Is Your Reserve Fund On Pace?
It's almost time for the majority of Community Associations to start their annual process of developing and adopting the budget for the following year. This is likely the most crucial work that Boards and their Managers will take on in the course of the year.
There are estimates to be gotten, contracts to be worked out, and difficult forecasting decisions to be made. The Managers we work with frequently report that it is the most stressful time of the year. It's the time of year when volunteer Board members realize that these money choices truly represent the lifeblood of the association.
Managing the Reserve Fund
What to do with the Reserve Fund is one of the issues that many associations encounter. The amount to budget for long-term repair and replacement of common area assets might seem high, in comparison to other line items in an association's annual budget. How can you tell how much is enough? There are balance sheets and income statements with a lot of impressive-looking numbers, but is this the complete picture?
Try this quick workout. You learn from a friend that the homeowner's association treasurer has just finished analyzing the most recent financial accounts. He will speak at the annual membership gathering to let the other homeowners know that his association has $500,000 in their Reserve Fund account. Because of that, he will claim they can cut next year's funding in half. After all, they have $500,000 in the bank, and that’s a lot. Right?
You know nothing but what he’s told you. If the Treasurer lived in a fairly new condo building with one pool and a tennis court, you’d probably figure they’re in great shape. But what if he represents an aging 200-home community with crumbling roads, deteriorated amenities, and a 3,000 square foot clubhouse that needs a new roof and a paint job? How would that change your perception of things?
By now, you’re appreciating that dollar balances don’t tell the whole story. To truly know where the Reserve Fund stands financially, you’ve got to have something to compare against. When it comes to Reserve funding, this means comparing the actual reserve account balance to some kind of benchmark.
National Reserve Study Standards & the Reserve Fund
National Reserve Study Standards define this benchmark as the “Fully Funded Balance”. “Fully Funded Balance” (FFB) is a financial representation of the “deteriorated portion” of the common area components. Deterioration is normal and inevitable!? The physical deterioration of a building starts the moment new construction is completed and starts afresh after each cycle of common area repairs & replacements.
Let’s use a simple example to show how FFB is calculated. Imagine the roof of your Association was replaced 5 years ago and you were told that the roof had a life expectancy of 20 years.? If the current cost to replace the roof is $100,000, how much money should the Association have already saved “to be on pace” with the roof’s deterioration? The answer should be intuitive-$25,000, right? The roof has “aged” (or used up) 25% of its Useful life, so it makes sense that the Association should have 25% of the current $100,000 replacement cost on hand. That’s it. Notice that there’s no mention of how much the Association actually has on hand today or what it will cost in the future. All you know is that there is $25,000 of deterioration, so $25,000 of cash would offset that deterioration. The FFB is a calculation yielding the value of 5 years worth of actual “roof deterioration.”
Percent Funded: A Measure of Reserve Fund Strength
Taking this process a step further, we are able to calculate in real terms exactly how well the Reserve Fund actually has kept pace with common area deterioration. We express this relative strength in terms of Reserves “% Funded”, another fairly simple National Reserve Study Standard calculation involving FFB:
“% Funded” = ratio of the Actual Reserve Balance to the Fully Funded Balance (FFB), expressed as a percentage.
So, if the Association has $25,000 actually sitting in the bank for the new roof after 5 years, and the roof’s FFB is $25,000, the “% Funded” is $25,000 divided by $25,000 or 100%.
Remember, “% Funded” measures how well the Reserve Fund matches, or has kept pace with deterioration, and 100% Funded means perfectly “on pace”!
In reality, an Association’s common area consists of dozens of different reserve components, each with unique useful lives, remaining useful lives, and replacement costs. So a measurement of whether the Reserve Fund is “on pace” only has meaning when it is based on a “% Funded” calculation involving all repair & replacement projects.
Why Percent Funded is Important: Accountability & Special Assessments
Now that you understand what it is and how it’s calculated, you might be wondering why “% Funded” is so important. There are two reasons:
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The first reason goes back to that Treasurer acquaintance who’s preparing to address the homeowners at the upcoming annual meeting. He knows the amount of the Reserve Fund is half a million dollars and he’s ready to publicly pat the Board on the back for having so much money set aside. But does he really know if the Reserve Fund has “kept pace” with the actual common area deterioration? A half a million is a lot of money (to the Treasurer, and to you and me), but is a half a million a lot of money to the association? Can he assure the homeowners that $500,000 means the Association is in a position to perform timely repairs & replacements? Is he prepared to have prospective buyers rely on his personal assessment of the situation to make an informed purchase decision? Reserves “% Funded” is the only meaningful, independent, and reliable measure.
The second reason Reserves “% Funded” is so important is that it can be a reliable predictor of the likelihood of special assessments. This colorful infographic demonstrates the relationship between “% Funded” and the Risk of Special Assessment.
Associations above 70% Funded (the green zone) have a less than 5% chance of ever needing a special assessment to make timely repairs & replacements. By contrast, Associations less than 30% Funded (the red zone) are likely to need a special assessment every 2 or 3 years. Notice that there’s no mention here of Reserve balance. The only way to know whether a Reserve Fund is “on pace” with respect to deterioration is by looking at the association’s Percent Funded - the comparison of cash in reserves to the FFB benchmark.
Hopefully, you can now see why every Association needs to recalculate its "% Funded" each fiscal year. Along the path to a prosperous financial future, there are numerous other crucial steps that must be taken, such as maintaining an accurate Component List (detailing the scope and schedule of reserve projects), projecting the Reserve balance accurately, and creating a future Funding Plan that provides sufficient cash in the future when it is needed. In order to ensure that the calculations are precise and the forecasting is carried out by a qualified, independent expert with experience with similar associations, many associations opt to engage a professional Reserve Specialist to assist with this process.
The only way to determine whether the Association is keeping up with ongoing deterioration and positioning itself for sustainability is to know the association’s Reserves "Percent Funded”.
? Is a Reserve Study right for you? ???https://www.reservestudy.com/
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