Checking HOA Financials

One critically important item which is often overlooked when purchasing a home which resides in a “common interest development” are the HOA’s financials. If you are thinking of purchasing a home or currently own a condominium or a detached home in an area which has “common” elements, the information below will be very pertinent information for you. As an owner or potential owner in a common interest development you are obviously hopeful that the property you now own or hope to own, is maintained in a way which not only preserves but increases the equity and value of your interest. If you are a current owner in a common interest development you are probably familiar with “HOA financials” which are periodically produced and copies provided to all owners. Prospective owners/buyers should be provided the most current financials during the “contingency” portion of the escrow process. My discussion here is centered on a very important portion of the HOA’s financials, the “Reserve Study”. Preparing the annual budget and overseeing the HOA’s finances and facilities are perhaps the most important responsibilities of the HOA board. To do so properly, directors must develop a schedule and funding plan for future repair or replacement of common elements, such as the roof, swimming pools, decks, paving, concrete, fencing, signs, HVAC, plumbing, elevators, entries, etc. It is essentially a long range financial planning tool. Funding Options. To fund future repairs and renovations, HOAs have several funding options, including: • Regular assessments, commonly known as monthly dues/fees • Special assessments • Bank financing or • A combination of the first three The latter two are needed only when adequate monthly dues have not been previously collected. Also, please note the word “adequate”. Monthly dues which are not sufficient/adequate to meet on-going maintenance, etc., obligations and which also allow a portion of the dues to be “bankrolled” for future obligations (“reserves”) will eventually require funds from one or more of the latter three options noted above.  Amongst the financials, you should see what is termed a “reserve study” which provides a current estimate of the costs to repair and replace major common area components over the long term. Ideally, all major repair and replacement costs will be covered by funds set aside each month (top option noted above) by the association as “reserves” so that funds are available when needed. The reserve study is completed by: • An examination of the association’s repair and replacement obligations; • A determination of costs and timing of replacement; and • A determination of the availability of necessary (reserve) cash resources. Because the board has a fiduciary duty to manage association funds, not only does the reserve study supplement the annual pro forma operating budget; the reserve study is also an important management information tool as the association strives to balance and optimize long-term property values and costs for the membership. Current association members (owners), are often reluctant to contribute to reserve funds because they feel that these are an added cost of living. This is not true. Reserves are designed to replace assets as they are used up. When contributions are made, they pay only for the benefits received by those who received the benefit, not for some stranger in the future. Reserve planning also helps assure property values by protecting against declining property values due to deferred maintenance and the inability to keep up with the aging of components. For a potential buyer and the buyer’s lender, the reserve study discloses the manner in which management of the association (i.e., the board and the property management company) is making provisions for non-annual maintenance requirements and shows a more accurate and complete picture of the association’s longer term financial strength and market value. Also, most, if not all, lenders now require that they be provided a current reserve study in order to approve a buyer’s purchase or a current owner’s loan refinance. Those HOAs which do not have a current reserve study risk having loan applications denied. This has become very common because history has proven that HOAs which properly plan and put aside reserves have a much lower loan default and foreclosure rate amongst their owners than for those HOAs that do not properly plan. The reasons for creating and adequately maintaining a reserve fund include: • Fulfills the board's fiduciary duty • May be required by state law (discussed below) • It eliminates the need for unfair, unpopular & possibly uncollectible special assessments • Reserves enhance resale values, and • Accounting standards require reserve plans. Reserve Funding Methods. There are four funding strategies:  1. Full Funding is designed to attain and maintain the reserves at or near 100 percent every year. If, for example, a roof has a 20 year life and costs $20,000, $1000 should be reserved each year to maintain 100% funding. If the same approach is used on all components, reserves are maintained at or near 100% each and every year. This is the most responsible model since all members pay a fair share of expenses directly related to their time in ownership. 2. Baseline Funding keeps the reserve cash balance above zero at all times. This means that each component is not fully funded and the reserve balance can drop to zero during the projected period. This model is likely to result in one or more special assessments. 3. Threshold Funding is similar to Baseline Funding but sets a minimum reserve cash balance as the threshold of, say, $50,000, instead of zero. 4. Statutory Funding is based on state statutes which may establish specific funding minimums. The bottom line is that setting aside anything less than full funding means that some members in the future will be required to make up the shortfall. Baseline and Threshold models contribute less to reserves (sometimes a lot less) which ultimately will result in special assessments to fill the shortfall. Why is planning to fund reserves by special assessments not recommended? Because they are often uncollectible due to individual financial circumstances and doing so is unfair to those members who must pay them. Additionally, the board will have failed in its fiduciary duty to protect the interests of all members current and future. Legal Requirements. • California Civil Code Section 1365 requires that homeowner associations prepare and distribute certain financial information, including a pro forma operating budget, 30-90 days prior to the start of the association's next fiscal year and that a part of the operating budget shall be a study of the HOA’s reserves. • Section 1365.5(e) notes that “at least once every three years, the board of directors shall cause to be conducted a reasonably competent and diligent visual inspection of the accessible areas of the major components that the association is obligated to repair, replace, restore, or maintain as part of a study of the reserve account requirements of the common interest development, if the current replacement value of the major components is equal to or greater than one-half of the gross budget of the association, excluding the association's reserve account for that period. The board shall review this study, or cause it to be reviewed, annually and shall consider and implement necessary adjustments to the board's analysis of the reserve account requirements as a result of that review.” While it is common practice for many HOAs to regularly distribute financials, including the reserve study, to all members of an HOA, not all do. If yours is one which does not then I would very strongly encourage you to get a copy, understand it, ask questions and be certain that your vital interests in the property are being maintained. Note that due to the experience required to perform an accurate reserve study, the board should only use specialists like those who hold the Professional Reserve Analysts (PRA), the highest credential available in the industry awarded by the Association of Professional Reserve Analysts. See www.apra-usa.com for a list of members who carry this credential. A properly prepared reserve study is both science and art. The science involves accurate costs, measurements and useful lives. The art recognizes the political dynamics of HOAs and members' desire to protect their castles. Not having one is tantamount to steering a ship without a rudder. Last, remember this…..the smaller the HOA, the more critical a reserve study is because the cost per owner generally increases. Obviously, I am bringing this to your attention because I believe this is an extremely important issue. I encourage you to review “California Reserve Study Guidelines”.

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