January 08, 2014

Why Are Reserve Accounts Needed?

Association reserve accounts are established and maintained by associations to hold funds for the long-term or deferred maintenance and replacement of any assets that the associations are responsible for maintaining. Generally these assets have a remaining useful life of less than 30 years. For example, an association might hold funds in a reserve account for the replacement of items such as HVAC equipment in a condominium building, for the repair or replacement of the roof on a community clubhouse, for the replacement of exercise equipment in an association’s fitness center or for other less obvious items, such as the replacement of property following windstorm damage. In the context of condo hotels, ample reserves are also needed for the replacement of all furniture, fixtures and equipment contained within the condo hotel units, particularly at a branded condo hotel where hotel brand standards must be maintained.

Are Reserve Accounts Required?

Requirements for the establishment of association reserve accounts vary from state to state and depend on whether the association is established under a condominium regime (including condo hotels and timeshares) or a community association regime. The requirements are also dependent upon the terms of the governing documents, such as an association’s declaration or by-laws. While it is a widely accepted principle that the establishment of an association reserve account is both necessary and prudent, the requirements for funding and managing association reserve accounts are significantly less clear. To complicate matters further, funding requirements for reserve accounts depend entirely upon the physical components of the subject property, and rarely are two properties identical.

What Is the Current Legislative Trend?

The current legislative trend is toward stricter regulatory reserve funding requirements. Like many states, the state of Florida has reserve account requirements in the Florida Condominium Statute, the Florida Homeowners’ Statute as well as Florida’s Vacation and Timeshare Plans Statute. For example, FS Chapter 718.112(2)(f)(2) provides that the annual budget of the condominium must include reserve accounts for capital expenditures and deferred maintenance, in addition to annual operating expenses, unless an exemption applies. FS Chapter 718.112(2)(f)(2) requires the following:

In addition to annual operating expenses, the budget shall include reserve accounts for capital expenditures and deferred maintenance. These accounts shall include, but are not limited to, roof replacement, building painting, and pavement resurfacing, regardless of the amount of deferred maintenance expense or replacement cost, and for any other item for which the deferred maintenance expense or replacement cost exceeds $10,000. The amount to be reserved shall be computed by means of a formula which is based upon estimated remaining useful life and estimated replacement cost or deferred maintenance expense of each reserve item. The association may adjust replacement reserve assessments annually to take into account any changes in estimates or extension of the useful life of a reserve item caused by deferred maintenance.

However, condominium association reserve accounts in Florida can be waived or funding of the reserve account reduced under two circumstances. First, prior to the turnover of control of an association by a developer to unit owners, the developer may vote to waive the reserves or reduce funding the reserves for the first two fiscal years of the association’s operation. Second, if the budget is adopted by a majority vote of the association members at a duly called meeting of the association, the funding requirements do not apply, and the association members can provide for no reserves or less reserves than what would otherwise be required.

In comparison, Florida’s Homeowners’ Association Statute at FS Chapter 720.303(6)(b) is somewhat more permissive and provides, in part:

In addition to annual operating expenses, the budget may include reserve accounts for capital expenditures and deferred maintenance for which the association is responsible to the extent that the governing documents do not limit increases in assessments, including reserves. If the budget of the association includes reserve accounts, such reserves shall be determined, maintained, and waived in the manner provided in this subsection. Once an association provides for reserve accounts in the budget, the association shall thereafter determine, maintain, and waive reserves in compliance with this subsection.

Despite the differences among various legislative requirements, the deterioration of common elements is an eventual certainty, and damage from extraordinary events such as hurricanes, wild fires and other natural disasters is a statistical likelihood. Thus, an under-funded reserve account could result in a disaster of a different kind for developers, board members and homeowners.

Who Is Liable for Under-funded Reserve Accounts?

The failure to adequately fund association reserve accounts can be costly to homeowners and could potentially result in legal action against the developer or owner-elected directors of the association. When there are budget shortfalls and inadequate reserves for a capital or deferred maintenance expense, the first step generally is imposition of a special assessment against the unit owners. This means that, in addition to regular monthly or quarterly assessments paid by unit owners, the unit owners are required to make additional special assessment payments to the association to cover the expense. In some cases, the association needs to borrow funds, if such loans can be obtained by the association, to supplement the revenue obtained from the special assessments. Borrowing funds, if they are available, adds the cost of financing to the cost of the underlying expenditure. In addition to the obvious financial risks to the association and the unit owners, there are also risks of legal liability. With current real estate market conditions depressed in many regions, and with the litigious nature of our society, developer boards as well as owner-elected boards are at risk for breach of fiduciary claims for failing to cause the appropriate funding of reserve accounts. A verdict against a director for a breach of fiduciary claim could result in personal liability of the director. This leaves developers, association managers, board members and homeowners wondering whether to pay now or possibly pay later.

Breach of Fiduciary Claims Gets the Courts Involved

State courts have begun to address the lack of proper reserve account funding. In January 2007, the New Jersey Superior Court, in Ebert v. Briar Knoll Condominium Association (N.J. Super. A.D. 2007), addressed reserve account funding issues. The unit owner alleged that the condominium association did not maintain adequate reserves for the maintenance of the condominium’s common areas. The association had a reserve study prepared in 2000 which provided the amount that the association should maintain in its reserve, but the association’s reserve contained less than one-third of the amount recommended. The Superior Court agreed with the unit owner, holding that the association had failed to provide adequate reserves for the maintenance of the common elements. The Superior Court added that the association breached its fiduciary duty “to preserve and protect the common elements and areas for the benefit of all of its members.”

How Are Reserve Accounts Estimated?

Reserve account studies assist in helping associations determine how much is needed to properly fund a reserve account. Reserve analysis from companies that specialize in performing and documenting this information is readily available. The state of California, Department of Real Estate, established guidelines in addition to its statutory requirements, and published the “Reserve Study Guidelines for Homeowner Association Budgets” www.dre.ca.gov/pdf_docs/re25.pdf just a few years ago (the “CA Reserve Guidelines”). The CA Reserve Guidelines are designed to “assist boards of directors of California common interest developments (CIDs) to better understand the preparation of the reserve study portion of the association’s annual pro forma operating budget ... and to assist buyers in understanding the financial implications of an association’s replacement reserve funding.” The CA Reserve Guidelines explain the purpose of reserves, and include a step-by-step procedural manual for estimating reserve account needs and properly funding the accounts. The CA Reserve Guidelines describe various reserve account models. The “Unfunded & Special Assessment Model” description states the obvious about unfunded or under-funded reserves, in particular that the lack of reserve funds is likely to result in special assessments against unit owners:

Unfunded & Special Assessment Model: This is the default model in place in many associations today. The association does not have reserve balances that will cover expected replacement costs, and the only recourse is to schedule special assessments to cover these costs when they are due. Lack of information about needed special assessments is a real problem for some common interest development owners. One-time costs impose an additional financial burden on owners who often have chosen CIDs for cost reasons. This is the riskiest of the models, and could jeopardize the financial viability of the association if assessments cannot be raised when needed.

Reserve Analysis and Proper Funding Are the Key

Comprehensive reserve analysis and prudent reserve account management should be utilized by each association to maintain adequate reserve account funding. Taking these steps will help developers, association managers and board members avoid situations in which disgruntled unit owners are looking to make somebody else pay.