Most homeowner associations are entrusted with substantial common elements which must be maintained, replaced or renewed. All of this costs a lot of money. Borrowing said money is a very bad idea because it comes at a very high price in the way of interest and fees which must be repaid along with the principal. The cheapest and fairest way to pay for these expenses is to earmark a portion of the monthly, quarterly or annual fees and hold this money in reserve for future expenses. A properly done reserve study will inform the board how much the earmark should be so that all pay a fair share of a 30 year plan. If this is done, special assessments are never needed and the board has the money when needed.
But keep in mind that even the best reserve study has its limitations. While it predicts likely useful life spans and replacement costs, it can’t guarantee either one. A reserve study is based on assumptions that change over time. The climate, weather, soil conditions, maintenance, design and construction quality play a role in the aging process, causing some components to age differently than expected. The financial climate is also variable. Investment earnings and the inflation change. To keep the reserve study accurate, industry experts recommend (and state statutes often require) that the reserve study be updated annually.
How Much Do You Need? The reserve study will estimate how much money is needed for future projects and when the funds will be needed. For the typical garden style condominium, it is necessary to reserve 25-35% of the annual budget to meet future needs.
Communicate with Owners. For HOAs that are not currently contributing enough to reserves, the solution is to start contributing more by increasing the monthly fees. Lenders shy away from HOAs which have little or no reserves but it negatively impacts a lender‘s collateral. Once the reserve study is completed, provide owners with a copy and encourage them to read it. Hold a special meeting and invite the reserve study provider to explain it. Make sure owners understand the reserve funding schedule and emphasize the relationship between the reserve level and property values. It is not just lenders that will be scrutinizing the HOA’s finances. Savvy buyers will be scrutinizing them as well.
Don’t Commingle Funds. Reserves should not be used to pay for ongoing preventive maintenance and repairs. Those should be paid out of the operating budget. Reserve funds should be segregated in a special bank account apart from operating funds. Typically, the portion of HOA fees earmarked for reserves is swept into this separate account monthly. Only reserve related expenses should be paid for out of this special account.
Borrow Reserves Funds Carefully. Borrow from reserves only in an emergency or because of seasonal high expenses like an insurance premium that comes due early in the year and not enough fees have accumulated yet to pay it. If you must borrow, document the board vote approving that decision, establish a reasonable repayment plan and stick to the plan.
Develop a Reserve Investment Plan. Reserve funds are typically placed in FDIC insured savings accounts, money market accounts and Certificates of Deposit. Most state laws don’t have specific reserve investment standards for homeowner associations. The governing documents usually give the board investment discretion. Boards should develop a written investment policy that defines the investment goals, establishes the objectives against which the investment performance will be measured, and identifies the boundaries within which investment selections will be made.
The investment policy should include:
- Keep the reserves safe (don’t risk the principal).
- Preserve earning power by choosing investments that match or exceed the inflation rate when possible.
- Ensure that the funds are available when they are needed.
Other issues to consider include:
- Consider working with an investment professional. This is particularly important when the reserve fund is large.
- Remember that this is OPM (Other Peoples’ Money). Tread carefully.
- Document the investment decisions in meeting minutes.
- Diversify the investments (savings, CDs, etc.)
- Focus on liquidity. Industry experts recommend holding 5% of reserves in cash for emergencies, another 10-15% in short term (six months or less) securities and the rest spread among varied investments with varied maturities. The reserve study provides the schedule for work and projected cost for investment planning.
- Review your investment strategies annually to make sure they still match near and long term goals. Don’t let cyclical changes in the market alter the investment strategy which should remain long term.
Maintaining adequate reserves is a fundamental part of the board’s fiduciary duty. Make sure to earmark the budget for reserves.
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