Underfunded reserves are one of the most critical issues facing condominium associations today.
While there are a million and one reasons why this problem is so pervasive across the country, ultimately the root cause comes back to a condo board’s overly optimistic or poorly informed view of what it costs to maintain the common elements of their community.
Case in point. When talking to other condo owners or board members about how they are funding their reserves, many of them reference Fannie Mae’s “10% of operating budget” requirement as the funding method they use. For those not familiar with this requirement, Fannie Mae has an extremely rigorous set of requirements that a condominium must meet before it is eligible for them to underwrite a mortgage.
One of those requirements states that “… a minimum of a 10% dedicated expense allocation in the budget to a replacement reserve for the future repair/replacement of the project’s major components”. On the surface, this seems like a logical funding approach for a board to take (If it is good enough for Fannie it’s good enough for us!) however many boards seem to gloss over the fact that the 10% requirement is a “minimum” amount.
To take this a step further, I thought it would be useful to see how the “10%” method would play out in a real world scenario. In the example below I used an actual reserve analysis generated using our HealthyReserves application and modeled the annual reserve contribution at 10% of the operating budget over a 30 year period.
This community is relatively new (2018) and consists of 45 townhomes. The original reserve analysis was done several years after handover from the developer in 2022. For purposes of this exercise, we're going to use the exact set of objectives, assumptions and common expense elements.
Note: The property name has been changed for this exercise.
Step 1: Setting Objectives.
The first step in the process is entering the association's funding objectives and background information related to items such as their current reserve balance, assumed interest rates, etc.
Step 2: Generate the Component Inventory
As you can see in the image above, after generating the component inventory this community had $2.1M in estimated common elements replacements over the 30 year period.
Step 3: The Funding Plan
For this test case we used the initial year’s (2022) operating budget of $445,000 and then an applied our assumed inflation rate of 3.5% on a YoY basis. Annual reserve receipts are calculated based on that number at a 10% contribution rate.
The result? A Sea of Red ! Where to even begin trying to sort this out. If you recall, we set our funding objective to maintain a minimum % Funded of 70% and right out of the gate in year 1 we are only at 48% and it only gets worse from there.
But that’s not even the biggest problem. If you look at the Year End Balances for the first 12 years in a vacuum, you can see how a board could misguidedly see six-figure balances and feel that they have a pretty good handle on managing their reserves. This is a major risk and it happens more often than you might think.
To give you a sense of how far off this 10% model is, take a look at the funding plan below which is the actual funding plan that was put in place by this community. Look at the the difference in the Annual Reserve Receipts and you’ll notice that the actual funding plan is almost double that of the 10% model!
While this is only one example of utilizing the "10%" method for funding reserves, it is instructive of the hidden risks an association can encounter especially when an association has responsibility for big-ticket common items such as roads, roofs, decks, etc.
If you’re considering using the “10%” method to fund your reserves, make sure you have a clear picture on what your replacement expenses will look like over a 30-year period.
Without this visibility you may be significantly underfunding your reserves and heading for a large special assessment to make up the shortfall.
Dave Cloyd is the President of HealthyReserves. In addition to being a former board member of his HOA, he also serves on both the finance and infrastructure committees.
He can be reached at dave@healthyreserves.com