Reserve Data Analysis, Intl.
 
Articles and Information
 

 

Properly Funding Reserves

 

prepared by

 

Edwin G. Edgley, CEO/Founder

Reserve Data Analysis, Intl.

June 1, 2010

 

There are two separate and distinct elements to a common interest development's budget, the "Operating Budget" and the "Reserve Budget."  The Operating Budget is characterized as including expenses that occur at least annually, regardless of the amount of the expense.  Examples of operational expenses include, utilities; service fees such as management, landscaping and accounting; and also include maintenance and repair expenses.  The reserve budget is characterized as including all major expenses that typically occur other than annually and which must be budgeted for in advance in order to provide the necessary funds in time for their occurrence.  They are expenses that, when incurred, would, if not reserved for in advance, significantly impact the smooth operation of the budgetary process from one year to the next.  Examples of reserve expenses include, roof replacements;  furnishing and equipment replacements and painting costs.

 

While the annual operating budget, from one year to the next, can be effectively prepared based upon past experience, preparation of the reserve budget usually requires the expertise of a specialist in the areas of replacement costs and the useful lives for the major components in question.  The reserve study provides a detailed inventory of all the assets that will require repair or replacement, determines the remaining useful life of each item as well as the cost to replace that item, and then calculates the monthly contribution required in order to achieve proper funding for each asset.  The payment plan allows each member to make small, uniform payments as part of the regular membership dues.  Special assessments, which are often substantial and usually unfairly apportioned, can be substantially avoided.

 

Over the years, the reserve study has evolved to address two basic questions.  The primary question ask, "How much money should be set aside, in order to assure that when a major repair or replacement is needed, there will be sufficient funds on hand in order to effect the required repair or replacement?"  The second question logically followed, "What is the appropriate level of reserves that should have accumulated at any particular point in time?"   Are we presently "underfunded" or "overfunded?" 

 

The answer to the second question was not addressed by a professional reserve analysis firm until Reserve Data Analysis in 1984.  It began with a simple observation.  Given that the basis of funding for reserves is to distribute the costs of the replacements over the lives of the components in question, it follows that the ideal level of reserves would be proportionately related to those lives and costs.  If you have a component with an expected estimated useful life of 10 years, you would set aside approximately one-tenth of the replacement cost each year.  At the end of 3 years, one would expect that three-tenths of the replacement cost would have accumulated, and if so, you would be "ideally funded."  This model is important in that it is a measure of the adequacy of an association's reserves at any one point of time, and is independent of any particular "method" which may have been used for past funding or may be under consideration for future funding.  The formula is based on current replacement cost, and is a measure in time, independent of future inflationary or investment factors:

 

         Ideal Level of Reserves  =  Age of Component  ÷  Useful Life  ×  Current Replacement Cost

           

The question concerning the proper level for funding reserves has since become a major issue of debate.  One theory advanced indicates that as long as there is some money in reserves you are "ideally funded" simply because you didn't run out of money.  However, no matter what particular "method" is used to calculate future reserve requirements, one fact cannot be ignored:  No matter what an association's reserve requirements may be, and regardless of the funding method used to calculate the future requirements for reserves, the result of the calculation is directly dependent upon the amount of money an association has to start with.  If you have $50,000 in reserves and perform your calculations, the resulting requirement will be lower than if you had $30,000 and higher than if you had $70,000.  Given the above model, if you have an 8 year old component with a replacement cost of $10,000 and a life expectancy of 10 years, one would expect that at year eight the fund would have "ideally" accumulated approximately $8,000.  If the fund had only $6,000, not only would you have to fund a "normal" contribution to reserves over the next two years, but you would have to make up the underfunding shortfall.

 

This author has always held the belief that the Board of Director's, has a responsibility to uphold decisions that are in the best interest of the community.  The community is not only comprised of present members, but also future members.  Any decisions made should not benefit the present membership at the expense of future members.  Unlike an individual determining their own course of action, the Board is responsible to the "community" as a whole.  Any decision by Board of Directors to adopt a calculation method or funding plan which would disproportionately burden a future membership into making up for past reserve deficits would be a breach of their fiduciary responsibility to that future membership.

 

When a member buys into a community, that member buys into a promise.  A promise that in exchange for their payment of the regularly assessed membership dues, the association will maintain the community in a good state of repair in accordance with the association's governing documents.  The only way that the Board of Director's can assure their ability to maintain the assets it is obligated to maintain is by assessing an adequate level of reserves.

 

Edwin G. Edgley is the CEO and founder of Reserve Data Analysis, Intl.  Mr. Edgley is a published author, routinely lectures at a national level, and teaches on the subject of reserves and reserve analysis preparation.  He is the author of the RDA RESERVE MANAGEMENT SOFTWARE program, and is actively involved as an expert witness in his field.  This document may be freely quoted, copied, reproduced and/or distributed, in whole or part, for non-commercial purposes, provided all credits and copyright information remain intact.

 

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