Reserve Studies and Reports > Reserve Study Primer

Simply put, Reserve, or as some prefer, Replacement Funds are those monies set aside to pay for major expenses associated with the replacement and/or repair of assets. Thus, a reserve study is a financial plan which defines the payments to the reserve fund that are necessary to ensure that the monies are available when the expenses occur. Its objective is to distribute the cost of each repair or replacement over the life of each component.

The origin of the concept of Reserve Studies can likely be traced to the California Department of Real Estate. In 1975, the DRE distributed its first publication designed to aid real estate developers in their submission, for department approval, of an initial budget the for common interest developments they were establishing. The initial budget had to address operating expenses which focus on such day-to-day expenditures as utilities, management company fees, taxes, landscaping and pool service. In addition, it also had to address an allocation to a fund to be used for large-ticket expenses that occurred on a frequency of two years or more and could reasonably be expected to occur at least once during the life of the homeowners' association.

The fund was known as a Reserve Fund because its purpose was to reserve monies for large periodic expenses associated with the replacement of the commonly-owned assets-those items which are owned by all of the members of the community. Typically, those expenditures include re-roofing, painting, slurry sealing and overlays for asphalt streets and parking lots, resurfacing swimming pools and spas and replacement of fences. Of course, expense categories vary from one project to another.

Defining the size of the Reserve Fund and the annual payments needed to maintain it is accomplished with a Reserve Study. An initial Reserve Study includes two major tasks: the Component Analysis and the Financial Analysis.

The Component Analysis begins with an inventory of the components which are the responsibility of all owners to repair and replace. Usually, the association's governing documents define, at least in bold strokes, those components which should be included in the inventory. After establishing the inventory, the current condition of the included components should be assessed so that their individual remaining lives can be estimated. Finally, the estimated total useful life and current cost of each component must be determined.

The Financial Analysis is essentially a long-term financial plan for the association. It uses reserve component cost and life data from the Component Analysis and financial parameters including estimates for inflation, allowable year-over-year assessment increases, rate of return on invested funds, the desired contingency and the existing balance in the reserve fund. Standard financial equations applied to the data, result in a funding schedule necessary to meet the anticipated replacement expenditures.

While the California Department of Real Estate may have started the "reserve ball rolling," a number of states have adopted legislation which, like California, require common-interest associations to perform reserve studies on a periodic basis or require associations to maintain a reserve fund. In addition, the American Institute of Certified Public Accountants' Audit and Accounting Guide for Common Interest Realty Associations (CIRA) recognizes the need for funding of reserves stating that "Above all, boards of directors need to be aware that the goal of whatever policies they set should enable them to meet their fiduciary duties to maintain and preserve the common property."

Common-interest developments are still the primary users of reserve studies, however, other organizations are increasingly finding value in the budgeting tool. Schools, churches and businesses including the hospitality industry have found the projection feature of reserve studies valuable to complete the budget picture and to avoid being blind-sided by major expense spikes that can occur when repairs and replacements which occur on one cycle unexpectedly coincide with those on another cycle.

The frequency with which a Reserve Study should be performed is a debatable issue. California legislation, known as the Davis-Stirling Common Interest Development Act, states "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 which the association is obligated to repair, replace, restore or maintain as part of a study of the reserve account...." Absent legislative requirements, it is probably prudent to revise the reserve study when:

• severe weather or other "acts of God" may have reduced the life expectancy of major components such as roofs or painting,
• high cost components are nearing the end of their estimated useful lives and substitution of actual bid costs for estimated costs is appropriate,
• costs of one or more components increase at a rate substantially more or less than the rate of inflation,
• reserve fund contributions have not kept pace with the recommended rate,
• and/or items of significant value are either added to or eliminated from the community.