Whenever I’m asked the question, “How much should be in a reserve account?” I respond with something like, “It varies” but I quickly add that the better question to ask should be at what rate should reserve funds be accumulated – what should be our annual contribution to reserves? A capital reserve account is there to accumulate funds to be able to replace each common area component at the end of its anticipated service life. So the amount in reserve at any given time will vary with both short and long term anticipated expenses. On that there is common agreement.
Let’s see if we can gain some converts to belief in a fluctuating reserve account. First off, let’s discard the notion of any rule of thumb, like a percentage of operating funds. Not only is every association unique, but such a concept falsely implies a static situation. And that is just not the case. There is no lack of advocates for approaches to how to fund a reserve account. One position holds for “fully funding”. Not every one understands the technique the same way, but essentially it says that you should contribute to the reserve account in proportion to the rate at which you “use up” the component. If your roofs will cost $100,000 to replace and will last 20 years, then you should be setting aside $5,000 a year. But that can ignore the varying rates at which all your combined expenses accumulate. And fully funding can easily, in many cases, result in over funding at a time when there is no need for cash.
Over funding penalizes current homeowners. They have better places to put their money than adding value to value already in place. If a roof was just re-shingled, its value is in place. Under funding penalizes future homeowners who can be faced with a special assessment. We tell clients that one of the main purposes of their capital reserve fund study is to determine reasonable reserves and reasonable contributions that treat current and future homeowners as even handedly as possible.
We call that reasonable approach “threshold plus contingency funding”. It matches the rate at which expenses accumulate plus a contingency for the unexpected, which, as we know, should always be expected. This approach recognizes the principle of declining value with advancing depreciation. As roofing shingles age, the depreciation of their initial value increases. So, we reason, the rate of contribution to reserve should increase to match that depreciation. Homeowners, (and astute buyers) seeing an aging roof matched to accelerating contribution will sense that the inherent value of the property is in balance.
So it’s really a matter of maintaining value, isn’t it? Homeowners are not contributing to a roof. They are contributing to value. Contributions to capital reserve need to respond to depreciating holdings with increasing investments. How do you know what the comprehensive rate of accumulated expenses is and the aging level of components? You start by having a capital reserve fund study done, preferably by a professional engineer who is also a certified reserve specialist.. The study tells you what your cash flow needs to be to replace components on a schedule that responds accurately to field observed conditions. It will also tell you what the annual rate of contribution needs to be to pay for the replacements.
The bottom line is that reserve accounts are not static line items in a budget. Your level of contributions to reserve needs to accurately anticipate the accumulative rate of expenses for replacement of capital items. To do that, your reserve account needs to be shaking hands regularly with the changing reality of what’s on the ground, on the roof and in your blueprint for planned maintenance.
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