Reserve Study Tutorial

• Buyers finding lack of Reserves back out of real estate purchases.
• Lenders finding lack of Reserves may not lend money.
• The board has a fiduciary responsibility to plan for predictable expenses.
• The costs of maintaining the property will be fairly shared by all owners.
• The Reserve Study provides a predictable maintenance plan.
• A healthy Reserve Fund helps maintains the highest market value of the homes.
• Adequate reserves help avoid special assessments which are both unfair and difficult to collect.

To conduct a Reserve Study, you need the following information:

• Component Description
• Number of Units per Component
• Replacement Cost per Unit/Component
• Year Built or Placed in Service
• Life Expectancy in Years

Step 1 - Make a List of all Common & Limited Common Elements   These are defined in your association's governing documents. Some examples include: Decks/Patios, Gutter & Downspouts, Roofing, Siding Repair, Elevator Renovation, Fire Protection Equipment, Pavement Overlayment & Sealcoating, Restriping, Pool Equipment, Furniture, Pool Replastering, Fences and Signage. See Reserve Study Component List

To ensure a thorough list, consider all structures on the property, not just the most obvious ones. For example, unit roofs are obvious but don’t overlook garages, clubhouse and shed roofs. If similar items are built or placed in service in the same year, lump them together as a single line item and note the total number of items; if not, list them as separate line items. This will be the case in associations which were built in phases.

Avoid combining dissimilar items together, like clubhouse roof and unit roofs. Separating these gives a more accurate picture of your Reserve needs and reduces confusion should questions arise in the future. If you feel you must combine items, document the rationale behind it.

Document any assumptions made to eliminate confusion. By doing so, anyone unfamiliar with the association will be able to understand the report. Note, for example: "The boat dock is not being reserved. Although a common element, it was decided by an association vote to remove it at the end of its useful life. Refer to the May 2001 Board minutes."

Step 2 - Determine Life Expectancy & Replacement Cost   These items go together.  Check association records for work that has been done to determine an item's Life Expectancy and Replacement Cost. If the developer is still available, request construction detail and cost information.  If you are in an older development, ask qualified contractors. Some contractors may require a nominal fee for a detailed estimate. However, most will credit payment for an estimate toward any work done within a reasonable time frame. 

You can also obtain costs for labor, material, and useful lives through cost estimating resources like RS Means or Craftsman Books that provide national averages indexed to your local area. This is generally sufficient for long range general planning. If you use national averages, always get a detailed estimate near the end of the useful life of a component for a more accurate picture.

Step 3 - Establishing a Funding Plan  You now have all the required information to complete a Reserve Study. Next, you must select a funding strategy. This decision is very important and has serious financial implications for your association. The preferred funding strategy combines reserve contributions, expenditures, inflation, interest earned on invested reserves and taxes payable on interest earned over a 30 year period in order to determine a reasonable and regular reserves contribution (usually monthly) to avoid the need to ever have a special assessments.

A Reserve Funding Plan requires:

• Current Reserve Balance.
• Interest Rate on Invested Reserve.  Reserve funds should be placed in insured investment like CDs-Certificates of Deposit and Treasury Notes.  The longer the money is committed the higher the return.  For example, two year CDs return higher interest that one year CDs which return higher interest than six month CDs.  Investing in stocks, bonds, mutual etc. is an option but due to higher risks, the board should never use do so unless the owners agree in a Reserves Investment Resolution which authorizes them to do so.  For current insured and guaranteed investment options, click here.
• Taxes.  There are two ways to report financial activities to the IRS:
  Form 1120H is the tax form specifically made for homeowner associations and is likened to the 1040EZ for its relative simplicity.  The tax rate for 1120H filers is 30%.  
  Form 1120 is an option for all incorporated HOAs (and all should be).  While it is more complex, it carries a tax rate of 15%.  Since healthy reserve funds can often rise to hundreds of thousands and even millions of dollars, it is usually prudent to use the Form 1120 and cut the tax rate in half.  Check with a knowledgeable CPA.
• Inflation Factor.  Incorporating the current area inflation rate is important because over a 30 year period, it will dramatically affect costs and the reserves needed.  See InflationData.com

Annual Review & Revision.  Extremely important.  In conjunction with your annual budget review, review your Reserve Study in he areas listed below. A change in any will often have a profound effect on your plan.

1. Life Expectancy  Can vary due to use, weather, workmanship, etc. As items get close to the projected end of their useful life, closer monitoring is warranted.
2. Replacement Cost  As items get close to the projected end of their useful life, you will need to get a minimum of three bids for their replacement from qualified contractors.
3. Addition/Removal of Items  As time passes, items may be added or deleted from list of Common and Limited Common elements, like removing a boat dock or adding a gazebo.
4. Inflation  Adjust your inflation factor is it has changed (and it usually has).
5. Interest Earned.  Adjust the interest yield on invested reserves. 

Who Performs the Reserve Study?  There are a number of Reserve Study Specialists/Analysts that are available to perform this work.  Check out the Service Directory-National for options or inquire with local HOA management companies for referrals.  Unless you have a knowledgeable construction cost estimator in your group or your Reserve Study is very simple (few components), it's prudent to have a professional do the work.  There are a number of advantage.

• Objectivity.  An insider will always have a conflict of interest and usually want to minimize costs.  An independent Reserve Analyst looks at the reality of your components, materials and their useful lives.

• Expertise.  Reserve Analysts are trained in construction and cost estimating.

• Connected.  Reserve Analysts have connections with professional contractors that helps develop reliable cost data.

Healthy reserves are critical to the well being of every homeowner association. Investing in a comprehensive Reserve Study and following a carefully charted funding plan will reap huge dividends in the coming years. If your HOA hasn’t already done so, get the ball rolling today!