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RESERVE STUDIES & FUNDING

Reserve Studies Are Required


All associations, regardless of size, must prepare a reserve study (Civ. Code § 5550) unless the total replacement costs are less than 50% of the gross budget of the association, excluding the association’s reserve account for that period. (Civ. Code § 5550(a).) The purpose of a reserve fund is to repair, replace, restore, or maintain the major common area components. (Civ. Code § 5510(b); § 5565(b)(1).) The reserve study process can be simplified as follows:

  • A reserve company retained by the board identifies all major common area components, their cost to repair or replace them, and their remaining life span.
  • The reserve company calculates how much money is needed and when.
  • The board decides how to fund the reserves--whether through increased assessment contributions, special assessments, or a combination of the two.
  • The funding plan is annually disclosed to the membership in the year-end budgeting process.

Small Associations. Small residential associations, even as small as two units, must perform reserve studies if they have common areas--unless the total replacement costs are less than 50% of the annual gross budget. (Civ. Code § 5550(a).)

Independent Credentialed Reserve Analyst Recommended


The Davis-Stirling Act does not specify who should perform reserve studies for common interest developments. That means a CPA, a manager, or the board could perform it. However, an independent, credentialed reserve analyst is the best option for three reasons:

  • Expertise. Boards rarely have the expertise to evaluate a component's condition, its remaining life, and the cost of replacing it.
  • Liability. Boards should not take on potential liability. There is much less exposure to associations and boards to have an independent, credentialed specialist prepare the study. Depending on the extent of the common areas, preparing reserve studies internally arguably violates the Business Judgment Rule.
  • Politics. Having a specialist prepare the study also saves the board a lot of criticism. Homeowners who dislike the board will often challenge in-house studies by the board or a manager. Using a specialist eliminates such criticism.

The arguments for an independent professional are stronger when the association needs a “full” or “update with-site-visit” reserve study. Less sensitive “update no-site-visit” reserve study projects tend to be much simpler and less of a problem if done internally. Boards should ask prospective reserve study companies (i) if they are credentialed and (ii) how long they have been performing studies. Do they follow National Reserve Study Standards? The Community Associations Institute (CAI) issues a "Reserve Specialist" credential to qualified individuals. A similar credential is called the "Professional Reserve Analyst" administered by the Association of Professional Reserve Analysts.

Visual Inspection Every Three Years


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. (Civ. Code § 5550(a).) "Diligent" is not defined in the statute but is more than a cursory inspection. Black's Law Dictionary defines diligent as "attentive and persistent in doing a thing." In addition to "diligent," we must factor in what proceeds diligent, i.e., “reasonably competent," and what follows, "accessible areas."

  • Reasonably Competent. "Reasonably competent" does not require a particular professional license, but two national credentials are available to reserve study professionals. One is the Professional Reserve Analyst (PRA) administered by the Association of Professional Reserve Analysts (APRA). The second is the Reserve Specialist (RS) administered by the Community Associations Institute. Both organizations require a demonstrated background of training and experience in properly preparing reserve studies before they issue designations.
  • Accessible. Inspection of "accessible" areas does not mean tearing off roofs and opening walls. In my opinion, it means getting onto roofs, entering elevator rooms, opening electrical panels, and opening equipment service panels (such as on boilers) to obtain equipment information. NOTE: elevated structures are treated differently.
  • Disclosure. Finally, industry standards require that reserve professionals disclose whether a complete inspection or representative sampling was used, whether field measurements or plans/schematic take-offs were utilized and whether destructive testing was employed.

Annual UpdatesThe allocation of reserve items is not written in stone. Allocations are only projections and are subject to revision annually as roofs, boilers, etc., wear out at their own rates. As a result, boards must review the reserve study, or cause it to be reviewed, annually and implement appropriate adjustments to the reserve account requirements. (Civ. Code § 5550(a).)

Elevated Structures. Even though elevated structure inspections have a 9-year inspection cycle, they must be included in the association's reserve study and visually inspected every three years.

Inventory of Major Components 


A reserve study is not truly a "study" of the roofs, boilers, streets, etc. Instead, it is a list of major common area components with an estimate of their remaining useful life. As provided for in Civil Code § 5510(b), an association's reserve study must contain the following reserve component details:

  • Components. The study must identify major common area components the association must repair that have a remaining useful life of less than 30 years. Examples are roofs, painting, pool heaters, and asphalt repairs/replacement. 
  • Useful LifeThe study must identify the probable remaining useful life of the components. These are estimates since it is impossible to know the true remaining life of each component. Lifespans will vary depending on (i) the original quality of the component itself and (ii) whether the association has a program of regular preventative maintenance.
  • Repair Costs. An estimate of the future replacement costs of components must be included. Inflation should be factored into the estimate.
  • Reserve Contributions. An estimate of the total annual contribution necessary to defray the cost to repair, replace, restore, or maintain the components identified in paragraph (1) during and at the end of their useful life, after subtracting total reserve funds as of the date of the study.
  • Funding Plan. The study must contain a reserve funding plan to pay for future component replacement. The plan might involve monthly contributions to the reserve fund or a combination of contributions and special assessments.

Allowances. The study should list the items for major components with an unknown life, such as sidewalk repairs, plumbing repairs, slope failures, perimeter block wall repairs, etc., and add a reasonable dollar amount as a contingency. For example, an association with many slopes will likely experience a slope failure. The board should set aside a reasonable amount for a single failure, not a dozen. If and when a failure occurs, funds are available. Once repairs are made, the "allowance" for that item can be replenished. 

Duty to Fund Reserves


By statute, boards must impose regular and special assessments sufficient to perform their obligations under the governing documents, which include funding reserves. (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 Assessments for Reserves. 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). At its discretion, the board may 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).)

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 reserves were not required to be funded. The court disagreed and ruled that replenishing 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.)

Transfer Fee Limitations. Associations cannot impose fees on the transfer of real estate for the purpose of funding their reserves. 

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 reserves are, divide the amount of money actually in reserves by the amount that should be in the account. For example, if in year 5, you have $25,000 instead of the $50,000 called for by your reserve study, you are only 50% funded. Members can expect special assessments if reserves are in the 0-30% funding range. 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 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 in 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 consider inflation, interest earned, and other factors that will change from year to year. As a result, the actual contribution will fluctuate around the $10,000 figure.

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.

Required Reserve Disclosures


Required Disclosures. Boards are required to make the following reserve disclosures:

  • DeficienciesDisclose any deficiencies in the reserves expressed on a per-unit basis. (Civ. Code § 5565(d).)
  • Deferrals. Disclose whether the board plans to defer repairs or replacement of any major component, including a justification for the deferral. (Civ. Code § 5300(b)(4).)
  • Loans. Disclose whether the association has any outstanding loans with an original term of more than one year, including the payee, interest rate, amount outstanding, annual payment, and when the loan is scheduled to be retired. (Civ. Code § 5300(b)(8).)
  • Funding Plan. Prepare and distribute a funding plan that indicates how the board plans to fund the annual contribution to meet the association's obligation to repair and replace all major components. The reserve funding plan must be adopted in an open meeting. (Civ. Code § 5560.) Beginning January 1, 2009, boards must distribute their reserve funding plan to all members along with the association's annual operating budget, not less than 30 nor more than 90 days before the start of the association's fiscal year. (Civ. Code § 5300.) The summary of the association's reserves is not admissible to show improper financial management of an association, provided that other relevant and competent evidence of the financial condition of the association is not made inadmissible by this provision. (Civ. Code § 5300(d).)
  • Assessments. If the board determines an assessment increase is required to fund the reserves, the assessment must be adopted in an open meeting and separately from the adoption of the funding plan. (Civ. Code § 5550(b)(5).)
  • Form of Disclosures. Prepare and distribute specific reserve funding disclosures that comply with (Civ. Code § 5570.) NOTE: There seems to be some concern over paragraph (3) in the Funding Disclosure Summary, which requires a definitive "yes" or "no" answer regarding future events over which the association has no control. While it is helpful for members to find a clear yes or no answer, boards anxious about potential liability may add qualifying language stating the answer is only a projection. The association's attorney and/or reserve preparer can provide appropriate modifying language. Paragraph (7) also raises questions. It calls for a number of estimates for each of five years. If those estimates appear in the more complete 30-year Funding Plan, that document can be attached, more than satisfying the Paragraph (7) 5-year requirement.

Disclosure WindowThe disclosure must be made not less than 30 days nor more than 90 days before the beginning of the association's fiscal year. This is an improvement over the old requirement, which had a 15-day window for making the disclosure. For other disclosures, see the disclosure checklist.

Reserve Funding's 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 cost per square foot) of units in 100 comparable condominium associations to 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 those with weak reserves (under 30% funded). In general, the following factors are indicators of an unhealthy community association:

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 community association issues, subscribe to the Davis-Stirling Newsletter.

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