Updated: Sep 13, 2021
by Nico F. March
As we have seen recently within the financial markets, volatility is a part of life and within associations; it is also a part of life that all physical assets will deteriorate with time. You may remember the old saying “time is money," and this is very true when it comes to common interest developments, timeshare and community or homeowners’ associations. Most "major" components which the association is responsible to maintain will require replacement in a fairly predictable manner. But almost everyone forgets about the stuff they never see: infrastructure. Plumbing, electrical, sewage, gas lines, irrigation and myriad of other items most of us never think of until there is a catastrophe. In one Hawaii association we currently work with, this catastrophe will cost the owners $8.5 million to repair and replace their plumbing systems; a cost borne by current owners that could have and should have been reserved for previously. As most associations and boards are aware, the Reserve Study is one of the tools used to identify and prepare for these inevitable expenses, spreading out the contributions evenly over time (in a sound, businesslike manner), rather than irresponsibly ignoring the pending expense until the association is left with no choice but to special assess, increase dues unfairly or borrow money, leaving one unlucky set of owners.
As corporate officers, developers, managing agents, and volunteer Board Members have a fiduciary duty; and have been entrusted by their owners with the prudent care, investment, and utilization of association assets for the benefit of all stakeholders. It is irresponsible to ignore the reality of major, or even minor common area asset deterioration, so Board Members need to plan ahead for these inevitable expenses in order to maximize overall values, owner enjoyment, and provide budget stability.
Today, developers, many beleaguered from lawsuits and now declining housing markets, must also consider how to financially incorporate infrastructure reserves into their budgets and maintenance fees as soon as the project is in development. Since Reserve contributions typically make up approximately 25% of an association’s total budget, Reserve contributions are one of the association’s largest budget line-items. Because deterioration rates will vary due to location, member usage, maintenance patterns, weather extremes and material quality, and the Reserve Fund investment portfolio may also change due to changing interest rates or investments, ownership delinquencies, and Reserve expenditures. Keeping Reserve Funds properly and prudently invested and “on track” needs to be considered a dynamic, ongoing, even day-by-day project.
In our almost 40 years of serving associations, we have basically found only four ways to pay for Reserve expenses:
1) Ongoing, budgeted Reserve contributions
2) Special or Emergency Assessments
3) Loans or Lines of Credit
4) Deferred Reserve projects that inevitably reduce the value of the asset
The most effective way to properly fund Reserve expenses is through ongoing budgeted Reserve contributions. Ideally, these fees are “Structured” into a well formulated investment process and are protected via safe and secure investment vehicles and interest-bearing accounts. Keep in mind the return and principal value of an investment will fluctuate with changes in market conditions. Upon redemption, it may be worth more or less than the original investment. The key factor here is that the association be earning the highest returns with the lowest possible risk, as well as maintaining liquidity on these funds. When needed, Special Assessment funds are typically held only for a short time until expended, so interest earnings while they may be minor in comparison to long term earnings, are still important in order to help offset some of these overdue expenses. Loans and Lines of Credit usually involve paying interest to a financial institution, so if required, interest expense may be working against the association, depending on their tax filing status. However, in certain situations, a credit facility may be beneficial whereby an association may be able to deduct interest expense against their interest earnings. Finally, deferred maintenance and lack of regular refurbishments usually results in lower values or disappointing vacation experiences for all owners and is almost always the most expensive way in the long run to “pay” for ongoing projects at the association. (Read the full article and some eye opening side bar interviews/case studies here.)
Nico F. March is the Managing Director for The March Group, LLC.