Reserve Studies and How To Read One in Five Minutes
Jim Talaga, President of Association Reserves Washington, presented an extremely informative, useful and insightful series of topics about reserve studies in our state. And he should know. Having grown up in the construction industry, and after having earned commissions selling real estate, his knowledge and leadership contributed to the collaborative efforts that resulted in Washington State's Reserve Study law. See RCW 64.34.380-392 (condominium associations and RCW 64.38.365-390 homeowners associations)
You can follow the links, above, and educate yourself using Association Reserves' free library and the applicable state law.
What is a Reserve Study?
Key to any reserve study is its definition:
"A Reserve Study is a planning document and budget model for the Association’s expenses whose infrequent and significant nature make them impractical to be included in an annual budget."
A reserve study is useful because its purpose is to prepare the association economically for the significant maintenance, repair and replacement expenses they can expect to face over time, while minimizing or eliminating surprises and special assessments.
At the risk of repeating myself, our buildings will survive us all. Reserve studies give owners a truer sense of the cost of ownership, because it gives boards a way to budget annual contributions to reserve accounts that accommodate the pay-as-you-use theory of building ownership.
Low assessments can be time bombs, because it's possible that they do not reflect effective contributions to reserve accounts. As of January 2012, condominium state law, above, requires reserve studies and their financial results be included in budgets adopted after that date, and disclosed to owners and prospective buyers of condominium units.
Lenders, insurance companies and educated buyers involved in common interest communities generally and increasingly require copies of current reserve studies in advance of any purchase.
A reserve study specialist can evaluate significant real estate assets and list them in the component list. Ideally, this is accomplished with knowledgeable board members. The condominium law requires six components and Jim has added the seventh. The list includes:
- Plumbing (the seventh)
Excluding any listed component requires an explanation of the exclusion: a downtown high-rise may not own any asphalt, for example.
Everything has a useful life, after which the component must be replaced or maintained at a significant level. There is no 'if' -- there is only 'when'.
Budgets adopted after January 1, 2012 must disclose:
- The percentage of budgeted assessments targeted for the association's reserve account
- Pending special assessments
- Whether the reserve account balances will be sufficient to meet projected expenses over the next thirty years
- If not sufficient, the additional assessment schedule necessary to ensure adequate funding during that period.
If the board refuses to produce a reserve study, in condominiums, 20% of the owners can demand one in writing, and summarily sue the board for its production should the board refuse to produce one. In homeowner associations, the percentage is 35%.
A current reserve study coupled with an adequate level of funding in the reserve account can enhance the attractiveness of a unit to a potential buyer. In Washington State and in Whatcom County, more and more buyers are aware of this requirement, and drill down into the economic health of a community before making an offer.
Unit sellers can point to reserve accounts as equity in their ownership, and enjoy higher returns on their common interest community investments.
As well, unit owners can sleep better knowing that their bank accounts will not be liable to a surprise and potentially draining special assessment.
How to Read a Reserve Study in Five Minutes
Yes, this is math, numbers and all that, but it's also basic economics of owning real estate. Elevate this exercise to the level of an investment, and it can be fun. You'll want to look for three things in your review:
- A list of components included in the study.
- A measurement -- the percentage is calculated for you -- of the adequacy of funding.
- A plan to prepare to pay for expenses at the ends of the useful lives of the components.
Component List Review
For each component, you'll see Useful Life and the Remaining Useful Life, both expressed in years, the Current Average Cost and a projected Future Average Cost.
How to read the Component List:
Look for what you know could be missing. In a high-rise, for example, if there are no elevator components on the list and you know there is an elevator, ask why the elevator components are not listed. This is mostly a common-sense test, given everything else you've learned about the property.
Adequacy of Reserves
This measurement is given as a snapshot. Here is an example:
"Results as-of 1/1/2013:
"Projected Starting Reserve Balance: . . . . . . . . . . . . . . . . . . . . . . . .$100,000
"Fully Funded Reserve Balance: . . . . . . . . . . . . . . . . . . . . . . . . . . . . $444,547
"Average Reserve Deficit (Surplus) Per Unit: . . . . . . . . . . . . . . . . . . .$ 6,891
"Percent Funded: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22.5%
"100% Full Funding 2013 Monthly Reserve Contribution . . . . . . . . . .$ 6,030
"70% Threshold Monthly Reserve Contribution . . . . . . . . . . . . . . . . .$ 5,280
"Baseline Contribution (min to maintain reserves above $0) . . . . . . $ 3.800
"Recommended 2013 Special Assessment for Reserves: . . . . . . . . . .$ 0
"Most Recent Reserve Contribution Rate: . . . . . . . . . . . . . . . . . . . . . $ 4,000
[Please forgive uneven column.]
NB: Full Funding means having enough in the reserves account at the end of the component's useful life to pay for its replacement or significant repair.
Notice that the difference between the Most Recent Reserve Contribution Rate and the higher funding levels -- 70% - 100% -- isn't that great.
How to read the Adequacy of Reserves in the example:
Reserves are currently funded at the 22.5% rate. As a comparison, statistically, associations with funding levels at the 70% to 130% levels enjoy fiscal stability with low risk of special assessments and/or deferred maintenance.
Risk of Special Assessment in Funding Percentages
Here's a table of percent funded and the risk of special assessment from the data provided by Association Reserves, Inc, gleaned from thousands of reserve studies:
- Zero -- 51%
- 10% -- 40%
- 20% -- 29%
- 30% -- 18%
- 40% -- 10%
- 50% -- 5%
- 60% -- 2%
- 70% -- 1%
- 80% -- LT 1%
- 90% -- LT 1%
- 100% -- LT 1%
KEY: First number is percent funded, second number is risk percentage of a special assessment, LT means less than.
Plan to Pay at the End of Useful Life
Again, this is a common-sense test. Ask the questions and get the answers that make you comfortable -- or uncomfortable.
Work with real estate agents who are knowledgeable about common interest communities, and who can help you assess the financial health of an association. Look beyond the granite countertops and believe that knowing more about your association's financial health means more in the long run that the first blush vanity appeal that you can see at a showing.