The Failure of Voluntary Reserve Funding

Published in the ECHO Journal, November 2006

Revisiting “The Hard Facts: Associations Need Cash!”

Author’s note: This article was originally published in the February 2003 ECHO Journal to inform community association boards of directors, managers and owners of the increasing shortfall in maintenance reserves. The survey of reserve accounts done then has recently been repeated using a much larger number of associations, with even more disturbing results. This article is a republication of the earlier article, edited to include the results of the new study.

Since 1999, we have been writing that common interest developments are infected with a fundamental flaw—the inability to raise adequate capital. We posited that this flaw is structural in nature, in that it arises from the basic political and economic nature of community associations, coupled with the legal environment in which they exist in California. These conditions include the legal limits on assessments, the diverse self-interests of individual owners, and the real cost of long- term maintenance and repair. We have suggested that these elements are responsible for a serious lack of cash reserves.[i] It is now apparent, following two surveys done three years apart, that California’s system of voluntary reserve funding has failed badly.

The statutory scheme that regulates community associations relies on the good will of developers and the good sense of boards of directors to accomplish necessary reserve funding. California law requires only disclosure of condition, not funding of reserves. Not only that, once an association begins to accumulate a reserve funding deficit, “the board of directors may not impose a regular assessment that is more than 20 percent greater than the regular assessment for the association’s preceding fiscal year or impose special assessments which in the aggregate exceed 5 percent of the budgeted gross expenses of the association for that fiscal year without…the approval of a majority of the owners.”[ii]

These opinions were based on evidence obtained in the course of our practices over many years, and on conversations with numerous industry professionals. Notwithstanding the fact that there has been almost unanimous agreement that this phenomenon, as we have described it, is real, there has been little empirical evidence supporting it. That “data gap,” if you will, was called into question by Senator Tom Torlekson in his comments on the study of Common Interest Developments performed in 2003 by the California Research Bureau, wherein he noted a lack of “objective evidence” on the financial condition of CIDs.

While few doubt that the problem is real, until now it had not been statistically verified. To remedy that, Berding & Weil and Levy & Company CPAs, in conjunction with ECHO, embarked on a survey in 2003 of 687 community associations to collect statistical evidence of the state of association reserve funding. What we found then was not pretty. Overall, for the 687 associations surveyed, the average percent funded was only 54 percent. This means that these associations had approximately half of the cash in the bank that they should have had to adequately fund their reserves![iii] In 2006, the size of the survey was increased to 1,254 primarily Northern California community associations using data prepared by independent reserve study companies.[iv] The 2006 survey produced a similarly unfunded percentage—53%; however when the survey results are broken down, it is clear the problem is getting much worse.

The average size of this reserve “gap” was approximately $1,400 per unit in 2003. In 2006, that figure ballooned to $5,600.00, or four times the shortfall of just 3 years ago. If these results are accurate for all of the estimated California community associations, computed at an average of 104 units per association, this represented a combined deficit of approximately $5.1 billion in 2003. But, in 2006 that combined deficit would be $25 billion! This is no longer a theoretical problem. These surveys were conducted with data available to the authors of this study. It may or may not be statistically representative of all of the associations in California, but coupled with other observations and evidence, many community associations in this state would appear to have been in serious financial trouble in 2003, and are in a worse financial condition in 2006. The following sections compute percent funded by association type, age, size, and by reserve study company.

Type of Development

In both surveys, results were summarized on the basis of:

1. Type of Development: Condo [includes condo conversion], planned development;
2. Age of Development: 1-5 yrs old, 6-10 yrs old, 11-15 yrs old, 16-20 yrs old, 21+ yrs old;
3. Size of Development: 2-25 units, 26-50 units, 51-100 units, 101-150 units, 151-325 units, 326-500 units, 501+ units; and
4. Reserve Study Company: 12 companies in 2006 and 13 in 2003, board/management and other. For the 2006 survey, condominium conversions were broken out as a separate type of development.

Percent funded was computed for three types of developments: condominiums, condominium conversions, and planned unit developments. The results by development type are shown in Table 1 and Figure 1.

The percent funding for condominiums (not conversions) are much worse now than three years ago—dropping from 52 percent in 2003 to 46 percent in 2006. In the 2006 survey, condominium conversions have the lowest percentage of the three—44 percent funded on average. Again, that means that such projects have only 44 percent of the funding on hand that is required by their reserve studies. This is especially worrisome since many of those projects have been converted recently and funding requirements are based only on the DRE approved component list, which is frequently inadequate to assess the needs of older apartment buildings now converted to condominiums.

Planned Developments, including townhouses, duplexes, and other attached housing that are not condominiums, have actually improved their funding percentage in the past three years from 59 percent in 2003 to 63 percent in 2006. This may be due to the fact that in such developments the community association is responsible only for the exterior “skin” of the building—the painting on the siding and the roofs—as well as the common area streets and landscaping. They are not responsible for many of the very expensive replacement items that are showing up in many condominium projects: siding replacement; wood balcony rot; wood entry structure replacement; and other termite and mold damage. These items rarely appear in a reserve budget until they are identified for repair; hence, immediate under-funding results because there are no funds earmarked for this purpose.

This situation is exacerbated in condominium conversions because many of those components require replacement not in 15 to 20 years after the project is first sold, as with new construction, but in many cases, almost immediately since the buildings themselves are often 20-25 years old with decades of deferred maintenance built in when they are converted and first sold as condominiums.

Age of Development

The data in 2003 indicated—no surprise—that the older an association is, the greater the underfunding of reserves is likely to be. Hence, as an industry, the underfunding of reserves, in the absence of any external influence(s), is likely to continue and/or worsen. However, in 2006, the information shows that this problem has gotten worse. In 2003, the newest associations, those 1-10 years old, hovered around 80 percent of their required funding. The 2006 survey shows a marked decrease, with the newest associations now showing they have only about 70-75 percent of necessary cash on hand. On the other end of the range—those associations over 21 years of age—the picture is much the same as in 2003. The oldest associations have only about 45 percent of the cash on hand that they should have. The funding situation for those in between, from 10 to 20 years old, has grown steadily worse, whereas funding ranged between 63 to 80 percent in 2003, it now ranges from 53 to 70 percent!

Percent funded was computed for five age groupings: 1-5 years, 6-10 years, 11-15 years, 16-20 years and 21+ years. The results by age grouping are shown in Table 2 and Figure 2.

Size of Development

The data based on size of the development seems counter-intuitive. Larger associations are better funded than smaller ones as Figure 3 below shows, although none of them have anywhere near the required amounts of cash in the bank. Larger associations, those with more than 100 units, showed percent funding figures for 2003 which are very similar to the figures for 2006—59 percent to 64 percent, compared with 57 percent to 65 percent. Smaller associations, those under 100 units, were between 43 percent and 55 percent funded in 2003 and between 47 percent and 55 percent in 2006. Based on development size, the funding percentages are almost exactly the same in 2006 as they were in 2003.

Percent funded was computed for 7 groupings of development size: 2-25 units, 26-50 units, 51-100 units, 101-150 units, 151-325 units, 326-500 units, 501+ units. The number of units is based upon the built-out number of units for the project. Accordingly, especially for the larger projects, the unfunded dollars per unit may be understated if the project is phased and not yet fully built out. The results by size are given in Table 3 and Figures 3 and 4.

TABLE

It may be that larger associations enjoy greater cash flow, which affords them the opportunity to make more use of professional consultants and managers, but whatever the reason, the most startling fact is in the amount all developments are under-funded on a per-unit basis. Larger associations are under-funded in the range of $3500 to $4600 per unit, although the very largest show only an $800 per unit shortfall. The very smallest developments, however, those with 2-25 units, show under-funding equal to $10,300 per unit. This contrasts remarkably with the following graph from our 2003 survey which shows a range of per unit under-funding from about $500 on the largest developments, to just under $6,000 on the smallest.

Comparison of Funding by Reserve Study Company

The percent funded by reserve study company is summarized in Table 4. Percent funded results were computed for 12 reserve study companies (and the board of directors) based on 18 or more reserve studies per reserve study company. This information does not necessarily indicate that under-funding is the result of the reserve study itself. Reserve studies calculate the amount of the cash that a particular association should have in the bank. There is no requirement in California law that the association actually put that money aside. Boards of directors and their managers have to make that decision, and very few choose to fully fund their reserves. 

TABLE

The foregoing results appear to indicate a greater degree of conservatism in computation of the percent funded performed by boards of directors or their management agents, as opposed to most outside reserve study firms. This tentative conclusion, however, is based on only 37 associations preparing their own reserve study, or approximately 3 percent of the population surveyed. It is also true that these results do not take into account the actual recommendations of the reserve study company which may have been more or less conservative than what was later adopted by the board of directors. It also relies on the actual cash in the bank, and not the actual recommendations of the companies themselves.

Conclusions

In most respects, this survey speaks for itself. Smaller, older condominium associations tend to be worse off than larger, newer, planned developments. That does not mean, however, that the newer, larger associations do not face capitalization problems. It simply means that their obligations probably have not matured to the point where the funding shortfall is critical. The 2006 survey clearly shows what common sense tells us—when you convert a 25 year old apartment building with lots of deferred maintenance to a condominium, the owners will most likely not be able to afford to fund necessary maintenance and repairs and an immediate financial crisis is likely. What the survey also indicates is that the trend is the same for all types of community associations. It also indicates that the funding crisis is just a matter of time.

What to do? As we have stated before, each director of a common interest development must insist on a realistic appraisal of the condition of the project and the cost of future maintenance. Any temptation to underplay these elements to keep assessments low must be resisted if the association is to have any chance at financial stability. The long-term financial security that would result from an aggressive program to increase funding will be worth whatever adverse short-term political consequences might occur. Those boards of directors that have the courage to put such a program in place will strike a blow for sound fiscal management. For those who do not, the financial consequences seem increasingly obvious.

Legislative Reform Needed

For many years we have hesitated to address the question of removing the statutory caps imposed on assessments by California law because it is a matter that is very sensitive to homeowners. It is clear, however, that if something is not done soon by the California Legislature, there will be widespread financial failure of community associations, especially condominiums. It is time to consider some form of mandatory reserve funding to protect the legions of homeowners in community associations. During the next few months we will address this issue as well as discuss laws in other states that already require reserve funding.

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All representations of percent funded included in this survey have been computed using the foregoing “straight line” computation of percent funded.  Effective July 1, 2005 this method of computing percent funded had to be disclosed in the annual pro forma operating budget. For the few reserve study companies included in this survey which did not compute percent funded on the “straight line” basis, such computations were performed based on the replacement cost data (estimated current replacement cost, estimated total useful life and estimated remaining life) developed by these reserve study companies.