By Bryan Farley, Association Reserves
Fully Funded Balance, Annual Asset Deterioration, Percent Funded, Total Annual Reserve Contribution Rate…
In trying to explain Reserve Study concepts for clients, Reserve Study companies and their lingo may have created some unintended consequences. Unfortunately, this just makes a board’s job more difficult.
The board hires a Reserve Specialist to put together a budgetary action plan, the board reviews, then distributes the findings and votes on an action plan. If a Reserve Study is shrouded in language that is foreign to the members of the community, then it will be hard for the board to do their job successfully.
What are some examples of this?
When we are hired to help a community out, I usually find that the board of directors is doing so under the encouragement of their community manager. This is great and we recommend this action. However, most of the time, the board is not really sure what they signed up for. They tend to understand that the Reserve Study will help them with their budget, but how?
Most of the board members that I interact with tend to think of the Reserve Study as a special cash flow statement, and by special they mean, “why are we paying someone to do this?”
A reserve specialist should make sure that the board fully understands why they hired a firm to complete their Reserve Study as well as how to utilize the final product. A reserve specialist’s job is to educate the board on the ‘Why’ of Reserve Studies.
Well, then why have a Reserve Study completed?
The reason a board needs a Reserve Study is to understand the annual deterioration costs of the property and make sure that all owners, today and in the future, pay their fair share each and every month.
“The reason a board needs a Reserve Study is to understand the annual deterioration costs of the property and make sure that all owners, today and in the future, pay their fair share each and every month.”
All boards understand the importance of their operating costs (landscaping, snow removal, water, gas) because these expenses occur on a daily/monthly/yearly basis. These costs are easy to understand because the board knows that if they neglect to pay their cost for the service, then that service will not occur. Meaning, if the board decides to not pay their water bill for the month, then they will immediately see the consequences of their choice.
However, the same board will neglect their two-million-dollar asphalt parking lot deterioration, even though the asphalt is failing every single day in front of their eyes. Yet, once the board sees a bid proposal to resurface their asphalt, the most common reaction is shock, denial, and then anger that no one had planned for this expense.
Why does this happen? This happens due to human nature. Researcher George Ainslie found that, “humans tend to opt for immediate rewards instead of rewards down the pike, even if the later rewards are greater. For example, when offered $50 now instead of $100 in a month, most people will choose the fifty bucks.” *
If you live in an HOA, then you have probably noticed this. You may have asked yourself, “Why should I be paying for new asphalt in 15 years when I won’t be living here in 15 years?” Like most people, you would rather not pay now and not pay later - or basically get your cake, eat it, and have your neighbor pay for it too.
What is there to do?
Here are a few tools to help boards and their owners understand their Reserve Study needs in just a few minutes so they can put their Reserve Study findings into action:
#1 - Annual Deterioration Rate:
If you take a look at your Reserve Study, then look for the table that explains the annual rate of deterioration.
Think of the annual rate of deterioration as the ‘bill’ or ‘cost’ of your reservable assets. The reason that this number is so powerful is due to the fact that it is a static number. That means that regardless of whether an owner lives in a community for one year, or twenty years, that owner needs to pay the deterioration cost for every single year that they live in that community. This will allow an equitable spread of the community’s costs over the lifetime of the property's assets. It forces the board to look at the current annual cost, rather than the future estimated cost. If the board can frame the reserve expenses as a current and necessary cost, then the ownership cannot just pass the buck along to the future owners.
In this example, the property has about $38,000 in annual deterioration costs. Let us say that there are (35) unit owners that contribute into the reserve account. That means each owner needs to offset at least ~$1,100 per year in deterioration costs. To break it down even further, every single day the cost of this property’s deterioration for each owner comes out to ~$3 a day.
Therefore, in order to just keep pace with the deterioration, each homeowner at this property needs to contribute ~$3 per day into the reserve account to break even with the ongoing maintenance deterioration.
This is the cost or the bill of the reserves for the property. If the current group of ownership decides to either not contribute to reserves or to significantly underfund reserves, then the costs will just compound year over year and the community will get further and further behind.
#2 - Recommended Contribution Rate:
Once the annual deterioration rate has been established, the next step is to offset the inevitable deterioration with ongoing reserve contributions that get the property financially ahead.
On average, a well-funded property contributes about 30% more than their annual rate of deterioration. Using the example above, a property that has about $38,000 in annual deterioration costs should be putting away around $49,000 a year into reserves.
The difference between the annual deterioration rate and the recommended contribution rate, in this case $11,000, represents the amount needed to outperform inflation and shortfall due to prior underfunding.
It is more important for the board to pursue adequate ongoing reserve contributions then try to time their expenses. In other words, if the monies are predictably contributed on an ongoing basis, then the board will be prepared for a premature failure of a heater, or any other asset.
#3 - Percent Funded:
If the association begins to contribute at the amount recommended needed to adequately cover the annual deterioration and inflation costs, they will soon be considered a ‘well-funded’ property. We determine which properties are well funded by their percent funded. Percent funded is found by a simple calculation:
It is easy to figure out the numerator of this equation: It’s the amount of reserve funds (if any) that have already been set aside within the reserve account.
The denominator translates deterioration into monetary terms. It requires a calculation, combining the fraction of deterioration that has occurred to each and every component each year.
Percent funded tells us statistical risk for a property’s reserves. If a property has a low percent funding level, for example between 0%-30%, then we know that statistically the property is at a high risk for special assessments, deferred maintenance, and cash flow deficiencies. However, when a property has a high percent funding level, 70% and above, then the property has a less than 1% risk of special assessments, deferred maintenance, and cash flow deficiencies.
The percent funded is a simple way to describe the current health of the property’s reserve fund. A low percent funded does not mean that a property is ‘bad’. A high percent funded also does not mean a property is ‘good’. Percent funded just tells us current statistical risk. Each year, the percent funded of a property will change, either lower or higher, depending on the reserve contribution rate and whether or not reserve projects are completed on time.
Although we used a little math along the way, the hope is that this article can be used as a simple cheat-sheet at the next board meeting when there are questions on interpreting the data from the recently completed Reserve Study.
*George Michelsen Foy (2018, June 25). Humans Can't Plan Long-Term, and Here's Why https://www.psychologytoday.com/us/blog/shut-and-listen/201806/humans-cant-plan-long-term-and-heres-why
Bryan Farley, RS is the president of Association Reserves, CO/UT/WY. Bryan has completed over 2,000 Reserve Studies and earned the Community Associations Institute (CAI) designation of Reserve Specialist (RS #260). His experience includes all types of condominium and HOAs throughout the Rocky Mountains.
