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Reserve Policy & Prudently Building Community Reserve Funds

08/01/2019 10:36 AM | CAI Rocky Mountain Chapter (Administrator)

CAI-RMC Member Opinion Piece

While an HOA’s board of directors (BOD) has many duties, proper management of finances is the one responsibility that cuts across all aspects of a community.  Management of funds falls into two categories; short term and long term.  Short term funds deal with the daily operations of the community – keeping the lights on, mowing the grass, trimming shrubs & trees, heating the pool, etc.  It also means paying for the services of these day in/day out functions.

Long term duties concern the repair, replacement, and upgrades of community assets.  Marquee signs, concrete, siding, fencing, elevators, light fixtures, and roofing, etc.  These are more difficult to properly manage for several reasons.  First, many board members know they will not remain in their current roles on the BOD, and so they may not feel that they need to have a ten, twenty, or thirty-year perspective on their community, especially if they do not plan on living in the community for a long time.  Second, deterioration is slow and not as easily noticed as say, hail damage to a roof from last night’s storm.  It does not provide the same sense of urgency.  Third, most long term items require a level of expertise that many board members simply do not have.  It is one thing to pick what kind of flowers to plant at the community entrance every spring, but how many BODs have intricate knowledge of light ballasts or roof underlayment?  Fourth, too many directors and homeowners believe that keeping monthly assessments as low as possible today (and forever) is their most important financial duty and the best indicator of smart decision making since everyone needs to keep costs low.  This task can be daunting for many.

In addition, when we consider the finances required for some of these projects, the funds required are quite large.  When we combine more complex projects with large dollar figures, and then add a layer of peer pressure to not raise monthly assessments (or even personal resistance), a recipe for disaster will be created in the future that is unavoidable.  Special assessments and loans can undermine a strong sense of friendship with neighbors, and ultimately will cost much more than addressing reserve needs more proactively.  Periodically raising monthly assessments over time allows homeowners to plan and budget.  Special assessments are worse than a gut punch.  Who plans for those?

Colorado has the Prudent Investor Rule that covers financial responsibilities when one or many people manage funds on behalf of others.  There are several parameters that are obvious to most with this statute, like using reasonable care, skill, and caution.  Also, liquidity, preservation of capital, appreciation of capital, and taxes are important to consider.  These are obvious to most people and do not require boring lectures to bring people up to speed.  One important consideration that is often overlooked is the effect of inflation.  Inflation is not tangible, happens slowly, and is difficult to notice (much like deterioration of siding or a roof under the surface).  This is one facet that should be placed high on the list to overcome.  Sadly, it is not.  According to the Bureau of Labor Statistics, in the 40 years leading up to 2010, average annual inflation was 4.4%.  Even if the last nine years since then of low inflation could have pulled the average down to 4%, we have a tough task of dealing with decreased purchasing power of reserve funds over time.  4% inflation means we need returns of 4% each year just to keep pace.  In fact, even when interest rates are higher, bank and credit union products will not keep pace with inflation over the long haul.  How can we fight this and still be prudent?

There is an important distinction between adding to reserves diligently, including increasing monthly assessments routinely, versus loans or special assessments.  The former involves foresight, planning, and strong communication.  The latter is reactive and puts a community in firefighting mode, which creates confusion and helps spread doubt in other areas of HOA decisions and processes, not to mention leadership.  The other advantage that the first approach adds is that there is an opportunity to have the reserve funds work hard for the community, instead of the other way around.

Looking at the difference between short (operating) and long-term funds (reserves) we should realize we need two policies in place.  For the short term, we should mandate zero risk.  Banks and credit unions provide us with funds that are FDIC or NCUA insured.  We can’t lose, even if a banking firm fails outright.  We need to make sure the electric, landscape, or insurance bills get paid.  Having the bank or credit union of our choosing backed by Uncle Sam is a prudent route.

For the long term, we need to understand the role inflation plays as discussed above.  By their very nature, banks and credit unions do not help us keep pace with inflation.  We must look elsewhere, which takes us away from FDIC or NCUA insurance.  This means we need to take extra effort and care (or hire an expert) to make sure our decisions are in the best interests of the community.  This is where the Colorado Prudent Investor Rule applies. 

So, what tools should be examined?  We need to look at treasuries, bonds, stocks, mutual funds, and other tools that have the potential to overcome inflation over the long haul.  These instruments have varying degrees of fluctuation or volatility.  While some will say that any loss of principal is unacceptable, the effect of inflation eroding purchasing power is the same net result.  When we are investing reserves for 10, 15, or 20 years or more, fluctuation in the short run becomes an opportunity to add monthly reserve contributions when the investments are “on sale.”  The fluctuation becomes healthy, and in fact, desirable.  

This does not mean we should move to the other end of the spectrum on fluctuation, however.  For example, while stocks outperform other asset classes over the long haul, their inherent high volatility would not sit well with the majority of HOA boards.  We must find a “sweet spot” to get over the inflation threshold without sticking our necks out too far.  This is where treasuries, corporate bonds, and municipal bonds, or even bond funds may fit the bill.  Please consult with your property management company and financial professional to inform yourself and your fellow board members to make the best decisions for your community.

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