Reserve Study Companies:
2535 Foothill Blvd Suite 101
La Crescenta CA 91214
RSI (Reserve Studies Inc)
9420 Topanga Canyon Blvd #201
Chatsworth CA 91311
Barrera & Co.
2207 Garnet Ave Suite H
San Diego CA 92109
Reserves are set aside by the HOA to repair and replace building common area elements as they wear out and deteriorate. Anywhere from 15% to 40% of the monthly HOA dues should be going towards the reserve.
California State Law, the Davis-Stirling Act, requires HOAs to have a Reserve Study (Sample Report) done every three years. A reserve study determines the amount of money needed to keep the reserve well funded. Figuring out this number can be tricky because annual maintenance expenses vary greatly from year to year.
The point of the reserve study is to help plan ahead for these big ticket items. Some of the largest Reserve expenses (roof replacement, elevator replacement, building restucco) may take several years for the HOA to set aside the needed funds.
The first step of the reserve study is to determine the component list. This is a list of all the major items in the building that need maintenance; it should be 30-40 items but can vary with the size of the building. There is a four part test to determine if an item qualifies for the component list:
- Must be part of the common area
- Must have a limited life
- Must have a predictable remaining life
- Must be above a minimum cost significance threshold (Minor items should be handled by operating budget)
Let’s look at an examples:
Should setting reserves aside for earthquake insurance deductable be on the component list? This item would fail #3- it is not predictable.
Should reserves be set aside for repairing water damage from a roof leak for inside the units? This item fails #1- this area is not in the common area
Should reserves be set aside for the construction of a new pool installed in the building? If there currently isn’t a pool in the building, then this is a capital improvement project which would be treated differently than maintenance. Once the pool has been built it can be added to the component list.
Estimates for how much remaining useful life each item on the component list has (RUL), quantity, and replacement cost are added from talking with contractors and construction cost manuals (Means Company, Inc., F.W. Dodge, Lee Saylor, Inc., Marshall & Swift) . This data is then used to calculate the total reserve requirement, the precentage funded, and the annual reserve contribution requirement. These numbers are usually presented on a summary page. The best number to look at when determining the strength of the HOA reserves is the percentage funded.
A percent funded of:
0-30% is WEAK
70% or more STRONG
100% or FULLY FUNDED
The definition of 100% funded is confusing to many people. If the reserve study says that the building’s roof has a 10 years useful life and it is brand new, and the estimated replacement costs is $30,000, “fully funded” does not mean that you have $30,000 in reserves for the roof today. Fully funded means that each year you set aside $3,000, so next year $6,000 would be set aside, and so on, until the 10th year when the entire $30,000 is due. So the amount of reserves to be fully funded goes up and down each year depending on which maintenance items are due.
The idea is that the amount of funds added to the reserves each year offsets the amount of deterioration for that year. This number is called the annual contribution requirement. Double check that the reserves are being added to each year in the financial statements that are close to this amount. This means the HOA is keeping on track.
The majority of condo buildings in Los Angeles fall into the FAIR category for reserves. With the tough economic times it is becoming increasingly common to see condominium complexes with weak reserves, especially in smaller buildings of 12 units or less. There are a few reasons for this- when a building has a large number of delinquent owners, this lowers revenues. Another reason is that the budget is handled by the board. The board can decide to keep HOA dues low because raising them would be politically uncomfortable, and as a result, they are underfunded.
There are a few negatives that come with a weak reserve. One is that these maintenance expenses will be due at one time or another and if the reserve is insufficient to cover the expenses then the HOA must levy a special assessment or borrow money from a bank and pay interest (banks won’t lend to an association that has 5% delinquency or more). From the graph above you can see how the risk of a special assessment being levied goes up to almost 50% for HOAs that are 10% or less funded. I tell my clients who are thinking about buying a condo in a building with low reserves to count on higher HOA dues that what are listed. because these buildings are certain to have special assessments. Another downside of a weak HOA is that the property probably has quite a bit of deferred maintance. This can make it less appealing to live there, and result in lower property values for the building. When a buyer is in escrow on a condo they have a right to review the HOA financials, including the reserve study. A weak reserve might scare off buyers. And finally lenders have become much more conservative since 2007 and they don’t like to make loans on buildings that’s reserves are less than 10% funded.