The Good, the Bad and the Ugly What Reserve Studies Can Tell Us

The Good, the Bad and the Ugly

While natural disasters causing catastrophic property damages are increasing every year, associations also have to be prepared for other unexpected expenses, such as a roof replacement or a new heating and cooling system. These major capital improvements projects come at great costs. Often residents deem the process as burdensome, taxing or both. Boards, on the other hand, should be at ease knowing that adequate funds are available for such projects; however, all too often this is not the case.

But what exactly are capital improvements as defined by industry professionals? “When referring to capital improvements as related to a residential community one is speaking of the property components that have a defined useful life and will need replacement at some point in the future,” says John Hersey of J. Hershey Architects based in Libertyville. “These components may be site or building items such as pavement, monument signs, wall cladding and roofing.”

While usually well-intended, associations, regardless of location or residential income levels, tend to make common mistakes when it comes to budgeting for required improvements such as new sidewalks.

“The biggest problem boards face is not having the information they need to adequately budget and make critical decisions,” says Stuart Wilkinson, a reserve specialist with the Reserve Study Group, a national consulting firm. “Boards need to arm themselves with information, including a reserve study that helps them not only understand their current circumstances but what options they have moving forward.”

Nik Clark, director of Client Services for the Milwaukee-based Reserve Advisors, says “failure to plan” is probably the most common mistake he sees on a regular basis. “Historically, many associations just didn’t plan/budget for major capital expenditures and took a ‘wait until it breaks’ mentality,” says Clark. “Other common mistakes are trying to do-it-yourself (DIY) without the expertise and knowledge to compile a comprehensive forecast.”

Hershey agrees with Clark in that poor planning is usually to blame for insufficient funds. “Very often we see that associations have not adequately put funds aside for future capital improvements. There are various reasons for this some of which include ‘we will worry about it when the time comes for replacement,’ or ‘we will not be living here when the improvements will be needed, so we will let the next owner handle the expense,’” he says. “Additionally, associations may not have properly prepared for future expenses because they have either not had a reserve study prepared or the reserve study they have does not adequately account for the future costs of improvements.”

Understanding Reserve Studies

Regardless of the state or location, a board should take the same approach to assuring there are enough monies in the reserve funds. This isn’t a rainy day fund because there is no question certain big ticket projects will come to pass. While management companies are usually excellent information resources for boards looking for budgeting answers, often times it is prudent to seek the advice of experts in this niche field as they can better prepare timelines.

“We recommend reviews annually although it depends on the complexity and condition of the association and its common areas. The more variables involved the greater the need for regular review,” says Wilkinson. “At a minimum, associations should have an on-site review at least once every three years.”

According to the Illinois Condominium Property Act [605/9 (c) (2)], all budgets for condominiums adopted after July1, 1990 must provide for “reasonable reserves for capital expenditures and deferred maintenance for repair or replacement of the common elements.” Section three of the Act allows an association to waive in whole or in part the reserve requirements of the Act by a two-thirds majority vote of the association.

Since “reasonable reserves” is loosely defined, Hersey recommends that boards and associations performed a reserve study approximately every five years. “Often during this period of time there have been improvements made that should be reflected accordingly in the reserve study,” says Hershey.

Timing and Costs

While fees for reserve studies vary, Wilkinson offered ball park figures. “The cost of a reserve study is dependent on the complexity, size and location of an association. It is basically a function of the time taken to prepare a report. We have seen studies cost as much as $12,000 and as little as a $1,000, so the cost can vary significantly,” he says.

In Clark’s estimation, the cost greatly depends on the size, age, complexity and the number of amenities offered by the association. “A typical study might run between $3,000 and $5,000 but there are many clients in the Chicagoland area that are large high-rise buildings that average between $5,000 and $10,000 or more,” he says.

There are a number of different professionals that typically execute reserve studies, explains Hershey. “In the residential property management community the professionals who perform reserve studies are often referred to as engineers. This term is an oversimplification of who is qualified for performing these services,” he continues. “Reserve study services are often performed by persons with varied backgrounds including architecture, civil engineering, structural engineering, mechanical and electrical engineering.”

Hershey adds that many firms have persons who are professionals in training but not yet licensed performing these services with varied levels of oversight. “It is important that the association understand the qualifications of the firm and individual(s) who will be performing the service for their property.”

When asked how long a reserve study assessment takes to complete, Clark responded: “While the timeframe probably varies from firm to firm depending on the time of year, and other factors. For example, fall budget season is a time when many associations who were late in getting the process started are in a push for the completed report, lead times can grow, but in general 45 to 90 days is a good range.”

Wilkinson explained that reserve studies should be prepared by professionals trained and certified in the field. One such certification is Reserve Specialist (RS), which he holds and is available through the Community Associations Institute (CAI). “To obtain this certification, candidates must have prepared at least 30 reserve studies within the past three calendar years, hold a bachelor’s degree in construction management, architecture, or engineering, or something equivalent based on experience and education, and comply with industry standards and codes of conduct.”

When a professional is hired to conduct a reserve assessment, they are looking for both the obvious red flags as well as problems that are hidden to the untrained eye. “In many cases it’s the obvious. Signs of deterioration, staining, cracks or an apparent lack of maintenance are in some cases overlooked by those who may see a property day in and day out,” says Wilkinson. “A lack of ongoing and preventative maintenance generally raises concerns that the condition of a community’s capital assets is well beyond its physical age and may fail prematurely.”

Avoiding Pitfalls

Most, if not all, management companies have experienced boards that were not prepared for a capital improvement project. While they might have had monies in respective reserve funds, it simply wasn’t enough to underwrite the project. This results in major headaches and troubles for boards and resides alike.

“The worst case scenario is that associations can, and have been condemned if assets are not properly maintained. This is a worst case scenario which results in huge financial burden for unit owners and sometimes loss of investment. More common are substantial special assessments that can be almost equally difficult for associations,” says Clark.

The special assessment is a double-edged sword. While monies can be obtained, it doesn’t adequately prepare for the future. It is deemed a stopgap approach to project funding and doesn’t always end well. “If a roof begins to fail and water damage is occurring, an association may have no choice but to special assess to the tune of thousands upon thousands of dollars. Unpaid assessments can result in liens and foreclosure,” says Clark.

Fund Me

Traditionally, there are these methods of funding: Straight-Line (component) funding and pooled (cash flow) funding. The former is more common and provides for the independent funding of each common element. As an example, a condominium roof has a 20-year life span. The roof is 10 years old with an estimated $50,000 replacement cost. If the reserve fund has $25,000, the board or association must collect $2,500 over the following 10 years.

Pooled funding is different in that there are no fund balances for specific line items but rather a collective pool from which to draw funds as appropriate. All major line items such as roof replacement and road repair are pooled into one fund. This removes the need for residents to vote when monies are withdrawn from the reserve fund for said projects; however, the pooled reserve schedule must disclose the estimated remaining useful life and replacement costs for respective reserve components.

These are also other commonly used methods of calculating how much money will be needed in reserve. Independent of methodology used—there is baseline funding; full funding; statutory funding; and threshold funding. Baseline funding means to establish a capital reserve funding goal of keeping the reserve cash balance above zero. Full funding means setting a reserve funding goal of attaining and maintaining reserves at or near 100% funded. Statutory funding means establishing a reserve funding goal of setting aside the specific minimum amount of reserves as required by local statutes. Threshold funding means establishing a reserve funding goal of keeping the reserve fund balance above a specified dollar or percent funded amount. Depending on the threshold, this may be more or less conservative than “fully funded.”

Boards must also differentiate between short, medium and long-term goals. This approach allows for proper funding practices. “The industry standard for a reserve study is 30 years. This is an appropriate time-frame because it encompasses the cycle of major replacement items that need to be considered,” says Clark. “Studies of five or 10 years might likely misrepresent—to the low side—proper reserve funding levels because major expenditures, which have useful lives of 15 to 25 years, may not make the radar screen.”

With board members often in flux, it can prove difficult to budget for a capital improvement project that is 20 years down the road when many residents and boards members will have moved on. This is why it is important for boards to take a collective long view with the assistance of industry professionals so boards don’t fall behind.

“First and most importantly is to gather all the information and data you can to make informed business decisions. This means conducting a reserve study to see where an association is at. Once you have that data you can begin to make decisions effectively,” says Clark. “That may include increasing assessments, preparing homeowners far in advance for special assessments, or utilizing the services of lending institutions, which specialize in loans for capital projects for associations.”    

W.B. King is a freelance writer and a frequent contributor to The Chicagoland Cooperator.

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