Reserve Projects – Now or Later?

Published in the ECHO Journal, October 2009

To spend now or not to spend now is the question for financially sound homeowners associations contemplating their spending plans for reserve projects. Obviously every reserve component will eventually need to be replaced. For those components starting to show signs that the need to replace is at hand, should the work be delayed because of the economy? For those components that are scheduled to be replaced within a few years, should the work be undertaken ahead of schedule?

There exists an enormous body of economic theory, and it is not our intent to argue the relative merits of these theories, especially in light of the fact that no existing theory is, during these trying economic times, proving itself to be particularly useful in explaining the present or predicting the future. However, a common sense look at the economic factors that are presently in play may be helpful to well-heeled associations reviewing their upcoming reserve project work. The short answer is that now might be exactly the right time to do reserve work, notwithstanding the grim economic forecasts.

Despite the absence of reliable guidance from the economists, homeowner association boards of directors and their management companies do need to function regardless of the rampant economic uncertainties. To function implies making decisions that inevitably involve the financial resources of the association.

Generally, boards of directors take seriously their fiduciary responsibility to protect and preserve the assets of the association. Boards also desire to avoid assessment increases that would be burdensome to the homeowners. Not surprisingly, boards sometimes find that upward trending expenses cannot be met by operating assessment revenue. Consequently, there is a long, but not so venerable, tradition of reducing reserve fund contributions when operating expenses temporarily drain cash. It is this ill-advised behavior that has prompted some of the disclosure requirements codified in the Davis-Stirling Act.

But current economic factors have taken the economic stress that associations experience to a whole new level. Associations are being severely impacted by foreclosures and the overall increase in the aging of their receivables. With less cash flowing in, many associations have responded by implementing cost cutting efforts, which can run the gamut from reducing the frequency of custodial service to draconian measures such as eliminating all services not directly required to maintain safety. These actions are in addition to the cessation of reserve funding mentioned above. Such associations have limited options and are not well-positioned financially to take advantage of the soft economy.

On the other hand, financially sound associations should give careful consideration to the early completion of reserve projects. At a minimum, these associations should be wary of delaying a scheduled reserve project simply because they are nervous about the current economy. Association boards need to avoid a knee-jerk response to economic uncertainty; however timely completion of reserve work (before collateral damage has occurred) can ultimately save an association money. Take for example a roof replacement. If done timely, the roof is merely being replaced. But if that replacement is delayed too long, the association may find that they are replacing the roof and also paying to repair damage caused by roof leaks.

In the normal course of events, an association should commence reserve component replacement as that component approaches the end of its useful life (or earlier if the possibility of early failure is identified). A good policy in the year or two prior to the scheduled replacement would be for an association to develop the specifications for the replacement job, to invite bids from qualified vendors, to evaluate those bids, and to award the job to the vendor whose bid is most attractive. During the year identified as the replacement year, the replacement project could commence and work would proceed as planned.

The question at hand is whether there is an advantage to the association if it elects to replace a reserve component prior to the end of its life. If a component is scheduled for replacement in 2013, should the association begin the bid process in 2012 or tomorrow? Does taking action today provide a unique benefit to the association that derives from the current economic climate?

As a result of the economic downturn, new housing construction has virtually stopped and demand for renovation, rehabilitation and remodeling work has slowed markedly. Due to reduced demand, the much sought-after financially healthy buyer may find this to be a good time to negotiate a very competitive price on a reserve project. While contractors are not willing to undertake projects for free, they may well reduce their profit margin in order to find work that allows them to meet their fixed and indirect costs. It’s good advice for association boards to consider seriously taking advantage of the current buyer’s market.

At this point it is appropriate to digress briefly to remind the reader of the necessity to work only with qualified vendors. In the past this meant verifying insurance, checking references, etc. Now, however, the due diligence required of boards and association managers extends to vetting the financial health of the vendor carefully. Does a contractor have the wherewithall to weather the economic times? Will he be here to finish the job? Does he have the financial depth to perform the inevitable rework? Can he afford his insurance premiums both currently and at the time of renewal? Ask for a copy of contractor’s audited financial statements and for information regarding the contractor’s borrowing capacity.

Just as the traditional microeconomic model of supply and demand formally explains our intuitive understanding of why prices might be low in a depressed economy, there is also the macroeconomic theory that links the rate of inflation to the money supply. Bottom line—when the money supply goes up, so does the inflation rate. The economic recovery package introduces in excess of $1 trillion “new” money into the money supply and inflation seems likely, although when this might occur is unclear.

Inflation will be manifested by increased prices of goods and services. The reserve project with a bid price today of, let’s say, $250,000 will have a higher bid price in the future for exactly the same work. An association that has $250,000 set aside in reserve funds today will find it is underfunded for the project in the future. The real purchasing power of the dollars in the reserve bank accounts declines as inflation sets in. This phenomenon is why some people switch from financial assets (such as savings accounts) to real goods (such as gold or a new roof).

The interest earned on the reserve funds may not compensate for higher prices of goods and services. Currently the interest rate on savings and investment accounts is a very low one percent. The conservative financial instruments that are the recommended investment vehicles for associations simply do not pay high interest because they are low risk. Inflation should increase the interest rate paid on these deposit accounts and investments. However the upward drift of interest rates may lag the upward movement of the prices of goods and services. If the inflation rate on products is expected to exceed the interest rate applicable to financial assets then net purchasing power will have been lost. Keep in mind that this is a permanent loss unless the compounding effect of interest payments on the savings accounts is sufficient to offset price increases.

Below is a simple model of the divergence between the increasing balance in a savings account compared to an inflation-driven increase in the price of a reserve project. To highlight this divergence, the exercise below assumes a significant difference between the rate at which reserve project prices might increase and the interest rate increases on a typical savings account. Interest is compounded on the savings account.

The model can be made to yield very different results depending on the assumptions made about the timing and extent of inflation, the actions of the Federal Reserve, consumer confidence, etc. In this version, the bank account balance increased by $10,841 from $250,000 to $260,841 over an 18-month period. During the same period the price of a reserve project increased by $24,167 from $250,000 to $274,167. At the beginning of the period the association had $250,000 in the bank to pay for a $250,000 reserve project. Eighteen months later, the association could not pay for the same project and was underfunded by $13,326. The shortfall on a $1,000,000 project would be approximately $53,000.

So, what should an appropriately funded association do? Should it go ahead with a reserve project that is currently scheduled or wait until the economic crisis has passed? Similarly, should it undertake a reserve project a bit early or wait for the normal replacement cycle? The answer cannot be completely known. However, it is the case that prices are currently depressed due to the weak economy and inflation may be looming. For those associations that are financially sound, perhaps it is better to spend now than to wait.

Marcia Nylander is the Chief Operations Officer at the Christison Company, a full-service association management firm in Livermore. She is a member of the ECHO East Bay Resource Panel.