s going to speak at the annual membership meeting to deliver the good news to the rest of the owners. She thinks they can probably cut next year’s budget for reserve contributions in half. After all, the association has seven figures in the bank, right?

Again, you know nothing but what she’s told you. If the association was a fairly new, not-too-large condominium building with only one pool and a tennis court for amenities, you might assume they’re in fair shape, and you’d probably be right. But, what if she represents a 30-year old, 5,000-home community with miles of crumbling roads, out-dated amenities, and a 10,000 square foot clubhouse that needs a new roof and a paint job? How would that change things?

By now, you’re appreciating that dollar balances don’t tell the whole story. To truly know where you stand financially, you’ve got to have something to compare against. When it comes to reserve funding, this means comparing your actual account balance to some kind of benchmark. National Reserve Study Standards define this benchmark as the “fully-funded balance.” This amount is a calculated figure taken at a snapshot in time and is the result of analyzing the association’s current reserve obligations. Let’s use a basic example to show how the fully-funded balance (FFB) is calculated.

Imagine a building’s roof currently costs $100,000 to replace, and it has a life expectancy of 20 years from the date it was installed. Now, let’s say that roof was installed five years ago. At this point in time, how much money should the association have saved up for when it will need to replace the roof? The answer should come quickly—$25,000, right? The roof is five years old, so 25 percent (5/20) of its useful life has been depleted. If it had been budgeting correctly, the association should therefore now have 25 percent of the replacement cost accumulated in reserves. That’s it. Notice that we didn’t say how much the association actually has, only that the $25,000 is the amount they should have on hand today. It’s an ideal, theoretical amount based on the age and current cost of the roof. (In this example, we’re ignoring the effect of inflation on future component costs, as this will be discussed further in the third installment of the series when we take a closer look at funding plans.)

Taking this process a step further, we can make a present-day calculation of how well-prepared the association is to replace that roof. The term for this measure of strength is called “percent funded” and is calculated by dividing the actual cash on hand by the fully-funded balance at any given point in time. Going back to the example above, let’s say that the association currently only has $15,000 in the bank. At this point in time, the association would therefore be “60 percent funded” ($15,000 divided by $25,000) with respect to replacing the roof. Of course, this example is limited to only one component. A large association may be dealing with dozens of different components, each with a unique life expectancy and replacement cost, but similar calculations can be made pretty quickly using a basic computer spreadsheet. The figures for these individual components can then be added together to analyze the overall reserve fund strength for the association as a whole. From there, the association can begin to consider the implications of that position in designing its budget and funding plan for future years.

So, what’s the bottom line? We’ve done the math and shown how an association can measure the strength of its existing fund, but what does it actually mean to be 60 percent funded as opposed to 90 percent funded (or 30 percent)? The best way to think of this figure is akin to how we think of a credit score for an individual. In both cases, we use a singular number, calculated at a specific point in time in order to evaluate risk. In the case of a lender considering an individual borrower, a high credit score represents a low risk of default on a loan. For an association, a high measure of percent-funded translates to a low risk of special assessments, bank loans, and other unwanted financial surprises that may result from poor planning. While reserve budgeting is only one aspect of running a successful community association, properly evaluating the strength of the reserve fund is a critical factor in reducing the risk of financial distress.

In our next installment in this series, we’ll continue to explore the financial side of reserve planning by examining the various ways that associations can put together funding plans. In doing so, we’ll look at the merits of various funding goals, and what key characteristics must be considered when budgeting for the long term.

Will Simons

President of the Florida Regional Office for Association Reserves

Will Simons, RS is the President of the Florida regional office for Association Reserves, one of the oldest and largest reserve study providers in the country. Since 1986, the company has prepared over 40,000 reserve studies for community associations throughout the United States and abroad. Highly regarded for its excellent customer service, attention to detail, and user-friendly reports, the company has been recognized as a multiple-time Readers’ Choice Award winner by the Florida Community Association Journal. For more information about the company, you can visit www.ReserveStudy.com.