By Will Simons, RS / Published August 2016
Editor’s Note: Part I, “Component Lists,” was published in the March 2016 issue and can be accessed by visiting pubs.royle.com/publication/?i=290576&p=44 and Part II, “Reserve Fund Strength,” was published in the June 2016 issue and can be accessed by visiting pubs.royle.com/publication/?i=303948&p=64.
This article represents the third 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 community association 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,” “Reserve Funding Plans,” and “Why Reserve Studies?”
In our prior two articles, we discussed the importance of creating a thorough and accurate list of reserve components and how to evaluate the current relative strength of an association’s existing reserve funds. In doing so, we covered two important questions that each association must confront when budgeting for reserves. First, what are the specific assets that we need to include in our planning? And second, as of right now, how well-funded are we, considering the current and future needs of our community? Once these two questions have been answered, the final (and most important) question remains: where do we go from here? The answer to that question comes in the form of a “funding plan.” Put simply, the funding plan is the recommended action plan by which the association provides income to the reserve fund to offset ongoing common area deterioration.
In order to determine its funding plan, the association can use one of two methods, either the component method (also known as the straight-line method) or the cash flow method (also known as the pooled method). In the days before computer spreadsheets made it easy to run multiple calculations instantaneously at the click of a button, the component method was a simple, reliable way to calculate how much money needed to be budgeted for an association’s reserve components. Nowadays, most industry professionals recommend using the cash flow method for a few key reasons. Most importantly, the pooled method allows for a more efficient allocation of available funds, recognizing that the important number is the total of all available reserves, with no need to distinguish between particular types of reserves. Not to mention, the cash flow method also permits the incorporation of interest and inflation assumptions and can be used to look forward over the long term, not just one year at a time.
However, the key point of this article is not to recommend one method over another, but rather to drive home the importance of fully funding your reserves, regardless of which method is used. To do less than fully funding is known as “underfunding” the reserves and is one of the leading causes of financial distress in the forms of unexpected special assessments and bank loans for communities throughout Florida. We’ll use an example based on the component method to show how easily things can go wrong if an association is not using an appropriate funding plan.
For background, using the component method for reserve budgeting goes like this: you take the cost of a component, divide by its useful life, and the result would be the amount of money you put into reserves each year over the course of its life, with the eventual goal being that the component would be “fully funded” when its life runs out. For example, if you have a roof with a 20-year life, and it will cost $100,000 to replace, you divide $100,000 by 20 years and get a required funding amount of $5,000 per year. If you then put a line item in your budget for roof reserves at $5,000, you would effectively be “fully funding” your roof reserve. You would do a similar, separate calculation for each of your other reserve components (painting, pavement, elevators, swimming pool, etc.) and budget for those components accordingly. Each year during the association’s budgeting process, a new funding plan would be created by adjusting the calculations based on the actual amount of money on hand and the remaining life of the components at that point in time. Continuing our example, let’s assume that 10 years have gone by (half the roof’s life), and you need to re-calculate the funding needed for the roof’s event-ual replacement. If the association has been “fully funding” all along, you would have half of the roof’s replacement cost saved up. Ignoring inflationary increases in the roof cost for the sake of the example, you would therefore need to have $50,000 saved after ten years.
However, what if during those years the association’s residents voted to “underfund” the reserves and you don’t have the full $50,000 saved? In that case, you would need to determine the remaining balance of the cost that is yet to be funded, and divide by the remaining useful life of the roof. So, let’s assume that after years of underfunding, the actual cash on hand in the roof reserve is only $20,000. (Those who read the previous installment in the series may recognize that comparing the actual $20,000 available against the ideal number of $50,000 would mean that the association would therefore be 40 percent funded at that time.) Given the shortfall, this would mean you would need to accumulate the remaining $80,000 over the next ten years of the roof’s life, at a rate of $8,000 per year.
That doesn’t sound fair, does it? Clearly, the owners who voted to underfund the roof reserve in the first ten years are paying less than their fair share of its eventual replacement. Imagine that one owner (let’s call him Jack) lived in the building for the first ten years, and then sold his unit to a new owner (Diane) who would live there for the next ten years. At the end of the roof’s life, both Jack and Diane will have benefited from ten years of the roof’s overall useful life, but since the contribution rate during Jack’s tenure was effectively only $2,000 per year, and it will be $8,000 per year while Diane lives there, Diane will end up paying four times more than Jack for replacing the roof.
In some cases, associations will vote to waive reserve funding entirely. If that were the case in Jack and Diane’s situation, Diane will end up paying all of the replacement cost, most likely in the form of a big special assessment, even though she only benefited from half of the roof’s useful life. It can certainly be much worse than that. What if Jack sold his unit to Diane in year 19 instead of year 10? If so, Diane gets only five percent of the useful life of the roof, but still pays 100 percent of the cost! What’s more, this is assuming a very limited example with only one component. In reality, underfunding or waiving reserves could mean that all of an association’s components are in a similar state. For some unlucky homeowners, we’ve seen combinations of underfunded components all reaching the end of their useful lives at the same time, resulting in required special assessments numbering tens of thousands of dollars per unit.
Aside from the obvious principle of fairness, there are other reasons to fully fund the reserves. One of these is the relative increase in market value of homes in associations with strong reserve funding. Since the housing market crash in 2008, we in the community association industry have seen an increasing level of scrutiny among smart homebuyers. We all know that an association’s budget typically consists of many costs that should be fairly consistent between comparable properties: insurance costs, utilities, and payroll are some examples. In the past, an association that advertised itself as having below-market monthly dues may have been much more attractive to potential buyers. These days, many in the know recognize that if the dues are below market, there may be a catch, and the likely reason for the lesser dues is that the reserves are being underfunded. As a result, potential buyers may look unfavorably on associations that are underfunding reserves, because the short-term benefit of lower monthly dues is weighed against the likelihood of paying more than one’s fair share for reserve expenditures. In turn, the market value of the homes in that association will suffer compared to those in associations with sound funding plans.
In our next and final installment in this series, we’ll discuss the value of a professional reserve study in the budgeting process and look at some ways that associations benefit from having expert guidance in this important aspect of running a successful community.
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 more than 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.