Current Industry Status of the Reserve Study (RS) Process

What is a Reserve Study? - Many within the industry fail to recognize that Capital Reserve Study is simply a form of a long-term capital budget. Current industry standards based on a once-every-three-years site visit and a static, paper report will continue to result in failure to meet expectations. The current process used by the industry contains so many disconnects that it is not surprising that special assessments are somewhat commonplace, even where Reserve Study reports have been prepared annually. Even where associations use Reserve Study software to provide more current information, software limitations prevent the creation of an effective knowledge based system.



There is a basic misunderstanding in people regarding what is a reserve study process. The HOA industry views the Reserve Study as a stand-alone capital budgeting process, and the Reserve Study report as the end product of that process. In fact, the focus should be on the establishment of RS policies and a long-term facilities maintenance plan that is integrated with operating facilities maintenance activities.



Current industry practice is to have a site visit RS evaluation made every three to five years, resulting in the issuance of a static, paper report. This is typically done based on a site visit by an outside professional, typically one holding the RS or PRA credentials. Associations that are more aggressive in the process prepare, in addition, annual updates without a site visit, resulting in an updated, static, paper report. Some progessive associations and management companies have seen the limitations of this paper-based process, and buy RS software in an attempt to keep their capital budget analysis current and actually use it as management tool.



For some smaller associations or those that don’t maintain complex or numerous common areas, this process may actually work. But, for larger associations or those that maintain complex common areas, the above method will always fall short of expectations.

The RS report is nothing more than snapshot at a point in time of the long range plan for the maintenance, repair, or replacement of association common areas. These are capital expenditures that do not fit within the annual operating budget. The Capital Reserve Study report is a budget that is part of a series of facilities maintenance activities. The Reserve Study for an hoa report does not determine the maintenance plan; rather, it is a reflection of the maintenance plan.





Establishing a long-term maintenance plan is a major first step. Removing the disconnects from the existing process is also necessary. The primary disconnect is the failure to establish appropriate capital budgeting policies, which results in:

In addition, identifying the correct software and capital budget consulting company are critical to this process. The software determines how you can accumulate and use component data. The capital budget consulting company determines the proper accumulation of data at the correct level.

At FAI we work with you to help you establish appropriate capital budgeting policies. We discuss with you your funding goals, and your opinions regarding interest and inflation rates to be used in the funding plan. Most importantly, we discuss with you how to set the scope of the study to produce the proper level of component detail so that the resulting reports will match your expectations. Lastly, we provide you with our internet-based software so that you can continue to keep your component database updated as you make capital expenditures and make contributions to your capital replacement fund.

You will find that our Reserve Study reports and component database differ from what is commonly seen in the industry. Others must accumulate components at a macro level; meaning many individual minor components are “grouped” into a single line item identified as a “component” for purposes of reporting in the Reserve Study report. This is generally done for two reasons; (1) it is too much trouble to separately identify each of the “minor” individual components, and (2) the software used is incapable of reporting detail components in any meaningful fashion, as the detail would overwhelm the readers of the report. Our software is capable of both providing sufficient detail, AND "rolling up" details into meaningful categories that are easily understood. This is because of the sophisticated basic structure of our software, which contains multiple category levels for better reporting of information. The complete description of the Facilities 7 software system is shown separately.

What is a reserve study?

A reserve study a long term capital replacement budget. The end product is the RS report, which is supported by a site observation and component condition assessment. The purpose of the report is to create a financial forecast - a funding plan for the association that estimates the timing and cost a future major repairs and replacements to the association's common area components. The homeowners association industry has coined the term reserve study, which, outside of this industry, is generally referred to as a long-term capital replacement budget. The association uses this reserve study report to determine the annual member assessments necessary to provide funding for the estimated future expenditures. The site visit is a limited scope visual observation of the association's common area components. It generally does not include invasive or destructive testing. The purpose of the site visit is to identify common area components, evaluate their condition, determine useful life and remaining useful life, and estimate the major repair or replacement cost.

Does my association need to have a reserve study?

Every Association that has common area components should perform reserve study on some periodic basis. Unless mandated by state law, the periodic basis may vary from one Association to another based upon their particular requirements. Those states that have established specific reserve statutes generally require that reserve studies be performed on a 3 to 5 year cycle. We believe that five years is probably too long for any Association. Even three years may be too long for Association if it is performing numerous major repair and replacement activities. Information can become outdated very quickly. We also recommend that associations perform an update of their reserve study without site inspection for every year in which no site inspection is performed. For those associations located in states where specific reserve study statutes have been enacted, associations must comply with that state law. However, even where no state law exists, it is prudent business policy to perform a reserve study. Most states hold that Association directors are subject to what is known as the prudent businessman rule. Simply stated, this means that if a prudent businessman would perform an act than the Association director should perform the same act. In our opinion, no prudent businessman would operate his business without performing some sort of long-term capital replacement budget. Therefore, we conclude that every Association should perform a reserve study on a periodic basis. In today's economy, the reserve study is often forced upon the Association by the requirements of property buyers or lenders.

What components should be included in the reserve study?

There is no single answer to the question of what items should be included in a reserve study. National standards established by CAI (community Associations Institute) indicate what common sense also tells us. The four standards established are: (1) the Association has maintenance responsibility, (2) there is a limited useful life, (3) there is a predictable remaining life, (4) there is a determinable major repair or replacement cost that falls above a minimum threshold. One overriding factor that must be considered is the association’s maintenance plan. The reserve study should be a reflection of the association’s maintenance plan. For condominium projects, most major components should be included in the reserve study. These components would generally include roofing, painting, paving, and fencing. If, however, as an example, an association was replacing portions of its fencing each year that matches the replacement life cycle, it may be appropriate to pay for this expense from the operating budget rather than the reserve budget. While that would be an extremely rare circumstance, it does demonstrate how an association's maintenance plan and budget and reserve policies can affect the reserve study. The Association should only include components for which it has maintenance responsibility. An examination of the association’s governing documents will generally provide guidance on this determination. It is possible to take the position that all components have a limited useful life. However a reasonable interpretation of the standard is that the limited useful life would fall within time periods reasonably related to the financial forecast period. As an example, a building structure is generally excluded from the reserve study as it is considered to be a lifetime component. That is, it has indeterminate useful life. The plumbing lines contained within the walls of the building structure are also normally considered to be lifetime components. However, if it is discovered that the plumbing lines are failing, and that the Association has a high probability of future expenditures to repair such plumbing, then this component should be included in the reserve study. Another example might be a roof with a remaining life of 40 years. Some people hold that this roof should not be included in the reserve study until it falls within the 30 year financial projection. We disagree. We believe that even though the initial life extends beyond the 30 year forecast period, it is still a limited useful life that is reasonably subject to estimation it should be included in the reserve study. If it has not previously been included in the reserve study but now has a remaining life of less than 30 years it should now be included in the reserve study. The minimum threshold for inclusion in the reserve analysis will vary from association to association. A small association with a $100,000 annual budget will have a relatively low threshold, perhaps $500. A large association with a $12 million annual budget will likely have a much higher threshold, perhaps $10,000. Items that fall below these thresholds should be included in the association’s annual operating budget.

What is a site inspection?

A site visit is a limited scope visual observation of the association's common area components. It is limited because it does not generally include invasive or destructive testing. The purpose of the site visit is to generate information to support the funding plan of the reserve study report. This includes an identification of, quantification or measurement of, and condition assessment of, all significant common area components for which the association has maintenance responsibility. The site visit is far less than an engineering study, the purpose of which is to determine the structural integrity of common area components. In older projects it is often wise to have an engineering study conducted that would provide additional information for the reserve study. Since an engineering study is far more detailed and far more expensive than the reserve study, the engineering study is generally performed only when there are significant questions about the condition of common area components that clearly cannot be determined by a limited visual inspection. The reserve study site visit consists of identifying all association common area components, quantifying by counting or measuring, evaluating current condition, determining useful life and remaining useful life, and determining major repair or replacement cost. This seems relatively straightforward, but can actually be relatively challenging, as some common area components may not be readily accessible. An example of this would be sump pumps or exhaust fans for elevator shafts, elevator braking mechanisms and door assembly mechanisms. An experienced reserve consultant has knowledge about what components should exist based upon the major components observed in the type of property is being evaluated.

What is a funding plan?

A funding plan is a financial forecast to determine the revenue stream required to provide sufficient funds for the estimated future major repair and replacement costs as determined by the site visit and component condition assessment. A number of factors must be considered in determining the funding plan. The factors that are inherent in this determination are; (1) funds presently available for reserves, (2) the annual amount to be funded, (3) the acceptable increase in the annual amount to be funded, (4) inflation estimate, (5) interest earnings estimate, (6) contingency factors, and (7) the possibility of additional funding from either special assessments or loans. The funds presently available for reserves should clearly exclude any operating monies and include only cash and investments and other net assesta available to pay for reserve fund expenditures. Most investment policies for associations exclude the possibility of investing in stocks or mutual funds. Certificates of deposits T-bills and government bonds would generally be considered as cash equivalents. Fixed assets and other assets such as notes receivable should generally be held in the operating fund rather than the reserve fund. While it is possible to determine an ideal annual amount to be funded, that is generally not the best way to construct a funding plan. It is more likely that the first-year funding amount will be a political decision rather than a financial decision. This is because the Board of Directors has knowledge about what will be an acceptable increase to the Association membership based upon its current dues structure. It is not realistic to create a funding plan stating that each member would pay $200 per month just for reserves when their current dues structure has them paying only $110 currently. The board might inform us that the $110 could be increased to $130 but could not be increased to $200. Based upon that information we would construct a funding plan that begins at $130 per unit per month, increasing funding over the remaining 29 years of our 30 year forecast period to provide adequate funding. The economic factors affecting the funding plan are the annual assessment increase, inflation, interest income, and contingency. We will discuss these items with Association management as part of the process of creating the funding plan. Most associations that are reasonably well-funded can create a plan that excludes the use of special assessments or loans. We will often use loans as a means of "smoothing out" the funding plan where there is not sufficient cash available to cover projected expenditures, thereby avoiding a large, one-time special assessment.

Should inflation be considered in the reserve study?

Inflation should generally be considered in the reserve study. Let's face it cost do not remain the same they increase over time, except in periods of deflation. Our review of inflation over the past 80 years tells us that there has not been a single deflationary year during that time period. The question is not really whether inflation should be considered, rather it is how much should that inflation factor be. Again, in examining and 80 year history there have been significant swings between years and inflation. However in the examining a moving 30 or 10 year average, it becomes apparent that inflation rarely goes above 4%. Therefore we feel comfortable in using a 3% or 4% inflation factor because the funding projection covers a 30 year period. Since most funding plans for research studies include an interest earnings assumption, you must also include an inflation factor to offset the distortion in funding that would be created by the inclusion of interest earnings if inflation were not considered.

Should the reserve study include a contingency factor? How is it calculated?

The question of whether or not to include contingency in the reserve study funding plan is one that is answered by each Association. There is no single answer that is appropriate for all associations. We generally favor inclusion of a contingency factor because our 27 years experience in preparing funding plans has demonstrated to us that associations rarely overestimate, but commonly underestimate future required expenditures. There are two ways to include the contingency factor into a reserve study. One way is to create a line item, equivalent to a component, that appears on the face of the reserve study. Most associations that use this method of including contingency in their reserve study either calculate a flat amount per year or calculate contingency as a percent of each year's expenditures. The other way to include contingency in the reserve study is to spread the contingency factor amongst all components included in the study. An example of this would be that if a 2% contingency factor were applied to a $10,000 component to be replaced next year then the future replacement cost would be $10,200.

Should income taxes on interest earned be paid from the reserve fund?

The majority of reserve study funding plans do include the calculation of income tax liability based upon the amount of investment earnings that are estimated in the plan. This is a reasonable position to take considering that the majority of most association’s interest earnings are generated by the reserve fund. However we do caution you to both consult with your legal counsel and Association accountant to determine if this is appropriate. While this may seem like overkill, there is a reason for this. Some Association lawyers have interpreted governing documents and or state law as prohibiting the expenditure of reserve funds for any purpose other than the major repair or replacement of common area components. Payment of income taxes clearly does not meet this requirement therefore we urge caution on the part of the Association. Assuming that Association legal counsel indicates that taxes may be paid on the reserve fund and then it becomes strictly a matter of Association policy as to whether or not income taxes are paid out of the reserve fund or the operating fund. Our recommendation generally is that it is simpler to pay for income taxes out of the operating fund.

Can painting be included in the reserve study?

For most condominium projects, painting is one of the largest expenditures that the Association will incur. Consequently it is logical that it should be included in reserves because it is not an annual maintenance expense. For most associations it will occur every 7 to 15 years. So why does this question even arise? In 1993 the IRS audited approximately 15 associations in San Diego, California that created a national furor within the inudstry. The IRS audits dealt significantly with the concept of the inclusion of painting in reserves. The reason this became such a big deal in the industry was because of the misunderstanding that occurred related to this issue. You must realize that the IRS has its own rules, and that they really don't care what the homeowners association industry thinks. The homeowners association industry generally refers to expenditures as being either operating or reserve in nature.

The IRS refers to expenditures as being either noncapital or capital in nature. These two definitions are not the same, and the major area of difference is painting expense. It is common practice within the homeowners association industry to exclude reserve contributions from taxation because they are capital assessments. However, the IRS states that in order for assessment to be classified as capital in nature, the related expenditure must qualify as being capital in nature. Unfortunately there are numerous rulings and tax court cases which clearly state that painting is a non-annual maintenance expense, it is not a capital expenditure. Consequently, the reserve contributions that most tax preparers were excluding from taxable income on the association's tax return now become taxable income. That makes it very difficult for an association to accumulate the necessary painting funds without incurring a huge tax liability. The easy answer to this question is to have the association file income tax Form 1120-H and avoid this issue of capital versus noncapital expenditures that exists only on Form 1120. It is our position that the tax tail should not wag the economic dog. Determination of reserves should be made based upon economic considerations, state statutes, and governing document requirements. Taxes should not enter into that consideration. Consult with the association's tax accountant to find out ways to avoid the tax risks on this issue.

Can capital improvements be included in the reserve study?

For purposes of this question we are defining capital improvements as the expenditure of funds for new, not previously existing, components. Some associations want to include capital improvements in the reserve study. Most do not. In our experience the only reason that associations include capital improvements in their reserve study funding plan is because they do not have a separate capital improvements budget and it is a very rare occurrence that they will actually construct a capital improvement. The association should look first to their governing documents to determine if there are any limitations on inclusion of capital improvements within the reserve funding plan. Secondly they should look at state law to see if state law prohibits either the accumulation of or expenditure of funds from the reserve fund for other purposes such as capital improvements. Our recommendation is that it is generally preferable to keep capital improvements funding separate from the reserve study report.

How Do You Determine Life and Cost Information?