Reserve Study Specialist at Association Reserves
Physical deterioration occurs at every community association with the same certainty that the sun rises every day! This inevitable phenomenon begs the one important question for boards and managers:
Is Our Association Prepared?
Because deterioration — and any corresponding repairs and replacements — must take place on an ongoing basis, “adequate” replacement reserves is, by definition, a moving target! Just because you have adequate reserves today doesn’t mean the Reserve Fund will be adequate three months, three years, or three decades from now.
In early 2018, CAI’s Reserve Professionals Committee defined “Adequate Reserves”:
“Adequate Replacement Reserves” is defined as a Replacement Reserve Fund and stable and equitable multi-year Funding Plan that together provide for the timely execution of the association’s major repair and replacement expenses as defined by National Reserve Study Standards, without reliance on additional supplemental funding.”
In other words, “adequate replacement reserves” means that, through reserve funding and long-term planning combined, you have enough money for repair and replacement without resorting to special assessments.
Defining “adequate reserves” was a major milestone and accomplishment among reserve specialists. However, definitions can only go so far. The second question boards and managers should ask about adequate reserves is a little more specific: How do we know if we’re able to provide for the “timely execution” of repairs “without reliance on additional supplemental funding”?
The answer to this question is twofold. It starts with the Reserve Fund, but the Reserve Fund cash balance, by itself, is not particularly meaningful. Reserve Fund strength is reliably reported by a calculation called percent funded, which compares the Reserve Fund ($) to the deteriorated value of all the Reserve components ($) at any point in time. Statistics show that for associations above 70% reserve fund strength, the need for “additional supplemental funding” (special assessments) is rare. For associations below 30%, the risk of needing special assessments is quite high.
But It’s Still a Moving Target
Claiming a strong Reserve Fund now doesn’t guarantee the association will have sufficient Reserves in the future to “provide for the timely execution” of a necessary repair project. Remember, the definition of adequate hinges on a combination of your starting point (i.e., Reserve Fund strength) and how well the association continues to prepare financially (i.e., Funding Plan) for the physical deterioration that occurs every day.
An association with a strong Reserve Fund (87% funded, for instance) may seem financially solid. But if Reserve contributions are significantly less than the rate at which the property is deteriorating, the Reserve fund will quickly drop in strength and the association won’t have the money it needs in six years to replace the roof. By the adequacy definition, that’s inadequate!
On the other hand, an association with a weak Reserve Fund (17% funded, let’s say) that is making significant Reserve contributions can build the strength of their Reserve Fund in time, to responsibly provide for anticipated upcoming expenses. Now that’s adequate!
You Need Reserve Fund Strength and a Current Reserve Study
The key to understanding how well prepared you are is to know your current Reserve Fund strength, and then compare actual Reserve contributions to the size of contributions recommended in your most recent Reserve Study. If the actual Reserve contributions are more than 20% less than the recommended contributions, the association is likely headed towards having insufficient funds to perform their Reserve projects on time without special assessments. But keep in mind that guidance from a Reserve Study more than three years old is of little value. If yours is that old, it’s probably time to get it updated.
The bottom line? Physical deterioration is inevitable, but also predictable. The board is responsible for protecting the investment of all owners by having “adequate” Reserves. Providing for the “timely execution” of Reserve projects “without reliance on additional supplemental funding” requires a Reserve Fund and a Funding Plan that work together to set the association up for success!