Don’t Raid the Cookie Jar Capital Budgeting is Essential

Don’t Raid the Cookie Jar

Sometimes the future seems like it’s an awfully long way away. If a roof is going to last 30 years, why should we worry about it today? Same with that shiny new boiler or that flat, crack-free pavement just poured two summers ago. Eventually, though, everything new grows old. Wear and tear sets in and soon, those elements we thought would last forever are in need of repair or replacement.

That is where a reserve study comes in handy—very handy, in fact, because it means the co-op or condo community has been socking away savings for years in order to pay for those replacements and repairs.

Industry Changes

“The Illinois Condominium [Property] Act does not state a specific dollar amount that a community needs to set aside for reserves,” says Joseph Baez, CMCA, AMS of Advanced Property Specialists, Inc. “The most effective way of achieving this is through the results of the reserve study.”

Knowing what your association needs, or might need, offers more than just peace-of-mind; there are other reasons why having adequately funded reserves is prudent. “Five or six years ago, mortgages backed by Fannie Mae, Freddie Mac and the Federal Housing Administration (FHA) only represented five percent of mortgages,” says Mitch Frumkin, PE, RS, CGP, president and founder of Kipcon, a full service engineering firm in North Brunswick, New Jersey and co-author of Community Associations Institute (CAI) book Reserve Funds: How & Why Communities Invest Assets.

“Today, 75 percent of condo mortgages are guaranteed by FHA, Fannie Mae and Freddie Mac. This tilted the scale in favor of reserve studies because they have regulations for insuring mortgages and in order for it to be guaranteed, there are certain requirements that have to be met,” Frumkin continues. One of those requirements is that ten percent of the budget must be set aside on an annual basis for future repairs, or the board must do a reserve study that shows they can afford to put aside less.”

“In a high rise, you can have a $7 million budget, and ten percent of that is $700,000 so that is what must be set aside each year,” says Frumkin. “If a reserve study is done, though, analyzing exactly what replacements and repairs must be made in the years to come and how much needs to be saved to pay for them, the number will likely be significantly less. You can pay $15,000 for a reserve study and save hundreds of thousands of dollars” on the repairs themselves.

A capital needs assessment is more short-term. “It says ‘In the next five years, these will be your capital needs,’” Frumkin explains. “They may need a roof replaced at the end of those five years, but it does not involve making long-term budget plans the way a reserve study does.”

“Capital improvements are any repair or replacement of assets (outside of routine annual maintenance) that extends or increases the useful life of that asset,” adds Nik Clark, director of client services for Reserve Advisors in Milwaukee, and they require a different kind of budgeting than regular operating expenses because the expenditures are infrequent, usually high-ticket, and outside of what an association normally has to plan for.

“For a lot of associations, reserving sounds like a daunting task because they might be aware that they’re underfunded, to which I would say you’re not alone,” Clark continues. “Most associations we come across are underfunded when we do their first reserve study, so it’s always a good idea to figure out where you are and become better funded. You might not get exactly where you need to be in three to five years when doing a study, but if you can become better funded and know where you’re at, everyone can plan.”

Finally, Clark says, “If a building community is really behind the curve with reserves and major maintenance projects, the first thing they should do is hire an engineering company to process a reserve study.” This study will show the life expectancy of the buildings’ components along with cost of replacement when needed.

“All buildings are different based on the type of materials that are used, the condition it is in and how many common areas they have. To determine the money needed, they need to run the actual calculations,” says Kevin Bobb, an engineer reserve specialist and the founder of Building Reserves in Milwaukee. “A pool or clubhouse or a fitness room or underground parking can really increase an association's reserve requirements.”

The reserve study is a multifaceted tool used to predict the cost of each common property component and the year the component will require maintenance and/or replacement. A reserve study recommends annual reserve contributions that balance the expenditures. As a result, the property is prepared for capital improvement and maintenance projects.

How Does it Work?

Reserve studies are usually performed by engineers or architects who have earned specialized designations known as Reserve Specialists (RS). These specialists examine the condition of the common elements such as the building’s exterior including the roof, façade, sidewalk, roadways, storm water drainage and more. After evaluating the building or association, the reserve expert will prepare a report including a 30-year expenditure page that shows prospective costs for each year. On average, it takes about 60 days to have a reserve study performed. Studies can be updated every three to five years.

“We actually walk the building,” says Daniel Baigelman, AIA, of Full Circle Architects, LLC in Northbrook. “We go through every stairwell, every corridor, go in every mechanical space. Before we develop their costs, we do a thorough evaluation and inspection—called an ‘existing conditions evaluation’—this way we can really put a good useful life on some of these main components before we do the so-called reserve study.”

In order to estimate the cost and timeline factors for the study, the expert looks at the typical standards for the expected life of an element—pavement, for example, may typically last 20 years. The engineer will then assess the current condition of that pavement against how many years are expected from it. The studies are updated on a regular basis. “In a new association or community, you can do updates every three to five years,” says one engineer. “As the community ages, you need to update them more frequently to ensure accuracy in pricing and to know that you’ll have the money there when you need it.”

In order to best accommodate the individual needs of each building evaluated, the firm conducting the reserve study “will try to phase the projects over a couple of years,” the engineer continues. Still, though, some buildings may find themselves underfunded, which means they may need to turn to an assessment—never a popular action—or alternative methods of financing, such as a bank loan.

Paying for it Wisely

Planning is everything when it comes to the successful maintenance and upkeep of a condo or co-op building. The number one mistake people make in these situations “is that they don’t do reserve studies,” says Frumkin. “Even if you don’t set aside the money, you’ll still need to replace the element. It’s not going to wait for you to get the money.”

Reserve studies also benefit from planning for those parts of a repair project that are unforeseen, says Jeffrey P. Roude, a partner with the East Coast-based accounting firm of SaxBST. Problems can arise “when you don’t put in contingency for a project,” he says. “There’s always some unforeseen additional repair.” He gives the example of a boiler replacement that also then requires some new piping. It is beneficial to add 15 to 20 percent to these budgets just to cover those unexpected costs.

For those buildings that either were not putting money away or that ran into unexpected circumstances that set them back in their saving, there are options for rebounding and still ensuring that repairs are made. That said, some may be more palatable than others to residents.

If the money is not there to do the renovations, there are basically three choices. “Borrow the money, delay repairs, which is not a good idea, or assess the shareholders,” says Roude.

Assessments are never a popular idea, which means borrowing quickly jumps to the top of the options list. “A lot of co-ops have refinanced mortgages and taken out extra money in anticipation of work that will need to be done so they have that reserve,” Roude says. Some buildings had high-rate mortgages so when they refinanced, they kept their payments the same but took out extra cash. “The cash flow stays the same, but now they have a reserve,” says Roude.

Other co-ops and condos may turn to lines of credit to supplement their reserves. Roude cites a building in Queens, New York that refinanced two years ago and took out money for repairs as well as a line of credit. After doing their reserve study, they realized they still did not have enough, so they doubled the line of credit and issued an assessment. Because they borrowed for the roof work that needed to be done, though, they were able to assess the shareholders over three years and not bombard them with one overwhelming amount. “It will cost us some interest over the years” but it solved the problem, Roude says. And for the residents and the assessment, “at least it’s not hitting them all at once. They can ease into it over three years and adjust their cash flow. In the meantime, the building gets to do the work now.”

Making sure there will be enough money on hand when the rainy day comes is of paramount importance for boards, managers and residents.

For boards who find themselves behind in their savings efforts, it is never too late to start. “It’s different for every association, but there are different ways to get to where you need to be,” says Frumkin. “If you’re underfunded, you can change how much you’re putting aside.” And boards and managers also can enlist the talents of industry experts who have experience in reserve studies and solid, prudent planning. “There are ways to get there if you work with someone who understands the different types of plans,” says Frumkin.

As difficult as it may be to set aside extra funds or as intimidating as it may be to inform a building’s residents that cash must be raised and saved, these alternatives still come out way ahead of finding out too late that there is no cash, no resources and few options for replacing a leaky roof during a rainy spring or a broken-down boiler in the dead of winter. As with everything in life, thinking ahead can help alleviate stress and put management in the driver’s seat for a safe, well-funded and well-planned future—an approach every resident and shareholder certainly can endorse.     

Liz Lent is a freelance writer and a regular contributor to The Chicagoland Cooperator. Associate Editor Hannah Fons contributed to this article.

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