What are reserves?
Reserves are funds set aside by an association to pay for the repair or replacement of community assets for which the association is responsible. The monthly dues that each member pays to an association are usually distributed between two budgets, the operating budget and the reserves budget. While the operating budget pays for the day-to-day expenses of managing and maintaining the association, the reserves budget is a "sinking fund" set aside to pay for future repairs or replacements of the association's major assets.
What is a reserve analysis study?
A reserve analysis study is a budgeting guide providing an association with a comprehensive payment plan which allows each member to make small monthly contributions to the reserves budget in order to have proper funding available as each community asset needs repair or replacement. The reserve study provides a detailed inventory of all the assets that will need to be repaired or replaced, determines the remaining life of each item as well as the cost to replace that item, and calculates the monthly contribution required in order to have proper funding available for each asset. The payment plan allows each member to make a small, uniform payment every month as part of the monthly membership dues. Special assessments, which are often substantial and usually unfairly apportioned, are no longer required. And there's no guessing as to how long a component will last or how much it will cost to repair or replace.
In addition, your reserve study is . . .
- A comprehensive analysis of your operating guidelines and other governing documents which determines the full extent of your maintenance and reserve funding responsibilities.
- A detailed and complete inventory of all assets for which the association is responsible.
- A complete collection of detail reports for each asset showing placed in service date, useful life, adjustments, replacement year, quantity, unit cost, percentage replacement, current cost, future cost, accumulated reserves, salvage value, required monthly contribution to reserves, interest contribution, net monthly allocation, and remarks detailing factors such as design, manufacture quality, usage, exposure to the elements and maintenance history.
- A long-term budgeting guide offering projections which show estimated replacement costs, annual membership contributions, annual expenditures, projected and ideal ending reserves and yearly percentages of ideal funding over the next thirty years.
- A payment plan which allows your association to become ideally funded with the lowest possible monthly contributions to reserves.
- Protection for the Board of Directors against personal liability regarding proper long-term funding for the association.
Why do I need a reserve study?
The primary reason for preparing a reserve study is to develop a payment plan allowing your association to set aside small monthly contributions in order to have funds available as community assets need repair or replacement.
The alternative to small monthly contributions are large special assessment collected each time an asset needs to be replaced. For example, your association may be responsible for a boiler which currently costs $8,000 and will have to be replaced in twelve years. Allowing for inflation, in twelve years the boiler will cost $14,000. With a payment plan provided by your reserve study, your association may contribute as little as $60 per month in order to have $14,000 available in twelve years. With a special assessment, you make no contributions for twelve years, but when the boiler needs to be replaced, the entire replacement cost of $14,000 is assessed from the current residents. This type of special assessment is considered to be unfairly apportioned since payment is required only from those who reside in the community during the replacement year, which are not necessarily the same residents who benefited from the use of the boiler during its twelve year life. A resident who moves out of the community in year 11 escapes payment for use of the boiler during the past 11 years, while a resident who moves into the community in year 12, the year of replacement, is expected to pay for a boiler from which that resident never derived benefit. Since most associations have several major assets with varying useful lives, relying on "pay-as-you-go" special assessments becomes even more unfair and inefficient.
The plan offered by your reserve study is the most fair and efficient payment plan a community can adopt to ensure proper funding and fair distribution of payment responsibilities over the life of the community.
In addition, there are four basic reasons why you need a reserve study:
1. Liability of the Board of Directors
The members of the Board of Directors, as officers of a corporation, have a legal and fiduciary obligation to maintain the community in a state of good repair, as outlined by the association's bylaws and California Corporations Code § 7231. Recent court rulings indicate that the judicial system regards directors as fiduciaries who owe an extremely high degree of duty to the members of an association, and the failure to satisfy the association's reserve requirements constitutes a failure of good management for which Board members may be held personally liable. By following the recommendations of a reserve study performed by a professional reserve consultant, the Board can protect itself from personal liability concerning proper and adequate reserve funding.
2. Legal Requirements
California Civil Code Section 1365 requires associations to establish reserve funds together with a long-term plan for repairing or replacing community assets for which the association is responsible. Reserves need to be disclosed every year within the pro forma operating budget which is distributed to all members. The pro forma operating budget needs to be mailed to each member between 45 and 60 days prior to the start of the next fiscal year (November 1st to 15th for associations with a December 31st fiscal year-end.) And a complete reserve analysis study must be completed at least every three years. Due to fluctuations in pricing, inflation, interest rates and wear and tear, combined with the changes and additions that occur ever year as well as variations in preventive maintenance programs, an annual reserve study update is highly recommended. (See What do California Civil Codes require my association to do?)
3. Auditing Requirements
The American Institute of CPAs (AICPA) recently issued new guidelines requiring accountants to address the topic of proper reserves funding during an association's annual audit. The yearly audit, required for associations with gross income of $75,000 or greater, must be performed during the first 120 days of the following fiscal year.
4. Loans and Mortgages
If the Board ever decides to secure a loan for the association, to compensate for construction defects or severe underfunding, the lending institution will request a copy of the reserve study in its evaluation of the association's ability to repay the loan.
In addition, an increasing number of banks are requesting reserve studies for first and second mortgage applications of individual homeowners, since proper reserve funding contributes to higher property values and ensures that the community will maintain its standard of living. Bankers will also look for future possibilities of large special assessments which may effect the homeowner's ability to make loan payments.
Your reserve study shows potential owners the financial strength and long-term preparedness of your association which helps in maintaining high resale value.