A formal reserve study is a tool used by an HOA to ensure enough funds are on hand for projected repairs and improvements. Such a study analyzes the physical condition of the entire community and projects the lifecycles of components to recommend when improvements and maintenance should be scheduled.
The most important reason to conduct a formal reserve study is to ensure that the value of each owner’s home is, at least, maintained. This is only possible if regular maintenance is provided to the community.
There is the perception of cost to consider. If homeowners pay a low monthly rate over time, then large, foreseeable projects will be covered and the monthly condo fee will be perceived as affordable to the owners. However, when large repairs are not planned for, special assessments will likely be required, which will result in a sudden spike of monthly cost to owners. This, in turn, will negatively affect condo unit sales.
Additionally, if a condo does not exercise sound financial practices or make regular repairs to common areas, buyers may not be able to obtain FHA, VA or FMA loans. This, in turn, will hurt condo unit values.
Not planning and regularly covering maintenance of the shared areas has additional costs. Leaks will occur in the roof, plumbing will burst and cracks in the walkway will cause accidents. Thus, liability and building insurance will increase because the number of claims will go up. In fact, in many states, condos must pass inspection to receive and to maintain insurance.
Management and Board Responsibilities
Boards, managers, and homeowners must be diligent to ensure that the major assets of their association are being funded on an ongoing basis through reserves.
As a nonprofit corporation, community association Board members are held to the same standard of duty by which other corporate directors are measured. Failing to plan and project needed repairs and improvements in the annual budget of the association leaves Board members open to legal actions and they may be held liable for their failure to act as a breach of fiduciary duty.
Likewise, the community manager has a contractual responsibility to advise and assist the HOA to maintain sound financial planning. In fact, a manager who does not strongly recommend their Board adequately fund their reserves also can be legally liable. Nationally, several lawsuits have already arisen for breach of contractual responsibility.
Additionally, a growing number of states have passed legislation requiring community associations to do reserve studies. These currently include Virginia, Ohio, Illinois, California, Florida, Hawaii and Nevada. Because this requirement is becoming the norm, more states will be developing similar legislation.
Ensuring the HOA Has Insurance
Insurance a condo community must purchase includes property, liability, directors and officers, flood (if in flood plain) and crime. Specifically, property (hazard) insurance must maintain 100% replacement cost coverage. Fidelity bond/crime insurance is required for any project with 20 or more units for which the coverage level must be at least equal to three months of HOA dues, plus the aggregate in all reserve funds, and ideally have a high deductible.
Not only that, if the HOA uses a management company, that company must have comparable levels of coverage and name the HOA as an obligee.
Borrowing for large projects can be problematic for an HOA. First of all, a condo that has not planned for a large project will be suspicious to any lender. Specifically, the FHA requires the HOA’s budget to have a separate line item for reserve contributions and the level to be at least 10% of the gross revenues. A community over a year old should have a balance that reflects an annual 10% contribution. In other words, a five-year-old project should have a balance equal to five years of contributions plus any other required reserves. The only alternative would be to provide a reserve study that meets HUD’s requirements that supports a lesser reserve amount.
No matter the circumstance, the FHA asks for some type of reserve analysis and requires that the HOA collects an appropriate amount of reserve funding and that the HOA has that amount in reserves. The FHA will reject loan applications for condos that have inadequate reserves.
Additionally, an HOA that needs a special assessment typically has a pattern of making claims. In which case, insurance deductibles will increase. In turn, to protect itself, the association will need to set a reasonable “allowance” amount for a possible deductible, so that in the event of a loss, there are some reserves to work with. This will further drive up the price for putting off collection for large projects.
In conclusion, not conducting a reserve study and maintaining sound financial practices can have legal and financial consequences, and it can affect the health of a community. Barring any legal consequences or financial constraints, the price tag for an HOA’s unwillingness to slowly build a reserve for foreseeable maintenance can be prohibitively high.