Planning And Paying Big Bills & Preserving Property Values
Even without the unpredictable…though somewhat expected…high winds, water, and other destructive elements, there is routine deterioration of physical materials that requires a plan. It takes money to roll back the clock on rust, gravity, and other forces to keep physical items in good shape, plus being prepared for the occasional improvement or effects of a natural disaster.
The purpose of a reserve study and funding is to maintain the property and preserve property values in a community. By having a good report and financial plan to deal with major repair and replacement projects, the community can reduce the risk of surprises and special assessments.
As association living develops a track record, the importance of reserves is becoming more widely understood. Potential buyers and their mortgage lenders are doing more homework and asking more questions about the financial health of a community before making a purchase or approving a loan. Communities that have never funded reserves are now getting pressure from owners who are unable to sell their units due to poor reserve funding. Underfunded communities are also feeling a higher impact as their infrastructure ages and replacement costs increase.
Reserves are collected annually for the future usage of a particular capital/component item. This is incorrect. Reserves are collected for the usage of a particular item ‘today.’ There are no refunds for reserve items on the day a homeowner sells his unit.
The idea that reserves are for future use rather than the current depreciation of an item may start with a community’s history. Most associations did not start out fairly paying annual reserves the day the city issued the certificate of occupancy. So, in many cases either inadequate reserves or no reserves were collected until after 5, 10, or 20 years of using the common assets. In order to slowly move from an unfair system to a fairer system of collecting reserves, the association will have to sacrifice by collecting more from their current homeowners. This is a very difficult task the board faces because new homeowners will object and feel that it is unfair to have to pay for a full roof replacement one to two years after moving into their newly purchased unit.
It is important to note that associations are nonprofit corporations—a business entity. As a business entity, it must work diligently and fairly in maintaining the assets for the common interest of current and future unit owners.
As a starting point for condominiums, Florida Statute 718.112(2)(f)2.a. and 3 states, “The reserve budget must include reserve accounts for capital expenditures and deferred maintenance. These accounts must include, but are not limited to, roof replacement, building painting, and pavement resurfacing, regardless of the amount of deferred maintenance expense or replacement cost, and any other item that has a deferred maintenance expense or replacement cost that exceeds $10,000… This subsection does not apply to an adopted budget in which the members of an association have determined, by a majority vote at a duly called meeting of the association, to provide no reserves or less reserves than required by this subsection… Reserve funds and any interest accruing thereon shall remain in the reserve account or accounts, and may be used only for authorized reserve expenditures unless their use for other purposes is approved in advance by a majority vote at a duly called meeting of the association.”
Different rules apply to homeowners associations. Homeowners associations require reserves for any items initially established by the developer or added later by a vote of the owners. Though budgeting just for amounts above $10,000 may be appropriate for a luxury high-rise, that amount is often too high for many smaller communities, so some may include projects as small as $2,500 or $3,000. For many, that is a significant budget amount. Associations should be more prepared and less exposed to extra stress on the operating budget.
Per accounting practices, capital expenditures are for items that last more than one year. It is important to try to gather as many capital expenditures as possible in the reserve study. The report will most likely be the one place the association can go for a list of their long-term assets.
The most prominent reason for funds to come up short is that the community historically voted to waive or partially fund their reserves. It’s no surprise in these communities when special assessments are levied. On the other hand, there are also a number of communities that believe they have adequate reserves but are surprised by unexpected expenses like concrete restoration, plaza decks, or plumbing issues that they did not have on their reserve schedule.
Each reserve plan should include a list of the reserve items, their replacement cost, total useful life, and remaining useful life for each item. We refer to this data as the physical analysis.
Including all items is the first step and can be challenging in itself. New items that are being discussed for the first time by associations in recent years include lake shore restoration, community drainage, hurricane and storm cleanup, hurricane deductibles, landscaping, and seawalls. All of these are legitimate items that should be considered by associations. These items cannot go into operating expenses, and to help avoid surprises through special assessments, the reserves might be a place to include them.
The State of Florida is unclear on these items, but hopefully in the future they will address these issues. They are to a certain extent unpredictable in their useful life and remaining lives, along with possible difficulties in measuring them. Associations should obtain estimates and opinions from contractors who specialize in the particular component. For example, a landscaping company can somewhat estimate the cost of replacing all underground piping related to the association’s sprinkler system.
Code changes can cause a surprise expense and may be an appropriate time for a special assessment. A board can’t always see code updates coming to plan for them but, some fire alarm and sprinkler code changes or life safety requirements might need to be included. For a number of years, the State has been trying to get fire sprinkler retrofitting in older high-rises. Some associations are allowed to opt out by a vote of the owners, but until they do, it may be advisable to consider these costs in the plan. In Florida, lake or pond dredging is often not a predictable need, so we would include funding for that type of project on a case-by-case basis.
One of the biggest expenses and one that is most difficult to forecast is concrete restoration. There are many coastal properties that are concrete structures sitting on the oceanfront exposed to water, salt, wind, and ongoing moisture. These elements can cause serious deterioration if the building is not properly waterproofed. It is hard to predict when or to what extent repair is needed until an inspector starts tapping for hollow concrete and chipping to find how deep the problem goes. Plus, concrete deterioration is not uniform; one balcony may need a few hundred dollars of repairs, while one 30 feet away needs thousands of dollars of work. The problems may be the result of neglect, not painting frequently enough, or using the wrong materials, but some problems are disguised, so extensive and expensive damage can occur before it is discovered.
Despite the secrets the concrete may hold, prudence requires some prediction. All risk factors need to be reviewed – balconies, catwalks, planters, a pool and plaza area sitting on top of a garage structure — these are all waterproofing risks. What is the age of the property, and how has it been maintained so far? On-site, we look for telltale signs such as cracks, spalling, and rust stains and check if these are in one area or are widespread. We will compare the situation to other properties we have worked with, and if the situation is severe enough, we will recommend bringing in a structural engineer or contractor for a more in-depth evaluation.
For some of the same reasons, it can be hard to tell the extent of plumbing problems. The board can’t see what’s going on, and it can be hard to tell the extent of the problems—whether there are a few pinholes or there are major problems throughout the building. In a worst-case scenario, it can mean opening walls and floors to re-pipe, which is very expensive; though, many communities are now using pipe relining techniques for plumbing repairs at that stage.
The cost of replacing an item can be significantly different from just the item itself, and those associated costs should be part of the reserve plan. Repair and replacement costs should assume local labor and materials as well as removal, disposal, mobilization, staging, traffic control, engineering, design, permits, fees, and project management costs as needed, depending on the project. Useful life estimates should consider condition, exposure, environment, materials, construction methods, use, maintenance practices, current codes, technology, and aesthetics, again, depending on the project. There is no universal database of costs or useful lives that would apply to every community. Each association is unique based on the factors above as well as the strategic direction and goals of the board and residents of the community.
Despite planning, additional costs may arise in major projects. Some of the items that should include contingency funds would be roofing, paving, building restoration, generator replacement, and elevator modernization, just to name a few. Items such as roofing can only be observed/inspected from the top. The work required under the roof, whether for concrete repair and/or plywood /trusses, can significantly increase the cost of replacing a roof.
Reserve studies typically expect the association to replace all related equipment together versus in sections or parts. If they are not, there is the possibility that one mechanical item will not work well with another component, and the original replaced item might have to be replaced prematurely. Elevators are an example of component items that should be replaced all at the same time if possible.
There are reasons to replace an item besides outright failure. Often the life expectancy of an object is on a spectrum from objective to subjective, so when determining when to replace an item, the nature of the component has to be considered. For pool furniture, the board may want to consider whether it matches and is appealing, while with an air conditioner, residents may just care if it is functional. However, the air conditioner may be functional, but the cost of electricity is killing the budget because it is energy inefficient. Or, the building may have a generator that is 30 to 40 years old and operates, but parts are not available. The board may want to pro-actively replace items like generators or elevators if an untimely failure could be catastrophic or more costly and time-consuming. It may be worthwhile to upgrade cameras or IT equipment for performance or security even if the current system is still working—the community’s priorities should be factored into reserve plans.
A variable that associations can use to their advantage in reducing reserve funding is preventive maintenance. Maintenance makes a huge impact in life expectancy of many items and it can extend life expectancy and reduces the amount of funding. Roof inspections, changing filters and servicing the air conditioner, pressure washing to remove salt—all can prevent problems. The two key pieces of information in calculating reserves are the item’s life expectancy and its cost. Preventive maintenance can help in both ways. For example, if a roof is not inspected, leaks can spread and then the underlying structure has to be replaced; it’s no longer just reroofing. Preventive maintenance is particularly important for coastal properties because the water and salt accelerate deterioration.
In addition to the physical analysis, the other major part of every reserve study is the financial analysis. One of the biggest sources of confusion on the financial side of a study is whether or not to include inflation. While all experts will agree that inflation will happen at some level, it is typically left out of the studies for Florida condominiums due to an interpretation of the applicable administrative code. The administrative code states that the reserve funding plan in a pooled analysis shall not have any balloon payments.
The DBPR (which oversees Florida condominiums and co-ops) has interpreted that to mean that any increase in the reserve funding over the length of the analysis is not allowed. Therefore, boards should not show any inflationary or other reserve contribution increases in their pooled funding plans. A board can include inflation on expenditures (for either the pooled or component methods), but if those increases are not offset by increases in annual contributions (which are not allowed in the pooled method), it creates inequity by putting a higher burden on current owners when future values of money are considered. Therefore, most Florida condominiums and cooperatives choose to leave inflation out of the equation unless they want to be extremely conservative and avoid having to adjust future assessment levels as inflation actually does occur.
More and more communities have been switching from straight-line (or component) reserve funds to pooled (or cash flow) reserves. In our experience, outside Florida pooled reserves are nearly universally used, but they weren’t allowed in Florida until 2002, so older communities may use straight-line reserves because it’s simpler and more familiar to accountants and property managers. However, due to the flexibility of using any reserve funds for a listed expense with pooled reserves. The required contributions can be significantly less with pooled reserves. For example, in one community the fund may require $1,200,000 with straight line funding but only $550,000 if funds were pooled. Usually pooled funding reduces owner contributions by a significant percentage as compared to straight-line funding.
A reserve study is not a once-in-a-lifetime event. There are a lot of moving parts to update. The life expectancy of a component may have changed, as well as the costs, the account balance, inflation, or items that may have already been replaced. If a hurricane damaged the property, and the roof and fences were replaced, the numbers need to be run again. As a rule of thumb, a professional update is recommended at least every three years.
Most associations do not use a professional every year, but construction costs and project timing can change rapidly due to inflation, housing booms, storms, technology, or other outside factors, so it is a best practice to revisit the community’s estimates every year to avoid surprises.
If the association waits three or more years to update their reserve study, be ready for greater than normal increases to the annual contribution. Inflation and interest are both unpredictable and can lead the association to the false assumption that adding the historical cost index will take care of any adjustments to future annual contributions. This is typically not the case. Cost increases vary by item and also by location.
Weather is another factor affecting the need for a reserve study. If two strong hurricanes come through South Florida in a year, even if the roof does not need to be replaced, its life may be cut in half. Concrete restoration, pavers, outdoor lighting, and many other component items can be affected by storms, which can affect the appropriate reserve funding. Additionally, if a major project is completed and the costs were greater than originally estimated, that might affect the funding of future projects, so the reserve study should be updated.
Consider updating of the reserves as preventive financial maintenance; catching problems earlier can minimize the damage (by spreading costs over time) and possibly prevent the dreaded financial “outage.”