A Reserve Study
The reserve study is a tool to preserve the integrity of a homeowners association. A detailed reserve study will assist the homeowner board in planning, maintaining and improving the common area assets under the responsibility of association. This is not a comprehensive look at reserve studies. Any detailed questions you have should be directed to a real estate attorney.
The California Civil Code §5550(a) describes a reserve study as “a reasonably competent and diligent visual inspection of the accessible areas of the major components that the association is obligated to repair, replace, restore, or maintain.” It is a report that details current & future anticipated expenses for the common area components of an association.
Components to be Studied
Every homeowners association will have components or systems which they are responsible to maintain. Common area include pool facilities, painted surfaces, roofs, decks, heating & cooling units, elevators & stairs, parking lots, tennis or basketball courts, landscaping and other hardscape such as fences, gates, walkways and driveways. A homeowners association must maintain all of the common areas of that association. Basically, the reserve study is a report card on the condition of the common areas.
The reserve study estimates how much remaining life there is in each of these components. It then gives an estimated cost for repair or replacement when each item will eventually wear out. The study will inform the HOA board how much money the association will need to set aside each year to pay for these expenses and create a funding plan for the board to accomplish this task.
Requirements for a Reserve Study
Not all states require that homeowners associations have reserve studies. In California, all HOA boards regardless of size must perform an onsite reserve study at least once every 3 years. There is an exception to this rule for associations that have very few common area assets.
It is a requirement for the board of directors to review the study each year and make any adjustments necessary. The projections created in the 3 year study are subject to revision as unexpected repairs happen throughout the year. The board must update the reserve study to reflect these expenses and fulfill the needs of the reserve fund.
Who is Responsible for the Reserve Study?
Your board of directors has the responsibility to hire a specialist to perform the reserve study. The board should not try to create their own study. Typically the board members would not have the skills to accurately estimate the cost for repairs/replacement of HOA components. The board should hire a credentialed reserve specialists (RS) or other similar qualified professional. They will have the knowledge and the tools necessary to calculate the useful life and values of every aspect of the common areas.
3 Parts of a Reserve Study
The Component List
First is the Component List as this defines the scope and schedule of all the anticipated upcoming reserve projects. This will be the basis for the analysis of the reserve fund. The study will include a price estimate for replacements of each component based on a best and worst case scenarios. Included is an estimate of the useful remaining life span of each item, dividing that number into the replacement cost. The resulting number is the amount the board should reserve each year in the budget to pay for that component. The component list should include photos and comments of each item on the list.
Second is an analysis of the current funding balance. This will determine if the association is on track to meet the needs of the membership. The total cost of the component list will be used as a factor in the analysis. The health of the fund balance will be given as a “percent funded” amount. This is known as the Fund Strength. Therefore, the Fund Strength will tell you if the association is meeting its reserve obligations.
Reserve Funding Plan
Third is the Reserve Funding Plan. This is a plan to offset the ongoing deterioration of HOA assets and provide for the ability to cover anticipated expenses. Creating a stable budgeted reserve plan will maintain a healthy financial balance sheet for the association. The plan will cover a multi-year schedule as a guide to insure the association stays on track to have a fully funded balance each year.
The Cost of a Reserve Study
The cost will depend on the complexity of the association. If all the association has a greenbelt and a monument sign at the entrance to the tract then it the cost of the study will be minimal. But if you have multiple swimming pools, a recreation center, tennis courts and a golf course then the study will likely cost as much as $10,000-$20,000 or more. The reserve study is funded by monthly membership dues and this expense should be referenced in the annual budget.
Maintaining a Healthy Reserve Fund
According to the Davis-Sterling laws, the reserve study is necessary to set up the reserve fund. The purpose of a reserve fund is to repair, replace, restore, or maintain the major common area components. The board decides how to fund the reserves base on the reserve study. If the HOA has been saving for the replacement of items all along then the association is considered to be adequately funded. Otherwise the association would be considered underfunded. The consequences of being underfunded means the HOA will have to find alternative means of collecting the funds necessary for repairs when systems need attention.
This could be done through an increase in the monthly membership dues. Although depending on the percentage funded recommendation in the study this may take too long to catch up. Many times a special assessment is required or a combination of increased monthly dues and a special assessment. The special assessment is commonly spread out over a certain period of time and is in addition to the monthly dues.
In the event that the association has a sudden issue with a major component (i.e. irrigation system needing replacement) the board may be required to create an emergency special assessment as a one time lump sum payment to be collected immediately from the homeowners. Decisions like this are never easy for the board or popular with the homeowner members. That’s why you always want a well funded reserve account in your HOA. The funding plan is provided to the membership in the year-end budget.
Special Emergency Assessments
A few years ago our HOA required an immediate special assessment of $790 to pay for a repair required to our common area drainage system. There was a government agency that was imposing a daily fine for not making the repairs. The funds were not in the budget and each day the repair was not made the fines from the county were increasing. This necessitated a one-time emergency special assessment payable by the homeowners within 30 days. This was very unsettling to the homeowners and became a litigious event that continues to this day. Although this case is a rare event it is not that uncommon for a homeowners association to be under funded.
Is Your HOA Fully Funded?
A healthy HOA is one that has a low risk of special assessments. The risk is determined by what percent the budget is funded. Percent funded is the ratio, at a particular point of time (typically the beginning of the Fiscal Year) of the actual (or projected) Reserve Balance compared to the Fully Funded Balance, expressed as a percentage. In simple terms, the Percent Funded is calculated by taking the amount in the reserve account and dividing it by what they should have (in the Reserve Study) to cover expenses and expresses this in the form of a percentage. If there is $40,000 in the reserve account but the reserve study states that you need $100,000 to cover expenses, then the HOA is considered to be 40% funded.
Associations under 30% Funded have a high risk of special assessments and deferred maintenance. At the other end of the spectrum, special assessments and deferred maintenance are rare at associations with reserves that are at least 70% funded. In between 30% -70% represents a medium or average risk to an association.
Adjusting the Reserve Balance as Needed
The Percent Funded will change each year as the Fully Funded Balance and Reserve Balance fluctuate. How much should the HOA be placing in reserves? It depends. Typically between 25% and 40% of monthly membership dues should be put toward reserves in order to establish a healthy reserve fund. This may require a larger increase in dues upfront, or smaller increases each year until the desired balance is achieved. The HOA board is tasked with this duty and must act in good faith and in the best interests of the members to avoid liability, maintain the common areas and keep property values from declining.
The Fully Funded balance is the goal for any association. Not meeting this objective does not mean the community is going to run out of money or end up with special assessments but it is the amount a community should strive for if the overall goal is a healthy homeowners association.
I hope this has been helpful in understanding what a reserve study is and how it affects a HOA controlled property.