Decoding Reserve Studies
Understanding the Terms, the Funding, and Why They Matter. This article first appeared in the Summer 2024 Edition of The Communicator Magazine.
By Zer Iyer, Esq.
RESERVE STUDY. The term is common in the HOA lexicon. Managers know their associations need them. Board members know they need them. But what is a reserve study, really, and why are they getting so much attention now? Well, it all comes down to – what else – money. Due to the number of unanticipated expenses that associations are now facing, (think: aging communities, increased insurance premiums, inflation impacting just about everything), financial planning for communities has never been more important, and reserve studies are the most effective financial planning tool associations have. Understanding what reserve studies are, how they operate, and the role they should play in an association’s budget is no longer something that only experienced or senior community managers need to know; it is knowledge that all community managers must have in order to effectively guide an association.
WHAT IS A RESERVE STUDY?
A reserve study is a comprehensive two part report created by a reserve analyst for an association every three years. The report contains a physical analysis and a financial analysis.
The physical analysis portion will identify all the various components the association is responsible for repairing, replacing, restoring, or maintaining in the next 30 years. For some developments, that means that the reserve study will only contain common area components. However, in other developments, which contain "townhomes," the reserve study will also include those components of the individual residential structures that the association is responsible for repairing, such as the building roofs or exterior surfaces. Once all the components are identified, the study then captures the current condition of each component with pictures and a written description, as well as a written projection of how well the component appears to be holding up over time. The reserve study will identify the average useful life for that physical component and its approximate remaining useful life. Most importantly, it will indicate the anticipated cost of replacement of the component at the end of its useful life.
The financial analysis of the reserve study is comprised of a table that identifies each component and projects the money needed to replace the component when it reaches the end of its useful life. Civil Code Section 5550(b) requires that reserve studies identify items which have a useful life of 30 years or less. Accordingly, the financial table will project out the approximate costs for replacement of each component over the next 30 years.
The financial analysis essentially puts actual numbers to components so the board has an understanding of how much money the association needs to have in order to replace a component when it reaches the end of its useful life. The reserve analyst then takes those replacement costs and factors in the timeframe for replacement and compares it to the association’s reserve account balance. They determine how much money the association should have in its reserve account in order to be ‘fully funded.’ The analysis will also include a reserve funding plan for the board to use when creating its annual budget.
This plan is intended to help the association prepare financially so it has the necessary money to perform the required repairs or replacement of components when the time comes.
Now that the basics of a reserve study have been reviewed, let’s take a deeper dive into what these terms actually mean.
Current Condition of Component
In order to know when a physical component needs to be replaced, an association needs to understand the current condition of the component. What does it look like? Is it showing signs of normal wear and tear? Does it appear to be in better or worse shape than an average component? Although the photograph that accompanies the discussion of each component is helpful for visualization, most board members will be completely unfamiliar with the physical components identified or what they should look like at a particular age. For this reason, the reserve analyst (who should have familiarity with such components) will often provide an opinion on the current condition of each component. Although the reserve analyst is not a general contractor, credentialed companies are required to undergo training and provide evidence of a certain degree of knowledge in such areas. Accordingly, the board can reasonably rely on the reserve analyst’s opinion on the current condition of the component.
The reserve funding plan typically states an exact amount per month (or per year) that the association should be contributing to its reserve account in order to have enough money to perform all the repair and replacement obligations identified in the reserve study.
Useful Life
The useful life of a physical component is generally considered to be the length of time that a component will typically last before needing replacement. Not all components are built to last as long as others, but the reserve analyst should know the approximate lifespan of any component at a development. Although no two products are exactly the same, the average useful life is a general benchmark upon which boards can rely for financial planning purposes.
Remaining Useful Life
Although the average useful life of a component is based on industry standards and general knowledge of the physical components, themselves, the remaining useful life of a component is far more complicated to determine. First, the remaining useful life depends on a number of different factors. Some components will age more quickly due to their amount of use, their directional exposure, or the quality of materials used in the component. Other components may fare better than expected because they don’t get used as often, are protected from the elements or because the product quality is superior. Regardless of the reason why, the reserve analyst will approximate the remaining useful life for each component in the reserve study. This remaining useful life number will determine what year the component will be projected for replacement and, in turn, will determine how much money the association will need to save each year so it can perform the replacement project when the time comes.
While the reserve study will identify a certain number of years for each component and recommend replacement at a particular year/component age, if the board believes that a component is faring better than anticipated or expected, the board can ask the reserve analyst or a consultant with experience with that specific component to inspect the item again. If the secondary inspection reveals that the component won’t need replacement until later and the consultant will put their opinion in writing, the reserve study can be revised to extend the useful life of the component. Note that the same holds true if a component appears to be wearing down more quickly than anticipated. If a component appears to be aging prematurely, the board should have a consultant inspect it, make a recommendation on its remaining useful life, and revise the reserve study accordingly.
Cost of Replacement
The cost of replacement for a physical component is another complicated issue. Fundamentally, this is just a projection of how much the association should anticipate spending to replace a specific item. The reserve analyst may use actual costs incurred by the association for a similar project, comparisons of similar projects the reserve analyst has estimated at other associations, and national guidebooks on cost estimating to arrive at the replacement numbers. Reserve analysts also factor in something that effects all pricing: inflation.
Many years ago, inflation rates were fairly consistent and adjustments to inflation were minimal in nature or – at worst – changed in slow increments so it came as no major shock. Unfortunately, as we all know (and experienced), the pandemic impacted far more than just the health sector. Inflation skyrocketed as a result of tumult in the global markets and the rate of inflation (though lower than it was one year ago) was still hovering around 3.5% as of June. Just as inflation rates impact the cost of groceries, gas, and cars for individuals, it also impacts the cost of materials, labor, and services provided to associations.
Accordingly, the replacement cost projected by a reserve analyst three years ago might not accurately reflect the costs today – much less the costs in several years when a component’s useful life has expired. For this reason, many associations are revisiting their reserve studies and requesting that the analyst update the replacement cost numbers. If an association uses the reserve study and the funding plan laid out within it as a roadmap, but those numbers are grossly lower than they should be, the association will lack the funds needed to perform its obligations. Therefore, although it is never good news to see a higher project cost, if an association is using the reserve study as a financial planning tool (as intended) then the board has an opportunity to pivot and plan for the anticipated shortfall, rather than be caught off-guard.
RESERVE FUNDING PLAN
Depending on your perspective, the most important aspect of the entire reserve study is the reserve funding plan. Keep in mind that although the reserve study identifies all the physical components, their condition, and what it will cost to replace them at the expiration of their useful life, the association’s ability to perform any of the repairs at any time depends entirely on how much money it has in its reserve account. Although the Civil Code requires all associations to maintain a reserve account, the law does not explicitly require that associations actually fund the account or how much money associations must put into those accounts on an annual basis. As a result, the funding levels of reserve accounts differ greatly from one association to another. Some are either fully or near fully funded, while others have a concerningly low amount of money saved for large-scale repair and replacement projects.
Without direct guidance from the Civil Code, how does a board know how much to save and how to properly allocate assessments to achieve those financial goals? The reserve funding plan contained within the reserve study should provide clear guidance about how a board should approach assessment values to attain full funding so that it has the money necessary to perform all the repairs needed when the time comes. The reserve funding plan typically states an exact amount per month (or per year) that the association should be contributing to its reserve account in order to have enough money to perform all the repair and replacement obligations identified in the reserve study. Of course, depending on the current amount of money in the association’s reserve account, the recommended funding plan might be overly ambitious. In other situations, the estimated contribution is beyond what the board can unilaterally impose as assessments on the membership. However, even if an association is not in a position to make the recommended contribution to its reserves, the funding plan sets a benchmark for financial stability and the board should consider it closely when arriving at an annual budget for the coming year.
WHEN YOU FAIL TO PLAN, YOU PLAN TO FAIL
My father’s most repeated saying is: When you fail to plan, you plan to fail. It has rung true in so many aspects of my life, and while I am certain he never dreamed it would be quoted in The Communicator, this adage is completely applicable to association reserve studies. Reserve studies matter – a lot. A reserve study is the best and most comprehensive tool associations have to gauge not just the physical health of its property, but to also diagnose an association’s financial health. The components listed in the reserve study lay out all an association’s major repair and replacement projects on a long-term basis and attempt to forecast how much money an association will need to meet those obligations. In order for an association to be a desirable place to live, the development must be properly maintained and financially strong. An association can only afford to maintain a development properly when it has the appropriate fiscal strength to do so, and a well-prepared reserve study should be the plan to help the association do both.
Zer Iyer is a principal at Hughes Gill Cochrane Tinetti, P.C. and the current co-chair of the CAI Educational Committee. She has been practicing CID law since 2005, handling both transactional and litigation matters for homeowner associations. Zer speaks regularly for various industry organizations and is passionate about educating others about the issues – legal or otherwise – impacting common interest developments in the state.