Q. What is a reserve study and what should I expect to find in a well prepared study?
A. A reserve study identifies the common area component inventory for your association, and establishes the rate of depreciation for these components over a specified period of time. The Washington Condominium Act requires reserve studies for all condominium associations to project repair and replacement costs for a period of thirty years.
Component replacement cycles are established by subtracting effective age of components from the useful life expectancy to determine the remaining life of common area components. Based on this remaining useful life analysis (RULA) a schedule for reserve fund expenditures is created.
From this analysis a funding plan is developed the accumulation of replacement reserves to pay for work when it is needed. Major repair and replacement costs for components such as roofing and recreational amenities are established in current dollars for all components which the association is obligated to maintain; subject to certain restrictions.
A Level 1 reserve study is comprised of two analytical processes; the physical condition assessment of common area components, and the economic analysis of those components. The two analysis’ are then integrated to create a reserve funding plan for the association. Several procedures are typical of any reserve study:
First, all major association maintained components are identified to create a component inventory. Next a remaining useful life analysis is performed to establish the replacement cycles for all components included in the component inventory.
The current cost to repair or replace each component is determined by contractor bid or construction cost estimate. These replacement cost estimates are used to determine the annual reserve funding requirements for each component which is being funded in the reserve study.
For example, if roof replacement costs $100,000 and the remaining useful life is 25 years, then $4,000 is required each year to pay for the work when it’s needed.
By completing this process for each component the reserve analyst is able to establish the total yearly contribution required to fund the reserve account.
A funding analysis is performed to determine if the association’s reserve fund is being adequately funded at the present time or whether additional funds are going to be required to correct a current funding deficiency.
Finally all of this analysis is integrated into a reserve funding projection which provides a year by year breakdown of the recommended reserve contribution; annual reserve fund expenditures; the year end reserve fund balance; and, if a cash flow funding model is used, the percent funded level at the end of each year.
This reserve funding projection must be adjusted each year for inflation, by the interest earned on reserve deposits, and by extraordinary increases in component replacement costs when they occur. Under the Washington Condominium Act (RCW 64.34) this entire process must be repeated every three years.
How should these reserve funds be accounted for? Reserve funds must be deposited to a separate account from the association’s
normal operating funds. IRS regulations and RCW 64.34 require that all reserve funds be kept in a segregated account. It is conceivable that reserves will grow to tens or hundreds of thousands of dollars. Prudent investing of these funds will reduce the amount of money needed from owners. Because the reserve study indicates when money will be needed, long term investments can be purchased
which will return more than savings accounts. Conservative investments like government securities or certificates of deposit (CDs) are recommended.
Q. Who should have a reserve study be performed?
A. All homeowner associations, regardless of size, should have a reserve study done. Once the study is completed and funding plan has been approved yearly updates are relatively simple and inexpensive. Periodic renewals, as required under RCW 64.34 will generally be much less expensive than the original Level 1
reserve study.
Q. What if the reserve study indicates our association is under-funded?
A. If the association has inadequate reserve funds at the present time, the reserve study will illustrate this fact very clearly. To replenish the fund, several options are available:
1) a special assessment (lump sum cash contribution from owners)
2) a phase-in period of several years where fees increase each year
3) a combination of both
Regardless of which method is implemented to remedy under-funded reserves, the goal of the association should be to accumulate an adequate level of reserves to pay for major repair and replacement expenses without the need for special assessments in the future.
Q. What is an adequate level of reserve funding?
A. Each association will have a different definition of what constitutes adequate reserve funding. For association’s which have chosen to fund their reserves using a cash flow funding model, you will hear the term “percent funded” or “percent funded level” used in the context of the association’s current reserves.
Determining what represents an adequate percent funded level is somewhat subjective. In general the higher the percent funded level, the more sound the association’s funding plan is considered to be. However it is important to note the percent funded level is a measure of current reserves compared with accumulated depreciation of common area components. It does not mean that if an association is “100% funded”, they will have 100% of the replacement funds required to pay for a given replacement expense at the particular point in time.
To illustrate this point consider the hypothetical situation wherein the total value of all common components which have been included in the reserve funding plan is exactly $1,000,000.00.
If we further assume the accumulated depreciation of those assets is $500,000.00; and we therefore have a current book value of the common components of; $500,000.00.
In this situation if the association were to have exactly $500,000.00 in current reserves they would have achieved 100% funding.
Hence 100% funding equals the accumulated depreciation of all components included in the reserve funding schedule, but only 50% of the total replacement cost of those same components; not 100% of the replacement cost of those components.
Q. What sorts of financial problems can my association encounter if we have inadequate reserve funds?
A. Without adequate reserves, associations must rely on special assessments to raise money for repair and replacement of common area components. Since special assessments are unpopular, the tendency is to postpone major renovations. This deferral accelerates the deterioration process, detracts from
curb appeal and erodes home resale values. A reserve funding plan with regular monthly contributions from each owner is both fair and insures funding for major maintenance, repair and replacement expenses is available when it’s needed.
Q. Can poorly managed reserve funds affect the sale of units?
A. Absolutely! Buyers and lenders look closely at how reserve funds are managed by the association. Lack of reserves is a red flag indicating a special assessment is inevitable; or maintenance and repairs are likely to be deferred.
Q. Given the choice between an association with healthy reserves and one with little or none, which would be the wiser investment?
A. As the mortgage industry becomes more restrictive in its lending policies, more and more loan underwriters are beginning to take a closer look at the association’s finances and their long range financial planning. Under-funded reserves are a real concern which lenders are beginning to take notice of when making lending decisions for mortgages on homes within common interest developments. Sellers, in particular, should be aware of these facts and should consider the potential impact on their ability to market their homes if the association has failed to implement a sound reserve funding plan.
Q. Which types of major repairs must be paid for by the association?
A. The association’s documents, and in some cases state laws, define what repair and replacement costs the association is responsible for. In common wall communities like condominiums, the association is usually responsible for items such as roofing, landscaping, siding, painting, paving, sidewalks, pools, clubhouses, signage and fencing.
There is a wide degree of latitude in how an association may be organized at its nception; and minimal statutory requirements for components to be included in the component inventory. Therefore every association must be evaluated by reviewing the CC&R’s to determine the common area component inventory.
Q. What kind of qualifications should a reserve study analyst have?
A. Building technology expertise is paramount the performance of the physical condition assessment. Cost estimating; planning and knowledge of project logistics; analytical financial and budgeting skills; and an understanding of how homeowner’s associations operate, are all important skills which contribute to the quality of the reserve study process. Good writing and communications skills are invaluable in the preparation of reserve studies which are easily understood by laymen and other non-professionals who will utilize the study in their planning and management efforts.
Recent experience preparing reserve studies; knowledge of the current regulatory environment and specialization are all desirable attributes for a reserve study provider. Providers who offer a wide array of services and/or who offer little in the way of specific expertise in building technology are not likely to provide the level of detail and accuracy required to generate a credible analysis.
Q. How much does a reserve study cost?
A. As with anything in life when you purchase a reserve study you will get exactly what you pay for. If you are swayed into thinking a low cost reserve study is the way to go you will end up with a low cost and most likely a low quality reserve study.
The state of Washington now requires a Level 1 reserve study to be performed by all condominium associations, barring one possible
exception for financial hardship; and that this study must be renewed every three years by a reserve study professional.
The definition of a reserve study professional in the context of RCW 64.34 may be interpreted as somewhat ambiguous. However it is clear the intent of the stature is to require all condominium associations to hire a professional practitioner to prepare a reserve study at least once every three years.
In determining what a reserve study should cost the buyer must therefore establish what their level of expectation is for the finished product. Generally speaking it is reasonable to assume a well researched, properly prepared Level 1 reserve study for a property of any meaningful size, will require a minimum of forty hours of staff time to prepare. In most cases, the amount of time is likely to be even greater.
Older facilities; extremely large communities; associations with a wide range of components and recreational amenities; high-rise buildings and condominium conversions, are all circumstances which will add to the complexity of the project and therefore the amount of time required to complete the study.
While there are no hard and fast rules which can be used to establish the cost for all reserve studies our experience has shown that most studies will range from $4,000.00 to $6,000.00; although it must be emphasized that there are a myriad of exceptions to any such pricing guidelines.
Perhaps more important than what the cost of a reserve study might be; is the question of what the cost of not obtaining a reserve study will be over the long run. There is little argument that failure to prepare a reserve study and fund a reserve account according to a well designed long range financial plan will result in financial hardship for many owners at some point in the future. In these cases a lack of reserves will generally result in the need for a special assessment. In older communities many people find themselves facing special assessments which are simply beyond their ability to pay. In these case there is really no way to calculate the true cost to those owners who may be faced with a radical change in lifestyle due to their inability to afford large special assessments after many years of irresponsible financial planning on the part of their association.
