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Back to the Future Reserves

De je vu all over again.  If there is one thing I can predict, is the eventual discussion with the board over the treatment of long term assets in the reserve fund study report.  How do you reserve for site infrastructure common elements with an expected useful life of 50 or more years?  For that matter, how do you treat the poured concrete foundation with a projected life of 100 years?

In Maine these types of issues become even more interesting due to the demographics of the large inventory of urban apartment buildings over 100 years old before they were converted into condominiums.  It always raises the issue what a reserve fund is all about.  Is it an exercise in good accounting for the future or is really a financial analysis of the investment funding unit owners are making to protect their net worth?

Some of these questions are answered in CAI’s instructions on best practices in reserve fund planning.  CAI suggests using one of two basic approaches to the reserve planning, namely, a Component Based or a Cash Flow based financial model.  There are sub-sets and variances of these models such as fully funded; percent full funded; baseline funding; and threshold funding but let us not go too deep into these methodologies.  Also, keep in mind some condominiums are required to use one method or the other due to statutory or covenantal funding requirements per their documents or the state they reside.  That being said, let us first focus on Component Based funding which considers each common element the association is responsible to replace in the near and distant future.

This method is similar to the familiar accounting term, depreciation.  That is, the replacement value of the asset is divided by the expected useful life and this cost component is put into each year of the spreadsheet.  As an example, if an infrastructure item such as the storm water drainage culverts were valued at $200,000 with a life of 50 years then you would set aside $4,000 each year for your study year period, say 30 years.  At first thought, this seems to make sense, but I do not recommend it.

True, this is the most conservative method of funding but in my experience this method of funding will find the association holding more cash reserves than absolutely necessary for prudent management of its financial obligations.  Instead, I suggest the association use the cash flow method where the estimated capital expenditure is placed in the spreadsheet in the anticipated year(s) for only those common elements requiring replacement in the study period.  This of course is compared to the yearly reserve contributions over the same study period with all numbers adjusted for estimated investment returns on the reserve balances and inflation.

So at this point is where the board debate begins.  Assuming the cash flow method is being used, the question arises about what to do with the long term common asset in a 30 year study requiring replacement in Year 31.  Do you extend the study to 31 years or just ignore the capital expenditure till the next reserve fund study update?  I suggest the latter.  I would also suggest this Year 31 expenditure be mentioned in the report narrative even though it has not been included in the spreadsheets so both current and future boards recognize this future issue.  Secondly, an allowance on a selected year(s) to provide funding for unforeseen problems due to premature deterioration of the asset or damage not covered by insurance.  As a further safeguard, the board may wish to set a minimum funding threshold balance in each year of the study.

Though we started this discussion by considering extended life common assets such as foundations and buried infrastructure, similar problems arise with siding and other visible building envelope items.  Many siding products have useful lives over 35 years yet experience shows these product fail due to unforeseen environmental issues; lack of maintenance; or initial workmanship problems.  This is why it is imperative the building committee periodically survey the building envelope(s) or mandate regularly scheduled reserve fund updates to catch small problems before they expand.  It may be true an association’s crystal ball cannot foresee all unwanted events; but it can manage the future with a well thought out plan.

 

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Article written by Jack Carr, P.E., R.S., LEED AP, Criterium Engineers

Published in Condo Media, February, 2016

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