There is no statute that specifically requires associations to properly fund their reserves. The legislature has repeatedly amended the reserve provisions in the Davis-Stirling Act and has had many opportunities to impose funding requirements but has not done so. Instead, it keeps increasing notice requirements.
Indirect Duty. An argument can be made that there is an implied requirement to fund reserves because boards have a duty to impose regular and special assessments sufficient to perform their obligations under the governing documents. (Civ. Code § 5600(a).) Setting aside sufficient funds to repair and replace major components is arguably one of those duties. In Raven's Cove v. Knuppe, the court held that the failure of the developer-controlled board to fund the reserves was a breach of the board's fiduciary duty.
Special Assessment. Boards must exercise prudent fiscal management in maintaining the integrity of the reserve account, and shall, if necessary, levy a special assessment to recover the full amount of the expended funds within the time limits required by this section. (Civ. Code § 5515(e).) This special assessment is subject to the limitation imposed by Civil Code § 5605(b) (unless the expenditures were for emergencies as defined by Civil Code § 5610). The board may, at its discretion, extend the date the payment on the special assessment is due. Any extension shall not prevent the board from pursuing any legal remedy to enforce the collection of an unpaid special assessment. (Civ. Code § 5515(e).)
Fee Limitation Argument. A member of the Foothills Townhomes Association sued his association claiming that a special assessment to fund the reserve account violated Civil Code § 1366.1 [now Civ. Code § 5600(b)]. He argued that it "exceeded the amount necessary to defray the costs for which it is levied" because there was no requirement that reserves be funded. The court disagreed and ruled that replenishment of the association's reserve account was a valid basis for a special assessment. The plaintiff also argued the special assessment was unnecessary because the reserves could be funded incrementally over time. The court again disagreed:
Whether the fund could have been replenished over time is irrelevant to whether the assessment exceeded costs for which it was levied. As a matter of law, an assessment does not violate Civil Code section 1366.1 [now § 5600] merely because the costs could have been recouped incrementally. Nothing in the language of the statute suggests that is so. (Foothills Townhomes v. Christiansen.)
Prudent Funding. Even though there is no mandate by the legislature to fund reserves, the prudent course is to fund reserves according to the association's reserve funding plan. To determine how healthy an association's reserve are, divide the amount of money actually in reserves by the amount that should be in the account. For example, if on year 5 you have $25,000 instead of the $50,000 called for by your reserve study, you are only 50% funded. If reserves are in the 0-30% funding range, members can expect special assessments. Associations in the 70%+ funding range are considered financially strong and special assessments should be rare. If the reserve account is over-funded, steps can be taken to bring it back into balance.
Fully Funded. The definition of 100% funding is confusing to many people. If your association's reserve study states that you need to replace your roof in ten years at a cost of $100,000, "fully funded" does not mean that you have $100,000 today. It means that you have $10,000 in the bank this year, $20,000 next year, $30,000 the following year, and so on until you have $100,000 on the 10th year when the roof is scheduled for replacement. It should be noted that the actual annual contribution for roofs would not be exactly $10,000 since reserve studies take into account inflation, interest earned and other factors that will change from year to year. As a result, the true contribution will fluctuate around the $10,000 figu
Underfunded. If reserves are underfunded and associations are faced with large-scale repairs, boards may have no choice but to levy a special assessment to raise funds needed to make repairs. To lessen the burden on members, associations often seek bank loans that allow them to make immediate repairs but spread the cost over 3, 5, 7 or 10 years so members can more easily pay for the repairs.
Effect on Property Values. The founder of Association Reserves, Inc., Robert Nordlund, conducted a study to see if property values were affected by the strength of an association's financial reserves. He compared the sales price (measured in price per square foot) of units in 100 comparable condominium associations to the their reserve fund strength (measured in % funded). He found that market values were 12.6% higher in associations with strong reserves (over 70% funded) than in associations with weak reserves (under 30% funded). In general, the following factors are indicators of an unhealthy community association:
- Deferred Maintenance
- Special Assessments
- FHA Lending Restrictions
- Lower Home Values
Recommendation: Associations with weak reserves should make a concerted effort to build strong reserves and, at the same time, raise the maintenance levels in the development. Doing so will increase property values.
ASSISTANCE: Associations needing legal assistance can contact us. To stay current with issues affecting community associations, subscribe to the Davis-Stirling Newsletter.