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What is the Association's Reserve Fund Condition?

By Mike Price CMCA, AMS, RS

 

This is a now a frequent question of lenders and prospective astute buyers. It should be the question of every owner. As we slowly climb back from the longest recession and real estate market decline in recent history, whether an association is adequately funded is a deal maker or breaker in the real estate market. Lenders do not want mortgage payment delinquency and resulting foreclosure losses, due to surprise loans and special assessments impacting mortgagees ability to make monthly payments. No lender or owner is happy with deferred maintenance due to inadequate funding. Foreclosures and delinquencies result in financial shortfalls, placing higher maintenance fees and special assessment payments on future owners. Loss of property value and investment is another result of inadequate funding.

A current Reserve Study by a reserve professional is more and more a necessary requirement of mortgage applications. Lenders look for strong funding and a complete component list of major assets requiring replacement by Reserve funding. Adequate funding begins with an accurate Reserve Component List.

A Reserve Study prepared according to National Reserve Study Standards (NRSS) defines the Reserve Component List: a clear description of the major assets maintained by the association with limited, predictable life expectancies. There is a 4 Part Test qualifying an expense as a Reserve Component:

  1. Component must be the Association's maintenance responsibility.
  2. Component must have a limited Useful Life (UL).
  3. Component must have a predictable Remaining Useful Life (RUL).
  4. Component must be above a minimum Threshold cost.

 

All parts of the test must be met for an expense to qualify as a NRSS Reserve Component and all qualifying components must be included and adequately funded.

The Component List is the foundation of the Reserve Study Report and calculation of Reserve Fund strength. The Board of Directors has the fiduciary responsibility for insuring that the Component List includes all assets requiring Reserve Funding. The reserve study or reserve study update process can be delegated to the management agent or professional reserve provider, but their report recommendation has to be approved by the Board of Directors after their review for completeness. Checking completeness of the Component List is not difficult and NRSS provide a handy checklist to assist with this review at www.caionline.org .

A Reserve Study prepared according to National Reserve Study Standards (NRSS) includes a bench mark calculation of Reserve Fund Strength based on dividing the current Fiscal Year (of the Reserve Study Report) Starting Reserve Fund Balance by the Current Total Deteriorated Value of all Reserve Components. This Current Total Deteriorated Value is labeled the "Fully Funded Balance" in the Reserve Study Report. No matter what funding objective is selected: Full Funding, 50% Hawaii Funding (Threshold Funding per NRSS), or Hawaii Cash Flow Method funding (Baseline Funding per NRSS) this benchmark measure of Reserve Fund Strength should be transparent in the Reserve Study Report. The calculation is stated as Percent Funded . An association's Percent Funded evaluation is not the same as " 100% Replacement Reserve" for the current year . Percent Funded is also not a comparison of current Reserve cash to the total replacement cost of all Reserve assets.

The NRSS Percent Funded strength is a measure of future risk of cash flow problems for the association. Percent Funded indicates the strength and adequacy of the reserve fund. A Percent Funded between 70% and 130% is considered strong because the association has Reserve cash on-hand roughly equivalent to the deterioration of its Reserve components, with the result that Reserve cash flow problems (special assessments and deferred maintenance) are extremely rare in this range. A Percent Funded between 30% and 70% is considered fair, as there is typically enough Reserve cash on hand in this range to manage the necessary Reserve projects without running into a cash flow problem when projects inevitably happen earlier or more expensive than anticipated. A Percent Funded below 30% is considered weak because Reserve cash flow problems are common, since there is little to no margin for the association to manage projects that happen earlier or more expensive than anticipated. Note: when all goes according to plan, there are no problems. But because reality rarely goes exactly according to plan, associations need some "margin" to avoid cash flow problems. This funding objective has the highest risk of cash problems.

Adequate funding of Reserves is responsible, required by lenders, and fair to all owners now and in the future. Enjoy the website and make wise reserve study decisions.

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 mprice@akamaireserves.com or (808) 936-4789.