Our firm was recently contacted by a condominium association that requested us to perform a reserve study for their small California community of 20 units. The Association was approximately 28 years old and had never conducted a prior reserve study, even though a reserve study is required by law in California.
The board member who contacted us stated that while the Board didn't feel that the Association needed a reserve study, they had agreed to have one performed to satisfy one of their members. This member was trying to sell his unit, and the prospective buyer was demanding to know the status of the Association’s reserves before he would commit to the purchase. Because this member was quoting California statutes and threatening legal action against the Association for failure to conduct a reserve study, the Board decided it would be easier to just have a reserve study prepared rather than fight this issue. Though this was a good decision, it was a little late- - and it didn’t erase the bad decision of never having had a reserve study prepared to begin with.
The board member stated that the Board didn't place much value on the reserve study and was not willing to pay much money for it. He further stated that because the Association was following FHA guidelines by setting aside 10% of its assessments into a reserve fund, the Association was complying with necessary requirements and was adequately funded.
We finally negotiated a reasonable fee to prepare the reserve study. (It was a reasonable fee simply because the Association was so small). As the reserve study report came together, it became clear to all concerned that the Association was seriously underfunded. This was the result of a failure to fund reserves in the early years, and the fact that several major components were now nearing the end of their useful life and would require replacement in the relatively near future. Although that “near future” was still several years away, the fact that adequate funding had not previously been made left the Association in an underfunded position.
The funding plan we constructed as an initial draft kept the same 10% funding that the Association was already making for the first year. We did this for two reasons: (1) the Association had requested us to keep the same funding, and (2) we wanted to demonstrate how clearly inadequate that funding level was. The result was that within five years, a significant special assessment was going to be necessary to replace the roof.
Once they had seen the initial draft of the report, the entire board of directors became involved in the process as they protested our recommendation of a special assessment. We simply asked them how they intended to raise the money to replace the roof if (a) they wanted to maintain a reserve assessment at the 10% level of total assessments, and (b) they didn't want to have a special assessment. Obviously, there was no answer to this question.
We then entered into a conversation regarding funding theories for reserves. Using several models, we demonstrated to them why it was necessary to project future expenditures as opposed to simply relying upon the rule of thumb of setting aside 10% of the assessments. We showed them examples of association funding plans where 10% was clearly less than adequate (just as in their own case), and also examples where 10% of assessments as a funding plan resulted in the overfunding of reserves. They ultimately decided upon an increase in monthly assessments, and started preparations for the future special assessment for roofing. Under California law, notice of that planned, future special assessment became an annual budgetary disclosure.
The fact is, using a flat percentage of assessments just doesn't work as a reserve funding model. FHA funding requirements notwithstanding, an association must project future expenditures to determine an appropriate funding level. No two associations are the same; therefore, no two funding plans are necessarily the same, and no flat percentage number will work for all associations.
