Imagine if you will, you are on the Board of Directors for a Homeowners Association and you need to figure out how much to collect each month in dues. You know you need to bring in enough to cover monthly and yearly expenses like the gardener, trash collection, and insurance. That’s easy to figure out.
But what about larger and less frequent expenses like replacing the roof, an exterior paint job, or upgrading the plumbing? You want to avoid special assessments if possible. Many owners would be against it and some simply could not afford to pay a large special assessment.
Therefore, you understand that you must save something back in reserves to pay for those larger, less frequent future expenses. How do you know how much to set aside? Really, how does a board know how much to set aside for the future? Well, luckily there is a tool for that. It’s called a reserve study. I’ll explain.
What is a reserve study?
A reserve study is a budgetary planning tool that homeowner associations use to financially plan for and maintain proper levels of funds in a “reserve fund” for common area components the association is obligated to repair, replace, restore, or maintain within the next 30 years.
Are all HOAs required to have reserve studies?
In California all associations, regardless of size, are required to have a reserve study (Civ. Code § 5550), unless the total replacement costs are less than 50% of the gross budget of the association, excluding the association's reserve account for that period. (Civ. Code § 5550(a).)
So, for the most part, all HOAs in California need a reserve study.
How often are reserve studies required?
In California, HOAs are required to conduct a reserve study with a “diligent visual inspection” on-site at the property every three years with an Annual Reserve Study Update taking place in the subsequent two years until the next site inspection takes place. Therefore, after an on-site reserve study is conducted there are two more Annual Updates that follow before the next on-site inspection. So essentially, there needs to be some kind of reserve study every year.
Who conducts a reserve study?
The HOA Board of Directors needs to initiate a study that is “reasonably competent,” and for purposes of liability, it is necessary to use an outside company or reserve study specialists.
Fortunately, there are several, very well-qualified providers to choose from and the Association of Professional Reserve Analysts (APRA) member directory is a good place to start.
There are two national credentials available for reserve study professionals. The Association of Professional Reserve Analysts (APRA) has the Professional Reserve Analyst (PRA) designation and the Community Associations Institute (CAI) has the Reserve Specialist (RS) designation.
What is included in a reserve study?
Reserve Studies should follow National Reserve Study Standards and in California they should also follow the State of California Reserve Study Guidelines. Studies should contain the following details:
- Common Area Components - The reserve study must identify and list major common area components that are the association’s responsibility.
- Expected Useful Life – There needs to be estimates of the expected useful life of these components.
- Estimated Costs – It needs to include estimates of repair and replacement costs associated with each component while factoring in inflation.
- Reserve Contributions – It shall provide an estimate of the total annual contribution necessary.
- Funding Plan – The reserve study must contain a reserve funding plan. The plan could be strictly through monthly contributions or a combination of monthly contributions and special assessments.
How does your average homeowner make sense of it all?
Diving into the details of a reserve study can be quite a lot. It is too much for most homeowners and many board members for that matter. If you want to get a bottom line general financial health of an HOA look at the Percent Funded number of the reserves.
This “percent funded” number is included in all reserve studies and is probably the most important number in the entire report. The general guidelines are as follows:
- Well-Funded - 70% funded and above.
- Fairly-Funded – 30% to 70% funded.
- Poorly-Funded – 30% funded and below.
There is not one “ideal” number, and the percent funded can vary depending on the timing of large capital expenditures. Many boards try to run as close to 100% funded as possible while others keep the monthly assessments lower knowing that they may need to make it up in the future. Just understand that the lower an HOA’s percent funded number, the more likely there will be future special assessments.
What if the numbers are wrong?
The numbers will be wrong. These numbers are estimates and forecasts put together by a reserve specialist in the field. However, there are always some surprises. That is why these reports are reviewed annually and the property is physically walked every three years. Most of the forecasts average out well, making a reserve fund study generally reliable and a valuable tool for homeowner associations.
Bottom line
A reserve study is a budgeting tool that HOAs use to plan how much money is needed to take care of its responsibilities. It is used to determine how much money needs to be contributed into a “reserve account;” if any special assessments are needed; and reflect the general financial health of a homeowner association.
Reserve studies are required in the state of California for almost all homeowner associations regardless of size. Reserve studies are required every year with an on-site, physical inspection done every three years and formal annual reviews taking place the following two years.
The process needs to be conducted by an outside reserve study company specializing in reserve studies. There are many qualified firms from which to choose. The Association of Professional Reserve Analysts (APRA) and the Community Associations Institute (CAI) have designations for reserve study professionals and are a good place to start.
There are national standards and California State guidelines that need to be followed. All reserve studies need to contain: common area components, expected useful life, estimated costs, reserve contributions, and a funding plan.
The most important number in the report is the “Percent Funded”. A generally accepted guideline is that associations: over 70% funded are considered well-funded, between 70% and 30% are fairly funded and below 30% are poorly funded. Although many HOAs shoot for 100% funded.
There is a lot to know about reserve studies and hope you found this introduction useful. Remember, we are not attorneys or CPAs, so we don’t give legal or tax advice.
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