How Much Should Our Association Have in Reserves? Fully Funded, Partially Funded or Under Funded is the Better Question.
One of the most widely asked question by the condo community association board Treasurer is how much should be in the reserves. Another typical question which is essentially the same is “How much should our association put away into the reserves as a part of our annual budget”? The answer is far from simple especially given the fact that there are no state or local laws that require any type of reserve requirements in the State of IL.
The best answer is actually a very short answer. Obtain a reserve study. This is the most comprehensive approach to answering this important question. However, for those associations that choose to not obtain a reserve study or don’t have the funds to pay for it, what then? As a result, let me some techniques that associations can use to determine the right amount of reserve levels.
#1: Employ the Monkey See, Monkey Do approach. In this approach, the board conducts research on the assessment levels of neighboring associations and sets their assessment levels at the same level or lower. This is based on the belief that if their assessment levels are higher than neighboring associations, that will make it harder for their homeowners to sell their units. This approach assumes that it is irrelevant to take into account capital replacement project needs of the association.
It is tempting for board members to study assessment levels of nearby associations and not make a determination of the proper reserve levels based on actual facts and conditions within the association. However, those assessment levels of nearby associations are really meaningless unless there is detailed knowledge of the associations 5 year capital plan and a deep understanding of the building profile and amenities.
#2: Mathematical Formula Approach. In this method, a scientifically developed formula is applied to determine the right level of reserves for the association. The formula is as follows: Take the total annual income of the last APPROVED budget and DIVIDE it by the average number of homeowners that have attended the last 8 board meetings and then MULTIPLY that by the number of effective 1-hour board meetings over the last 5 years. That result gives you the amount that should be in the reserves of your association. This is also a tempting approach to take a cut and dry formula but this doesn’t take into account real conditions for the association.
#3a: Reserve Level Funding Strategy. The association board decides on a funding level and incorporates that with a 5-year capital plan and this will determine the right amount in the reserves. There are 3 typical funding strategies:
#3b: Develop a 5 year capital plan. A 5 year capital plan will identify all the capital projects that the association will undertake over the next 5 years and sort them by priority and by year. The plan will also identify the costs and reserve amounts required to fund the projects. I also recommend that associations develop 5-year capital plans even though they have a current reserve study. A capital plan is an action oriented plan that is the actual agreed upon plan by the board. In contrast, the reserve study is a very comprehensive and complex document that has recommendations for capital replacements over 25 years but is often times not followed by associations due to the extreme funding level requirements for associations.
Now let’s take a look at some examples.
Example #1: A basic 20 unit condo association. This building has one entrance, a flat roof that is about 20 years old and is a conversion from an apartment building. The board has poorly maintained the association and there are a number of large scale capital projects needed including:
In this scenario, the association is significantly underfunded. The previous board clearly followed the “underfunded” reserve strategy. In this scenario, the association should have AT LEAST half of the $150,000 in order to follow a partially funded reserve strategy. The association does not have $75,000 as they only have $20,000. And the association of 20 units should keep a minimum of at least $20,000 in reserves at all times. So in this instance, the board will have to approve a special assessment of approximately $150,000 and require the homeowners to pay it back in 12 months since the projects need to take place in 2019. This is clearly a very precarious situation and is unfortunately all too common in community association living. A way to ease the monthly homeowner payments is for the association to apply for a bank loan and spread the special assessment over 3 years. This will add to the cost of the repairs but will lessen the monthly homeowner payments. So in this scenario, the association should have at least $75,000 in reserves at this time.
Example #2: A new construction 35 unit condo association. This building has 3 elevators and flat roof. The developer construction was better than typical new construction so the building has no immediate short term capital projects necessary.
In this example, the association has adequate reserves at this time with the assumption that the association will continue to fund the reserves with a $20,000 annual contribution going forward. So in this scenario, the association has sufficient reserves at $35,000 even with the landscaping project identified in 2020.
Example #3: A vintage 50 unit courtyard building. This is a 75 year old condo building with a U-shaped courtyard. There are 3 entrances and a parking lot in the back with 50 spaces.
In this instance, the association has a healthy amount of reserves vis-a-vis the 5-year capital plan. The assessment levels seem appropriate for the needs of the association and the reserves are sufficient enough to fully fund the upcoming capital projects. At the end of 2021, there will be approximately $150,000 in the reserves taking into account annual reserve contributions and the capital project expenses. So in this instance, the association has sufficient reserves at $225,000.
Based on the scenarios above, it is fairly obvious that there is no simple rule to determine how much should be in the reserves of a community association. The examples above prove that in some cases, a larger size community association is adequately funded with less reserves than a smaller sized community.
In cases of larger sized community associations such as high rises, it would make the most sense for the board of directors to pay for a reserve study. In those circumstances, the reserve study would dictate the assessment levels and reserve amounts. For smaller associations, I recommend reserve studies for those associations with larger budgets. In other circumstances, the boards can put together their own in house 5 year capital plan with or without the advisement of a community property management professional depending on whether the association is self-managed or has a community management firm.