Reserve Component DeteriorationBy Mike Price CMCA, AMS, RS
As soon as a component like asphalt, paint, roofing and an elevator is installed and placed into service it starts to deteriorate. Over time deterioration from use, sun exposure, weathering and abuse will require component major repair or replacement. Roofing and paint is eroded by wind and water action. Asphalt cracks and crumbles from settling and drying of petroleum binder. Mechanical equipment moving parts wear causing loss in efficiency, breakdowns and higher power use.
Long life components deteriorate if maintenance and protective seals are neglected. A concrete building life depends on maintaining paint seal to protect the concrete and support steel from water intrusion damage. Obviously cracks from settling or earthquake tremors need immediate repair and paint seal. Otherwise the structure deteriorates to an unsafe structural condition needing total replacement.
Evaluation and determination of cost for this deterioration. An example of this process is a building roof currently costs $40,000 to replace. Normally the roof will last 20 years. The surface is currently patched and the finish is worn off in places giving a poor condition and an estimated 3 years before replacement is needed to prevent serious leak damage. In a simplified calculation the total deterioration cost of the roof is 17/20ths of $40,000, or $34,000 (20 year life - 3 years remaining = 17).
If this is a single family owned dwelling then the owner should have saved $34,000 and have a plan to raise the remaining $6,000 to replace the roof. If the owner does not have the money then there is a cash flow problem. The roof is failing and the past practice of "patching & praying" is no longer viable. To make matters worse, what if the roof fails a year early? How will the consequential damage from a neglected leaking roof be paid for? The problem will certainly compound itself and stubbornly "not go away".
Community Associations are required to have a Reserve Fund and funding plan to avoid problems like the roof example. The deterioration evaluation is performed for all components (asphalt, paint, pumps, pool, fencing, etc.) listed in the Reserve Fund Component List. Then the calculated deterioration of all the components is summed and expressed as the Fully Funded Balance. This "pool' of cash should be adequate to manage replacements like the roof example without financial crisis.
How will the new roof be paid for in 3 years by the community association? Depending on the strength of the Reserve Fund cash balance several options are available.
If the annual budget maintenance fee adequately transferred money into the Reserve Fund off-setting historic deterioration, then the Board of Directors can schedule the roof replacement project, contract the work and pay for it out of the Reserve Fund in a timely manner.
If the annual cash transfer into the Reserve Fund was minimal and there is at least $40,000 available in 3 years, no cash flow problem exists and therefore no crisis.
If the annual cash transfer into the Reserve Fund was minimal and there is less than $40,000 available in 3 years, then the short fall needs to be collected in the next 3 years from the future owners. Maintenance fees need to be increased. No cash flow problem exists and therefore no crisis. Future owners may be angry that they are paying past owners' share of roof deterioration.
If the annual cash transfer into the Reserve Fund was minimal and there is less than $40,000 available and the roof fails early resulting in collateral damage to the building walls and owners' interiors, then there is a crisis. Costs go up, loans or special assessments are needed, and owners suffer surprise increased costs, disruptions and loss of use. All owners will be angry and rightfully vent their anger at the Board of Directors.
These options were listed in order of increasing risk of cash flow problems and consequences. How community associations collect for component deterioration determines the level of risk.
A Reserve Study is budgeting tool for properly maintaining the property major assets (components) in the future without cash problems, deferred replacement, or need for loans or special assessments. Directors need to choose funding plan goals that adequately collect cash over time for Total Deterioration of Reserve Components (Fully Funded Balance). Directors need to weigh the high risk of cash flow problems against the popular minimal reserve funding plans. Funding to offset deterioration with stable, fairly spread reserve contributions provides adequate cash to maintain the property. It is also the least "expensive" method in cash, time and reputation of the Board of Directors.
About the Author: Mike Price - CAI Reserve Specialist #164 and former President of Association Reserves Hawaii LLC, provides independent third party comprehensive reserve studies for all Islands. Mr. Price has a bachelor degree from Eastern Washington University and over 30 years experience in construction and project management. He holds the CMCA and AMS designations as a past condominium Site Manager and General Manager. Mr. Price can be contacted at email@example.com or (808) 936-4789.