2008 Issue 7

FUNDING CAPITAL PROJECTS
By Raymond R. “Russ” Fernandes

Our parents always taught us to “save for a rainy day.”  In the world of community associations, the rainy day that we need to save for is really when any capital replacement project is needed.  Without adequate funds available to perform needed replacements and repairs, the desirability of a particular property will suffer – along with its property values.  An important tool for funding such capital replacement projects and maintaining the value of a community association property is the Capital Reserve Fund. 

We should begin by defining a capital reserve fund. A capital reserve fund is an investment vehicle, typically funded monthly, to build the funds necessary to pay for the replacement of common element capital items. Funding this account, on a regular basis, should help prevent the need for special assessments, borrowing money, or being unable to perform necessary projects on a timely basis.  Making sure that the reserve fund is adequate is the purpose of the Capital Reserve Study.

The Capital Reserve Study would list the common element items that would usually be included in a reserve fund, typical items would include roofing, asphalt paving, concrete flatwork and curbing, and mechanical equipment such as common HVAC equipment.   Other items might include balconies, decks and pool equipment.

Why is a reserve fund important? The reserve fund helps to ensure that the value of your property is preserved or improved. Also, mortgage lenders often recognize the condition of having inadequate reserves. As a result, capital reserves are directly related to the security and risk of the lender’s investment, and the marketability of the homes within a given community or building. The Capital Reserve Study, as a tool, is invaluable in helping a Board fulfill their fiduciary duty to the association.

Under-funding a reserve account can be dangerous, but over-funding can also put an unnecessary burden on the ownership. So how do you know how much of a reserve is needed? The best way is to have a CAI designated professional Reserve Specialist (RS) perform the Reserve Study.

The capital reserve specialist has expertise in engineering and financial planning and will methodically assess the age and condition of each common element of the property, analyze the reserve fund for accuracy and adequacy, and recommend future fund levels.

When preparing a reserve study, typically only items with life expectancies of 30 years or less are included in the fund.  Items with expected lives that are greater than 30 years, such as building structures, piping systems and electrical wiring are usually replaced during a major renovation and financed at that time.  Including these items would result in an unrealistically high recommended annual contribution to the capital reserve.

The capital reserve fund is also not intended to cover annual maintenance expenditures.  However, expected lives are based on the assumption that proper annual maintenance is being performed.  Therefore, annual maintenance should be included in an Association's maintenance fee.  Without proper maintenance, accelerated deterioration can be expected, with shortened lives.  It should also be noted that it is only possible to reserve for future expenditures and that a current need must be financed separately by borrowing or assessments.

The Capital Reserve Study develops a recommended basic annual contribution based upon current replacement costs.  Inflation may increase future costs, and the accumulation of interest on the reserve fund deposits increases available funds.  Since a truly accurate projection of these factors is not possible, assumptions are made via cash flow projections.  For example, the effects of inflation and interest are shown via cash flow projections using several inflation and interest rate examples.  Also, accurate reserve funding requires regular updates to keep pace with cost increases of the reserved items.

In preparing such a study, the reserve specialist would normally review the master deed and offering statement to identify the common element items.  Quantities of the items to be included in the study would then determined by field measurements and a review of available building and site plans.  Cost estimates would then be developed from published industry standards.  Finally, remaining life expectancies are assigned to each of the included items based on available industry data and an analysis of the physical condition.  Once a reserve study is done, the specialist will provide you with a professionally prepared document to use as a guide for the years to come.

How long is a reserve study good for? The Community Association Institute recommends that reserve studies be reviewed annually and professionally updated every three to five years.  However, recent volatility of petroleum products has resulted in cost increases of construction components that far exceed normally expected price increases in the industry.  As a result, it is likely that many existing reserve studies are outdated.

To determine if it is time for an update consider these factors: Has the community initiated any significant repair or replacement projects? Has there been noticeable acceleration of aging of the common element components? Has inflation or interest rates varied significantly since the most recent study?  As communities age, the maintenance burden will increase along with the need to keep the available funding at an appropriate level.  By keeping the reserve study updated, unplanned expenditures can be at least minimized, if not eliminated.

Russ Fernandes, RS is a principal owner of Becht Engineering BT, Inc serving the Engineering and Capital Reserve needs of Community Associations throughout the Northeast and Mid-Atlantic states .  Russ is a Past President of the New Jersey Chapter of the Community Association Institute and has earned the CAI’s Reserve Specialist (RS) designation.  He is a frequent speaker at CAI-CT education programs.