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Don’t Raid the Cookie Jar Capital Budgeting is Essential

Don’t Raid the Cookie Jar

Sometimes the future seems like it’s an awfully long way away. If a roof is going to last 30 years, why should we worry about it today? Same with that shiny new air conditioner or that flat, crack-free pavement just poured two summers ago. Eventually, though, everything new grows old. Wear and tear sets in and soon, those elements we thought would last forever are in need of repair or replacement.

What's Enough?

But how much should your community have socked away? That depends, says Robert L. Kaye, managing member of the law firm of Kaye Bender Rembaum in Pompano Beach.

For condominiums, “Section 718.112(2)(f) of Florida Statutes provides that the annual budget of an association must include full reserves,” he says. “Whether or not to present the option to the membership to waive all or a portion of the full reserves is first up to the board of directors.” Under the statute, according to KBR, reserves are required to be included for roof, painting, paving and any item of deferred maintenance that will cost over $10,000. A separate schedule for the reserves is required to be included in the budget and the method of calculating the amount that must be reserved is provided in Section 61B-22.005 of the Florida Administrative Code. Funds held in reserve may only be used for the matter for which they are being held unless a different use is approved in advance by a vote of the unit owners.

According to Will Simons, RS, president of Association Reserves, which has offices in Orlando and in Miami, some associations vote to waive fully funding their reserves. Such a vote must constitute the majority of the unit owners. They may feel that the odds are that their new HVAC system won’t break down any time soon—but if it does, and they’re not prepared, they’re going to have a problem. Also, even if some elements seem totally adequate now, they may become obsolete in 10 years because of advancements in technology, mandating new expenses by the association to keep things up-to-date.

To stay abreast of this, says Kaye, “Each year, the proposed budget must include the formula for computing the full reserves set forth in Section 61B-22.005 of the Florida Administrative Code, which requires an indication of the estimated replacement cost of each of the items that must be included in reserves.”

That is where a reserve study comes in handy—very handy, in fact, because it gives administrators and residents alike a clear picture of how much is needed in the community coffers to pay for those big replacements and repairs.

For cooperatives, similar provisions can be found under Section 719.106(1)(j) of the statutes, and for HOAs, Section 720.303(6)(d) was added in 2007, providing that protected reserves (or funds used for a specified purpose) could only exist one of two ways. The developer of the community initially created the reserves, or secondly, reserves were created upon a vote of the members of the association by a majority of the total voting interests. Once the homeowners approve reserves, the board is then required to include them in the annual budget each year thereafter.

Change Begets Change

And knowing what's needed—or might be needed—offers more than just peace-of-mind; there are other reasons why having adequately funded reserves is prudent. “Five or six years ago, mortgages backed by Fannie Mae, Freddie Mac and the Federal Housing Administration (FHA) only represented five percent of mortgages,” says Mitch Frumkin, PE, RS, CGP, president and founder of Kipcon, a full service engineering firm in North Brunswick, New Jersey and co-author of Community Associations Institute (CAI) book Reserve Funds: How & Why Communities Invest Assets.

“Today, 75 percent of condo mortgages are guaranteed by FHA, Fannie Mae and Freddie Mac. This tilted the scale in favor of reserve studies because they have regulations for insuring mortgages and in order for it to be guaranteed, there are certain requirements that have to be met,” Frumkin says. One of those requirements is that ten percent of the budget must be set aside on an annual basis for future repairs, or the board must do a reserve study that shows they can afford to put aside less.”

“In a high rise, you can have a $7 million budget, and ten percent of that is $700,000 so that is what must be set aside each year,” says Frumkin. “If a reserve study is done, though, analyzing exactly what replacements and repairs must be made in the years to come and how much needs to be saved to pay for them, the number will likely be significantly less,” Frumkin says. “You can pay $15,000 for a reserve study and save hundreds of thousands of dollars” on the repairs themselves, he adds.

A capital needs assessment is more short-term. “It says ‘In the next five years, these will be your capital needs,’” Frumkin explains. “They may need a roof replaced at the end of those five years, but it does not involve making long-term budget plans the way a reserve study does.” With a reserve study, if a roof costs $100,000 to replace, the building will have been putting aside $5,000 a year for the last 20 years to pay for it. A capital needs assessment is “not a good financial tool to establish a funding plan,” says Frumkin.

How Does it Work?

Reserve studies are usually performed by engineers or architects who have earned specialized designations known as Reserve Specialists (RS). These specialists examine the condition of the common elements such as the building’s exterior including the roof, façade, sidewalk, roadways, storm water drainage and more. After evaluating the building or association, the reserve expert will prepare a report including a 30-year expenditure page that shows prospective costs for each year. On average, it takes about 60 days to have a reserve study performed. Studies can be updated every three to five years.

There are two methods that professionals use to conduct the financial analysis portion of a reserve study, explains Matt Kuisle, PE, RS, PRA, director of client services for the Southeast region at Reserve Advisors. One is the “component method,” which takes into account the replacement cost of specific items, such as painting, paving or roofs, as well as how many more years of useful life each component has, to calculate the required contribution into the fund. However, he says, this method doesn’t take into account interest earned or inflation or construction costs. “Obviously, the roof is not going to cost the same seven years from now as it will cost today.”

The “cash flow” method uses the same data as the component method, but it adds construction inflation and interest earned. In this method, all reserves at the end of the year are pooled into one account. “Reserve contributions are adjusted for the next fiscal year, and afterward increase by a nominal inflationary account” says Kuisle. “The benefit of those nominal increases each year is that present and future owners are treated fairly and equitably.”

“The primary benefits of a reserve study are an accurate and truthful disclosure to the owners and to the present and future boards about what expenses are coming in,” says Kenneth S. Direktor, a shareholder and the chair of the Community Associations practice group at the community association law firm of Becker & Poliakoff in Fort Lauderdale. “There are a lot of communities that don’t fund reserves, but then there are a lot of communities that are attaching a reserve schedule that is not based on realistic numbers. The failure to fund reserves reduces options; the continued inclination to not fund reserves is another mistake.”

Planning for a Rainy Day

Planning is everything when it comes to the successful maintenance and upkeep of a condo or co-op building. The number one mistake people make in these situations “is that they don’t do reserve studies,” says Frumkin. “Even if you don’t set aside the money, you’ll still need to replace the element. It’s not going to wait for you to get the money. Managers and attorneys have a responsibility to understand this and communicate it so they aren’t faced with an assessment.”

“When you have a major project, the money comes from one of three places, and I’m making the assumption that the project is costly enough that it can’t be paid out of operating costs,” says Direktor. “So the money is going to come from either reserves, all or in part or it’s going to come from a special assessment or it’s going to come from financing.”

For those buildings that either were not putting money away or that ran into unexpected circumstances that set them back in their saving, there are options for rebounding and still ensuring that repairs are made. That said, some may be more palatable than others to residents.

“Assessments are not popular, but the association is going to have to make a decision about financing depending upon the nature of the community,” says Direktor. “Sometimes a large assessment will force a lot of people into foreclosure. It is better for the association to finance money and have a special assessment that is payable over time and give the owners the option to either pay their shares in full or pay them over time. If you reduce the percentage of delinquencies you accomplish two goals: by financing it you will know you have a fund accessible to pay for the project as it progresses and it gives you the opportunity to string out the payments over time you will probably push fewer owners into default or foreclosure.”

Making sure there will be enough money on hand when the rainy day comes is of paramount importance for boards, managers and residents.

For boards who find themselves behind in their savings efforts, it is never too late to start. “It’s different for every association, but there are different ways to get to where you need to be,” says Frumkin. “If you’re underfunded, you can change how much you’re putting aside.” And boards and managers also can enlist the talents of industry experts who have experience in reserve studies and solid, prudent planning. “There are ways to get there if you work with someone who understands the different types of plans,” says Frumkin.

As difficult as it may be to set aside extra funds or as intimidating as it may be to inform a building’s residents that cash must be raised and saved, these alternatives still come out way ahead of finding out too late that there is no cash, no resources and few options for replacing a leaky roof during a rainy spring or hurricane-damaged shutters in the aftermath of the storm.

As with everything in life, thinking ahead can help alleviate stress and put management in the driver’s seat for a safe, well-funded and well-planned future—an approach every resident certainly can endorse.     

Liz Lent is a freelance writer and a frequent contributor to The South Florida Cooperator. Freelance writer Christy Smith-Sloman contributed to this article.

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