09.26.2024
Joel Tax
Unfortunately, that is not a title meant to get a click. It’s the truth that we see every day. Most of the communities we work with are severely underfunded; typically, having less than 20% of the money that they should have.
Reserve study professionals utilize a concept called Percent Funded in which 100% means than a community is on track to pay for their common area projects (e.g., fencing, painting, irrigation systems, roofing, etc).
Example: A community is going to paint a shed at the end of a 10-year period for $10,000 (inflation and interest ignored here for simplicity). Ideally and to be most fair to all members over time the community would collect $1,000 per year. At the end of Year 1 they would have $1,000, they would be considered 100% funded. Note, they still have 9 years and $9,000 more to collect before having enough to pay their paint Vendor. The 100% Funded simply means they are on an ideal track to reserving enough for this paint project as time progresses.
Alternatively, they could collect only $500 the first year; they would be 50% funded as they have collected half of an ideal amount for that point in time (1 year). Someone else later will need to make up for the underfunded reserve account (typically special assessments or loans). This underfunding of the reserve account can go on for 9 years 364 days, in this example, with no consequences. However, at the end of 10 years, if they collect only $500 per year, they will have $5,000 instead of $10,000 – a special assessments/loan will need to be imposed in Year 10 to make up the difference.
So, with most communities being only around 20% funded (in the above example that would mean they reserve $200 instead of $1,000 per year). This means someone at some point will have to make up for this underfunding of the reserve account reserve account. Often people have the incorrect notion that being 100% funded means you have 100% of the funds needed for the project – this is not the case (except on the day the project actually occurs – the ideal amount in the account, at that point, will be the project cost).
A larger percentage of our Common Interest Community Clients call us when the community reached one of two ages: at about 20-25 years of age and at about 40-50 years of age. This is because most of the large expenses for common interest communities have useful lives of 25 or 50 years and they see that they do not have the funds available for a large project. Some of the more common area components projects at these two ages include:
Commonly 25(ish) Year Useful Life
Asphalt
Fencing
Roofing
Decks Refurbish
Lighting
Recreational Facilities (e.g., pools, sport courts)
Mechanical Equipment
Tree Care
Common 50(ish) Year Useful Life
Indoor Plumbing (shared)
Water & Sewer Lateral Piping
Irrigation Piping
Electrical
Deck Rebuild
Siding
Windows
Doors
Note in the above examples that everything that occurs around 25 years of age, occur again at around 50 years of age. The older a building and common area asset get the more of them that will need replacement, things simply do not age gracefully.
How Did We Become So Underfunded?
So, why do our common interest Clients (typically communities that are around 25 and 50 years of age) that have had quarterly meetings, annual budgets, many Vendors recommendations, often very impressive looking spreadsheets/graphs and generally very capable software (Excel is excellent for reserve budgeting and essentially free) end up being so severely underfunded?
I have broken this answer down into the most common scenarios and reasons that we come across in no particular order.
Head in the Sand Approach to Budgeting
Things are simply ignored… While Many communities do have fancy looking software and impressive looking spreadsheets, many also do not. Ignoring large projects can be done for many years and sometimes decades. I have worked with many communities that don’t even reserve for their building roof replacement – something they can often get away with for 20-25 years.
In fact, the most common question we are “How can our community get out of doing a reserve study?” (this is particularly common in the regions where reserve studies are required by law). People will ignore things for a variety of reasons including but not limited to:
> they do not know the Community is required to maintain an asset
> they are under the impression that a common area asst will last much longer than what is realistic
> they do not want their dues to go up
> they will unlikely be living in the community when the project is expected to occur
> they will unlikely even be alive that far away in time (yes, this is a common excuse)
Only Looking to the Past Reserve Budgets Only
On the operational side of things looking to the past can be very helpful in trying to determine a ballpark figure of what the operational budget will be for the upcoming fiscal year as bills are often paid monthly or quarterly and the increases are often relatively small. However, this practice should not be applied to reserve budgeting. The reason is shown in the above example for the common area project at 25 years and at 50 years of age.
A community that is 40 years of age and looks backwards in their reserve budget will see all the “25(ish) Year Useful Life” projects that have been completed in their community but will totally miss they upcoming “50(ish) Year Useful Life” common area projects. While the past projects were without a doubt expensive it is the common area projects that are at about 50 years of age that are extremely expensive. So, looking backwards only did a disservice to the reserve budget needs.
One of the most beneficial attributes of working with a professional reserve study company is that an experienced reserve analyst will haved work with communities of all ages. We know these common area projects will be occurring, not because we can predict the future, but because all the older communities have already incurred the expense related to these projects. In a new community people frequently questions whether painting or roof replacement will be needed – in an older community these are questions that virtually never come up. In an older community people will often question they whole list of the “50(ish) Year Useful Life” common area projects simply because they have not happened yet. But we also frequently work with communities that are older than 50 years of age so we know they will, again not because we can predict the future but because we have a lot of experience working with older communities and see actual project cost/bids/estimates for these longer life components.
Delaying Projects Past the Vendor Recommendations
Reserve projects are frequently expensive and will wipe out a severely underfunded reserve account so often communities will delay a project thinking they are buying themselves some time (also refer back to head in the sand approach to budgeting) to reserve money and “deal with it later”. This is rarely a scenario that plays out well for a community’s reserve budget.
We always suggest following your vendors advice (e.g., when your Roof Vendor tells you the roof needs replacement – follow their advice). But frequently communities will make decisions based on what they can affords now versus wheat the best advice is. The end results are almost always a much more expensive project due to inflation (sometimes very high inflation) and collateral damage (a leaking roof will tun into a roof/sheathing/insulation replacement project at 3x the expense of just the roofing material).
We frequently see projects being 200-300% more expensive than it should be by pushing it out 5-10 years. This is due to compounding inflation but also something we call collateral damage. A couple of examples below:
> Inflation Example – Wooding fences more than doubled in recent years so many communities we work with that delayed a $100,000 perimeter wood fence project are now paying in excess of $200,000. While this is an extreme (but common one in recent years) example even a typical 3.5% inflation compounded over 5 years equates close to 20% higher cost to the community. Pushing it out simply results in a more expensive project later.
> Collateral Damage Example – Frequently communities will push out roofing and siding projects (timing recommended by their roof and siding vendors) due to their high expense. However, water intrusion at roofing and siding often leads to extensive rot/damage in a relatively short amount of time. We frequently see roof and siding projects costing 300-500% more than the original roofing and siding bid/estimate because in the 5-10 years the project was pushed out damage has occurred to other materials near the roofing and siding (sheathing, insulation, wood frame). When the Vendor tears off the roof or siding, they find underlying issues that have developed and now need to be repaired/replaced as well before they are able to proceed with their main project.
Not Having a Clear Understanding of What the Community is Responsible For
We frequently work with communities on private roads that have no idea they are responsible for the water pipes, sewer pipes and storm water system below their private roads. A quick call to the city planning department and/or utility company will provide an answer to these questions but he vast majority of community we work with have simply never asked (refer again back to the “head in the sand approach to budgeting”).
Usually, the larger expenses are outlined in the community plat and community governing documents so a clear understanding of these are essential in determining “who is responsible for what?” question. Other times things are not mentioned at all – in either case an attorney familiar in common interest law (HOA, Condo, Coop, etc.) should be consulted with to determine what these legal documents are spelling out to a reader.
> Reseve Analyst Tip - we do not suggest relying on a reserve study professional opinion in making an interpretation of these documents as there are laws, governing documents and case law all to consider when giving advice. A reserve study professional is typically not trained, does not carry the license nor carries the necessary insurance to cover errors and omissions for this type of legal advice– in a decent size community these are often multi-million-dollar questions.
Ignoring Inflationary Factors
We often come across communities that have what appears to be a decent component list (common area asset list) only to see that their numbers are all based on a project that was completed 10-20 years ago and inflation either completely ignored or assumed to be something extremely low.
When inflation is considered in their numbers, I frequently see 1-1.5% annual inflation being applied. This is less than half of the historical construction inflation cost average and generally either just plucked out of the air or based on some cost index not related to construction cost inflation.
> Example: The Consumer Price Index (CPI) is a basket of goods and services (e.g., hamburger, computers, rent) but none are related to construction cost to the end consumer. Just as I do not find an education or medical care cost index to be relevant to construction inflation, I do not find the CPI to be all that accurate, with respect to construction costs, over time.
** Link to Inflation Indexs: https://www.reservedataanalyst.com/blog/calculating-inflation-in-the-reserve-study/
Making Unrealistic Assumptions About Useful Lives
We frequently come across reserve budgets that make unrealistic assumptions about the useful life (how long will it last) of a common area asset. Some of the more frequent components useful lives we see in budgets are:
Asphalt Shingle Roof – 50 Years (sometimes even “Lifetime”)
Low Slope Membrane Roofs – 40 to 50 Years
Water Pipes – 100+ Years
Irrigation Pipes – 100+ Years
Asphalt – 50 Years
Wood Siding – 100 Years
Fiber Cement Siding – “Forever”
It has been our experience that often the above useful life estimates are simply plucked from the air, sometimes they are based on IRS depreciation tables, sometimes these useful lives are used as a selling tool by a manufacturer or Vendor salesperson, sometimes taken from warrantees that have words like “lifetime” but which is simply defined in the small print as a number the manufacturer uses (20 years is common), etc. Below is what we typically see in the field everyday and across thousands of common interest multi-family communities:
> Asphalt Shingle Roof – 20-25 Years
> Low Slope Membrane Roofs – 15-20 Years
> Water Pipes – 50-60 Years
> PVC Irrigation Pipes – 25-40 Years
> Asphalt – 20-25 Years
> Wood Siding – 40-50 Years
> Fiber Cement Siding – 40 to 50 Years
The reserve study should reflect actual estimates for reserve component useful lives and should be based on the ample amount of data and backed up with actual data from independent sources when possible (e.g., RSMeans Manuals and Marshall & Swift Data are great sources when used correctly). The reserve analyst completing the reserve study should be basing their reserve study recommendations on their actual experiences, Vendor specific recommendations and research and not what someone tells them to use because that fits their budget assumptions better. Doing so simply defeats the whole purpose of providing an independent reserve study that is giving recommendations to their client – We call these “made to order reserve studies”.
Now that being said, I frequently see community components that are much older than the “typical” useful life that we would use in the reserve study, but I rarely see these delayed projects without significantly collateral damage (see “Delaying Projects Past the Vendor Recommendations”) and a much higher project cost than it should have been; resulting in the need for a higher reserve allocation rate.
**Link to Useful Life Tables: https://www.reservedataanalyst.com/blog/useful-life/
Believing That a Future Special Assessment or Loan Will Fix It All
Often a Board will tell us that once an upcoming special assessment is passed or loan is secured things will be much different with relation to their reserve budget. This is opposite of our experiences with most communities.
> Special Assessments for Predictable Reserve Projects – Special Assessments money is collected, and it is generally spent on the project(s). So, while the special assessment has addressed the near-term reserve budgeting issues for a specific project(s) it has not addressed the reason the special assessment is being relied on for predictable common area projects (e.g., roofing, siding, paint, fencing, etc.). The real reason for the special assessment is a reserve allocation rate that is too low (i.e., annual deposits to the reserve account are not enough). It has been our experience that a community that is imposing a special assessment on its members rarely is also able to increase the reserve allocation rate (correspondingly the HOA Dues collected).
For condominium communities a special assessment of $25,000-50,000 per Unit is not uncommon, trying to raise a Unit owner’s Dues by a significant amount is rarely possible. The end result…. another special assessment must be relied on for a different project in another 5-10 years. Special assessments are simply a temporary fix to the ongoing budget problem of an underfunded reserve account.
> Loans for Predictable Reserve Projects - It has been our experience that Loans have all the disadvantages of a special assessment but also carry two additional disadvantages:
· having to pay it back over time (with fees and interest)
· having to try to increase reserves during term of the loan.
Often, we see communities paying 200%+ more the actual project cost when it is all added up, often over a 10 to 15-year period. Other than the dramatically higher project cost (project cost+interest+fees) it has been our experience that communities are rarely to address the real issue of a reserve allocation rate which is too low, all the while having to pay back an expensive loan. A community which was underfunded before is now expected to not only pay back the loan but increase their due significantly; the end result….. often more loans – a very expensive cycle.
