Anyone who has been involved with condominium associations knows about reserve funding. Chapter 718.112(1)(f) of the Florida Statutes requires that all associations put aside funds for large future projects such as building painting, roof replacement and any other project expected to cost more than $10,000. The amount of money that the association is going to contribute in any given year to reserves is included in the annual budget and is based on the expected cost and timing of future large projects. As Board members are not generally qualified to determine the remaining useful lives and replacement costs of the various parts of the condominium property, it is imperative that the Association hire a professional engineering firm that will complete a reserve study of the property and provide guidance to the Board. Reserve studies should be updated every 2-3 years to ensure that all estimates are still accurate. There are many different reserve study firms out there but I have had good experiences with Reserve Advisors in the past.
There are currently two different methods used to account for reserve funds. Below I have provided a brief comparison of the two methods.
The first method is called the Component or Straight Line Method. Here are several important things to consider about this method:
- Each maintenance project has its own reserve account and annual contributions to each account are determined by taking the current year’s project cost, subtracting the current value in the reserve account, and dividing it by the remaining useful life of the item.
- Once money is allocated to a specific reserve account, the Board cannot utilize those funds for any purpose other than that particular project without a majority vote of the homeowners. For example, if the Board has allocated $200,000 to the building painting reserve account based on expected cost, and the project’s actual cost only ends up being $150,000, they cannot use that additional funds for any other purpose. The extra $50,000 would be the initial value of the reserve account for the next time the buildings need to be painted. Likewise, if the project’s actual cost was $250,000, the Board cannot use reserves from any other reserve account to cover the additional $50,000 without a vote of the majority of the homeowners.
- Interest earned on reserve funds is kept separately and can be used for any reserve project.
- By using the current year project cost, as opposed to the expected project cost at the time of completion, this method does not take inflation into account. For projects that are expected to be completed in 1 or 2 years, this has a limited effect; however, for projects that are not expected to be completed for 15 or 20 years, this can cause an underestimation of the project cost.
- Expected interest that the reserve funds will earn is not taken into account in the association’s budget. If your association has material reserve funds, annual interest earned can be a material amount of money which, when using the component method, cannot be included in the reserve contribution calculations. Therefore, in essence, homeowners have to contribute more (the amount of interest earned annually) to the reserve accounts annually under the component method than they would if interest could be taken into account.
The second method utilized is called the Pooling or Cash Flow Method. Here are several important things to consider about this method.
- This method is similar to the component method; however, instead of having individual reserve accounts for each project, there is one pool of funds that can be used for any reserve project.
- Inflation is taken into account. For example, if a project is scheduled for two years from now, the current estimated cost of the project is $100,000, and annual inflation is expected to be 1%, then this method would require that the reserve pool have $102,010 available two years from now to complete the project. This is calculated as follows: $100,000*(1.01)^2.
- Earned interest is included in the reserve pool and anticipated future interest is taken into account. For example, let’s say that the reserve funds are held in a money market account with a .5% annual interest rate. If the pooled reserve account currently has $300,000, annual interest could be roughly estimated at $1,500. This is $1,500 that does not need to be contributed to the reserve pool from maintenance fees.
- Reserve studies anticipate property projects thirty years into the future and provide a schedule of annual reserve contributions for each of those thirty years. These schedules are set up to increase by no more than the estimated rate of inflation annually.
The following is an example that shows how the component and pooling methods would work in the same situation. Let’s assume the time has come to replace the roofing on all of the property’s buildings and the reserve account for this project has $250,000. Let’s also assume that the total amount of reserve funds for all projects is $750,000. If the actual cost of the project is $300,000, under the component method, the Board has several options. (1) The Board can wait to do the project until there is $300,000 in the roofing reserve account. If the roof replacement is urgent due to leaking or other issues, this may not be a feasible option. (2) The Board can issue a special assessment on the unit owners to make up the $50,000 deficit. (3) The Board can wait until the following year and increase maintenance fees substantially to make up the $50,000 deficit. (4) The Board can have a homeowner vote to take $50,000 from a different project reserve fund. This 4th option would require at least 51% of the homeowners to vote. Under the pooling method, the Board would be able to pay the $300,000 out of the $750,000 total reserve funds to complete the project in a timely fashion. The Board would then need to determine how to earn back the extra $50,000 that was used for the roofing project over future years. This could be done through an increase in reserve contributions in future years or, if lucky, another reserve project(s) will cost less than estimated. In the end, the pooling method provides significantly more flexibility to the Board and allows for more efficient project completion. However, it is also possible that the Board could decide to approve a $400,000 roofing proposal even though only $250,000 has been allocated for this project and, in doing so, could set up the community to not have enough funds down the road to complete the next big reserve project. In this case, a special assessment may be required which puts and unfair financial burden on the current homeowners.
So which method is right for your community? That decision is up to the homeowners. In order to switch from the component method (the method the majority of associations use) to the pooling method, a majority vote of the membership is required. If you are considering a switch to the pooling method in your community, there are several things to consider:
- When was the most recent reserve study completed? You should obtain a current reserve study using both the pooling and component methods to compare the required annual reserve contributions (typically the component method calls for higher contributions as it is the more conservative approach). If you are trying to avoid an increase in maintenance fees, switching to pooled reserves may help in that effort; however, this should not be the primary factor when deciding whether or not to switch to pooled reserves.
- Is the current Board fiscally responsible? Will future Boards be responsible with reserve funds? Pooled reserves allows the Board much more flexibility in reserve spending and, in the case of an irresponsible Board, this can lead to overspending.
- Is there a Board member that is comfortable enough with Excel to take the thirty year reserve schedule and adjust it based on actual project costs, changes in interest and inflation rates, and/ or changes in annual reserve contributions? This is very important because before a Board can decide if they should spend more on a particular project than estimated, or if they should complete a project sooner than anticipated, the impact on the reserve pool and future reserve contributions will need to be analyzed. You may be able to have the engineering firm that completed your reserve study complete this analysis for you but there would likely be a fee involved.
- How many reserve projects does your property have coming up? If you have a large property with many reserve projects, pooling reserves may benefit your community. Let’s examine why. Large communities may have one or two reserve projects annually and maybe more on rare occasions. If the community uses the component or straight-line method, they can only look to the reserve account for that particular project, and the earned interest account, when determining how much they can spend on that project. If the Board does not have sufficient funds in these accounts to complete the project and they don’t want to use operating funds or issue a special assessment, they may want to use some funds from a different reserve account (one that they think is overfunded or one that has funds remaining after a recently completed project). In order to do this, they would need a majority vote of the membership. Given that the estimates used to determine how much should be reserved for each project can often be inaccurate, it is possible that the Board could need multiple votes of the membership each year to move money between accounts in order to complete reserve projects. If your community is very active and obtaining a majority vote of the membership is easy to do, then this is no problem. However, in many communities, convincing a majority of the homeowners to submit a limited proxy can be a very time consuming task.
This post only serves to provide a brief overview of reserve funding methods. If you need any assistance in determining what the best path is for your community, feel free to email me.