Outside of major reconstruction, reserve expenses are the largest expenses an association will face. Too often, more immediate tasks are on the desk of an association manager, and the important task of preparing the community for inevitable major expenses is neglected. Whether the manager, staff, or the board likes it or not, every day the association is slowly approaching its own future. Every day major association assets are deteriorating and drawing closer to their replacement date, whether the association is financially prepared or not. Reviewing the operating and management behavior of our clients, we have a few suggestions to help associations understand and avoid the top Reserve Funding mistakes.
Mistake #1: It’s Just Another Accounting Task
Often managers and directors associate Reserve planning with an accounting task. While both involve the finances of the association, any direct comparison is flawed. Accounting is a field that fundamentally looks backwards in time in to bring order and clarity to a business or association’s finances. Reserve planning, on the other hand, fundamentally looks forwards into the unknown. One is based on the concept of accuracy and confidence, the other on predictions about future events that may or may not occur as planned. To prepare a successful Reserve Plan, one needs to be comfortable about creating the future, leading and planning. This is not a task for someone who is comfortable only when documenting the past. Creating a successful Reserve Plan involves strategic thinking, perhaps some market research, and trend analysis. Assigning the preparation of the Reserve Study to the wrong volunteers or staff dooms the project from the start.
Mistake #2: Confusing Red Letter Information with Red Herring Information
Special Assessment risk can be measured. Choices can be made, and plans implemented, that direct an association towards or away from special assessments. Special assessments are financially disruptive and politically destabilizing, and unfair to those owners hit by the special assessment (for deterioration that occurred years before they became owners). The “red letter” information is the association’s Percent Funded. This is a parameter that measures the strength of the Reserve Fund. The “red herring” information is the association’s cash balance. Focusing on the cash balance without knowing the Percent Funded is a tremendous oversight.
Percent Funded tells a board member, owner and manager the Reserve Fund strength, and therefore the risk of an upcoming special assessment. Percent Funded reveals how the cash Reserve balance matches against the fractional deterioration of community’s assets. Twenty years of experience over thousands of associations has revealed a direct match between Percent Funded and special assessments, and no correlation between Reserve Fund cash balance and special assessments. Sorry, but it’s true. 0-30% Funded means a high chance of a special assessment, while over 70% Funded means a very low chance. Knowing Reserve Fund cash (“We have $1.25 million dollars…”) without knowing the Percent Funded is a mistake.
Mistake #3: Failure to Update
But we just did a major review two years ago! We had a Reserve Study done three years ago; should we do one again? Both these statements reveal a misunderstanding about different types of Reserve Studies, and how they can be used to an association’s advantage. Due to physical issues (deterioration due to weather or owner usage and wear, damage, defects, or unexpected failures) or financial issues (Reserve contributions not made, interest different than planned, inflation higher than planned, some unplanned expenditures or expenses higher than planned), your Reserve Study becomes inaccurate months after it is completed. It is a plan, after all, and as the association moves forward in time the plan needs to be updated. Continuing to use an outdated plan for financial guidance is foolish.
To help an association plan effectively, there are three different “types” of Reserve Studies. An association can select the right “type” of Reserve Study to select the right level of service needed to gather or update their Reserve plan.
- Full Reserve Study: a comprehensive top-to-bottom inventory and evaluation of the entire physical facility.
- Update With-Site-Visit Reserve Study: a physical inspection performed to update projections about how many years each major common area asset will serve the needs of the association, and how many of those years are left.
- Update No-Site-Visit Reserve Study: a financial update where costs are updated, the starting balance is updated, and information on recent projects/expenditures are updated without a physical site inspection.
A Reserve Study comes in three types. Select the “type” needed by the association to update the association’s plan. Reserve contributions are large. A Reserve Study update doesn’t have to be a big deal. There are different Reserve Study types to fit an association’s different planning needs from year to year. If you use a credentialed Reserve Study professional, you’ll find Reserve Study updates significantly less expensive than a “Full” Reserve Study.
Mistake #4: Doesn’t Interest Equal Inflation?
Probably the classic mistake is that too often our clients fail to appreciate and acknowledge that interest and inflation are very real effects, very influential to the Reserve plan. Because inflation has its effect on the total value of an association’s asset (the roof system), while interest only has its effect on the fraction of roof replacement funds actually on-deposit, inflation is a much more powerful effect than interest. For instance, a 1% fluctuation in the assumed inflation rate requires a 13% change (on average) in the size of Reserve contributions. For associations maintaining a low Reserve Fund balance, this effect is even more pronounced. Interest does not equal inflation. Using a rough or bad estimate for interest and inflation is more accurate than choosing to neglect the influence of these powerful economic factors.
Mistake #5: Confusing Trivia with Significance
Within a Reserve Study, the Reserve Component List contains life and cost estimates for the major assets the association is obligated to maintain. Typically, this list gets longer and more complicated as stray projects got added to the Reserve Study, making the Reserve Study gradually more unwieldy, unworkable, and unimportant. This can be avoided with a Reserve Study that specifically focuses on the objective of helping the association plan ahead for the repair and replacement of major components instead of becoming an inventory and history of every asset that has been purchased.
Fundamentally, a Reserve Study is a budget preparation guide and forward planning tool. There are and always will be, exceptions to every well-laid plan. The wisdom is in knowing when the plan needs to be adjusted by excluding projects that are the exception and can be better served outside the Reserve Study. Time is saved, and money is saved, when projects can be accomplished with economies of scale and in a consistent, repeatable manner. The opposite is what we call “checker-boarding.” This is when exceptions are allowed to become the norm, and uniqueness becomes commonplace. The association becomes more difficult to manage because replacements begin to occur at different points in time, styles don’t match, and economies of scale are lost. Fundamentally, it begins to take more time to manage the assets, and it begins to take more money to replace the assets.
Accidents will always happen. A chair will be broken, roof tiles will break, a water leak will stain a wall and a carpet. Memorializing an exception by adjusting the Reserve plan is a mistake. Make the repair, make the room usable and attractive, and move on. Yes, the newer carpet will not need to be replaced when it is time to replace the carpet in all the other rooms, but go ahead and replace the still “fair” condition carpet in the formerly water-damaged room. When an exception is made, that does not mean you should revise the Reserve Study or your plan to replace all assets as one project at the next opportune cycle. This is where you choose to control the Reserve assets, instead of letting them begin to control you. The Reserve Study is a budget plan. Let exceptions remain exceptions. Keep the integrity of the plan. The key is seeing the Reserve Study as a planning guide, not a record-book. And this brings me back to my first point, confusing Reserve planning with an accounting or asset-tracking task.
Summary
Reserve planning can be simple, if you know what you are trying to accomplish. Any athlete will tell you that avoiding errors or turnovers is a key to success. Avoiding Reserve planning mistakes helps to keep an Association on the path to success.
Derek Eckert is president of Association Reserves–San Francisco, LLC. The San Francisco office handles Reserve Studies in the Northern California region. Association Reserves, Inc. is a national Reserve Study company, specializing in the preparation of Reserve Studies and Disclosures for its residential and association client base in 43 states and internationally. Association Reserves is a long-time member of ECHO.