HOAs are required to have reserves. These are earmarked for capital improvements and accumulate as savings. The BLMH reserve study has a 30 year horizon. It compares the collection of fees as reserves and the spending for each of those 30 years. Some items in the reserve list require decades of savings.
BLMH is currently in the middle of the cycle for roof replacements. The association has been saving vigorously for about a decade for these roofs. So too for other reserve items.
A question for all HOAs is where to safely put those savings? Safe investments such as Certificates of Deposit (CDs) and insured savings accounts have had very low returns in recent years.
Low returns on savings has had a real impact on the savings of associations and the fees that are collected to accomplish the capital improvements. There is no doubt that fees for HOA owners are higher today than they would otherwise be, if a reasonable return on savings was possible. Recent CD rates were as low as 0.2% which is ridiculous. Inflation has been low, but it has been consistently above the returns of most CDs. In other words, the value of the principal of the CD is decreasing and it is losing purchasing power at these abnormally low rates. The financial panic of 2008 and the implosion of residential real estate has been a disaster for many condominium owners. It has put additional financial pressure on boards.
Reserves and Savings
The reserves are not a constant thing. They are evaluated periodically, are collected monthly as part of owner fees, accumulated in savings and then spent a year or more in the future. I prefer to evaluate reserves annually, as part of the budgeting process. Professional reserve study updates and re-evaluations occur less frequently, perhaps at 5 year intervals.
It is true that a portion of the reserves can build up over a decade or more. This is for large, infrequent and sometimes expensive projects such as roofs and street replacement, which should occur only once about every 20 years. (Note 4).
HOAs have the choice of saving gradually over that 20 year period, or having spectacular special assessments. If saving gradually, then these reserve amounts are a portion of an owner's monthly fees and must be accumulated in a savings account or other safe investment. For example, at BLMH the amount saved for the current roofing project per unit owner per roof using a 20 year replacement schedule is about $22 per month. That's the monthly amount for the next cycle, because the assumption is we have 20 years to accumulate the necessary amount. For current roofs, of which the remainder should be replaced in three years, the savings rate has been much higher and a larger amount has been in the fees.
In other words, for roofs replaced in 2008, 2009, 2011, 2012 and 2013 the association should be setting aside an amount via reserves for the next replacement. BLMH should be setting aside about $165 each month for each roof as reserves for the next replacement. That's about $4,500 per month for these roofs for the next replacement which will commence in about 15 years, or 2029. Once it has begun the next replacement will continue for about 8 years (Note 3). . For roofs being replaced as part of the current cycle, which is all roofs to be replaced by 2018, the association should have about 85% of the cost of these remaining roofs "in the bank." If not, then the HOA does not have sufficient funds in reserves. According to the financial documents BLMH is collecting and saving at a rate sufficient to complete all roofs by 2018.
This is true also for the replacement of streets in the association. Savings for streets over a 20 year span should be at least $2,600 per month. That's about $7.75 per owner per month. A similar approach is used for street lighting, driveways, patios, garage floors, entrances, water mains, sewers, walks, streams and so on. Those mailboxes will not last forever and neither will the intercoms. Of course, if a HOA has insufficient reserves for specific projects, then the amounts collected each month for these reserve items must be higher. This is called "catching up" and reserves can be built in fewer years via higher fees. Of course "catching up" requires larger monthly fees. For example, doubling the amount collected for roof reserves will accomplish the same goal in 10 years that would otherwise take 20; but that means the monthly portion of fees for roofs increases from $27 to $54 per owner. Alternatively, and if shorter timespans are available the HOA can resort to special assessments.
As these savings are accumulating, the association puts these funds in "safe" investments such as CDs. It might be possible to purchase treasury bills, but these are not as liquid or as convenient as CDs. It is also a requirement that these reserves be accessible. While the plan might be to save for roofs, the funds or a portion thereof may be used for other, legitimate and more pressing reserve purposes. In an "emergency" the association can borrow from reserves. However, such borrowing must be repaid.
Unfortunately for us savers, the policies of our national government and the Federal Reserve Bank (the "Fed") have penalized savers. This has been deliberate, as the intent was to have savers free up those "safe" assets and put them into riskier places, such as the stock market. That is not a place for short term funds. Experts suggest no money needed in less than 5 years ever be put into such risky assets. As a fiduciary, a board member is in a special place, entrusted with preserving the assets of the association. As individuals we may feel confident in taking certain risks. Fiduciaries are held to a higher standard.
The Problem with Low Returns on Savings
The problem for individual savers and HOAs is identical. Saving and accruing interest is intended for a purpose and as an offset for inflation. This is not simply an exercise. For example, savings accounts have been giving about 0.5% per year (or less) while inflation has been running about 2% in recent years. That difference has real consequences over a period of 10 or 20 years.
Let's assume that an association has a goal to save $7,000 over a period of 20 years in a reserve fund for a specific purpose. How much would the association save each year to accomplish this?
The return, or interest on the account in which the savings are accrued makes a difference. Recent years have had returns of 0.5% or 1/2 percent per year. Here are the amounts to be saved per owner at different interest rates to achieve that $7,000 in 20 years. I'm using the closest whole dollar amount to get to within that $7,000:
Interest rate 0.50% = $333 per year = $6,986 saved after 20 years.
Interest rate 1.00% = $317 per year = $6,980 saved after 20 years.
Interest rate 1.50% = $302 per year = $6,983 saved after 20 years.
Interest rate 2.00% = $288 per year = $6,997 saved after 20 years.
Interest rate 3.00% = $260 per year = $6,986 saved after 20 years.
As you can see above, a better return at 3% per year via CDs may require one to save $73 less per year to achieve the same savings goal. This might seem a trivial difference. It is only about $6.08 per month. However, if the amount to be saved is much larger as might be required for a very large project, the numbers become significant. For example, if the amount to be saved over 20 years is $700,000, the difference in interest accrued per year is $7,300 or $608 per month. In a HOA with 300 owners, such a difference is about $2.00 per month in fees. This is however, only half of the problem facing HOA savers.
Inflation and Future Costs
The other half of the problem is the reason for such saving. In my example I set a goal of saving $7,000 in 20 years. Inflation, which is defined as an increase in cost or services over time, may not allow us to achieve our goal. Why? Because it is necessary to anticipate the future cost after years of inflation and to save to reach that future price, which is our target. To do this it's also necessary to estimate inflation. Actual inflation is an unknown. So we're saving an amount each month for 20 years with the anticipation that the price of whatever it is we are going to purchase in 2034 will match the amount saved.
This doesn't always happen. In 1969 I purchased a new automobile for $1,800. 10 years later a similar new car was about $5,000. If I had been saving for a new car with the expectation it would cost about 2% more each year than the previous one, in 1979 that automobile would have had a price of only about $2,200. I would have been far short of the actual cost because the inflation in the price of the car was about 10.75% each year. Such disruptions do occur from time to time and when they do, they wreak havoc on personal plans. So too for HOAs.
All things being equal, if the return on savings and the amount or rate of inflation are identical, then we should not be concerned. The cost of whatever it is we want to purchase in 20 years will be roughly equal to what we have saved. (Note 1). However, to determine the amount to save each month commencing in 2014 we must predict the cost of that thing in the year 2034.
This exercise has real consequences for the unit owner. If we guess correctly, then everything works. If we are wrong, then there can be ugly consequences. For example, if the price of something suddenly increases, and commodities such as oil are a good example, then real, long term inflation may be higher than the returns we are getting on our savings. The cost of oil impacts everything from asphalt for streets to shingles for roofs. It also impacts the costs of other goods and services.
It's obvious that it will require a series of boards, working diligently over decades to accomplish reserve goals. I'd also suggest that it's equally obvious that some unit owners may not have the patience or financial fortitude for such long term planning.
For capital projects, 2.2% is sometimes used as the real annual inflation for the costs of such things as roofs. In other words, a roof that costs $30,000 today could actually cost about $45,361 in 20 years. HOAs need to save for those future costs. A failure to do so can result in special assessments or continuous, larger than expected annual fee increases Or, it may require a ramping up of fees for a decade or so to "catch up." Does this seem familiar? It should be for unit owners at BLMH. (Note 2).
In my example, we assume that the return on savings, such as CDs is equivalent to the increasing costs of a roof due to inflation. If the returns are very low, as they are today, then there is a real danger that reserve collections on "autopilot" will be insufficient. That is the strongest argument for revising and updating reserve studies every 5 years. Another argument is the change in the infrastructure of the HOA over time. With this information in hand the amounts collected as reserves and saved can be adjusted if necessary. Such adjustments can result in a "glide path" which avoids a lot of financial pain or special assessments. Owners need to decide; would they prefer disruptive swings in fees and/or special assessments? Or gradual increases to achieve the necessary financial goals? Owners do elect the boards that make these decisions and each board member and every board does make a difference, for better or for worse.
CDs for HOAs and Unit Owners.
Most HOAs build CD or bond ladders. So do a lot of savers and many retirees have a portion of their financial assets in CDs.
When using CDs, the funds are placed in varying maturities. This is called a "ladder." Our HOA, for example, has CDs currently maturing in months to 4 years. Some of these were purchased one, two, three and four years ago. As these CDs mature the funds that are released are either spent on current reserve projects or are used to purchase new CDs with maturities of 4 or 5 years. This approach provides both liquidity and access to varying rates. Those rates hopefully are in sync with true inflation. The liquidity is necessary because when those large projects occur, such as the Lakecliffe repaving, some funds from CDs will be moved into savings for spending in the current year. Other CDs as they mature can be "rolled over" to purchase a new CD as the current rates. We hope the new rates will be higher than the old. The goal is to get as high as possible safe return on our savings.
Early withdrawal from a CD is to be discouraged. Such a CD is said to have not yet reached maturity. Early withdrawal of such a CD may result in significant penalties. However, some banks do allow early withdrawal, but accrued interest may be lost as a bank fee.
This chart is an example of laddering in a HOA. It compares the months to maturity to the value of the CD which is shown as percent of the total funds in CDs. In this example the months to maturity range from 0.6 to 48.2. In other words, there is a CD coming due in less than one month and the longest duration on the chart is a bit over 4 years. The chart has thirteen bars, one for each CD. In the example if a HOA had a total of $100,000 in this CD ladder, then in this chart a CD comprising 10% of the total value of the CDs would have a value of $10,000 plus accrued interest (10% of $100,000 is 0.10 x 100,000 = $10,000. A CD comprising 15% of the total would have a value of $15,000, and so on). HOAs should track their CDs and there are a number of ways to do so. The chart is based on a real spreadsheet used at BLMH which lists each CD, the value of the CD, the maturity date and so on. Those numbers are generated by management and the treasurer and included in the monthly HOA reports.
Alternatives to CDs
It could be possible for a HOA to purchase bonds which might provide a higher return than CDs. Some funds are put into reserves for very distant projects. The next cycle of the roofs, for example. It would be possible to purchase bonds with 10 to 15 year maturities each quarter with the funds earmarked for those distant projects.
Low Interest Rates Penalize HOA Unit Owners
Is the current interest rate environment important? Yes, it is and it has been since 2008. The interest rates on passbook savings has been less than the rate of inflation. HOAs and unit owners use passbook savings for short term funds.
In my example, we are using a return on savings that is less than the projected cost increases. Recently, returns on CDs were as low as 0.2%. This has gradually improved, but at current rates of about 1.8%, and with projected annual cost increases of 2.2% there is a need to save more to make up for that difference in return on the CD and inflation. In other words, unit owners are paying higher fees today because of the low rates provided by banks and other "safe" institutions.
How much higher? Here's an example using a very large roof. Now, don't use the cost of the roof as a fact at BLMH. It's an example. So let's assume the replacement cost of the roof today is $30,000. Using inflation of 2.2% per year, this roof will cost about $45,000 in 20 years. Of course, the HOA is saving for this future event and if those savings accrue a reasonable return, that interest if also saved will offset the future cost of the roof.
So how much should it set aside from owner's fees each month for this? With CDs yielding 1.8%, the amount to be saved will have to be about $156 per roof. Unfortunately, in recent years the return on CDs has been as low as 0.2%. In this example, such a low return requires a savings of $180 per month for each roof.
Unit owners are paying higher fees because of the policies of our government and the lower returns on savings. In my roofing example, the additional amount required to collect per roof per month is $24. At BLMH we have 40 large roofs and 4 smaller ones, so let's use 42 roofs in this example. The HOA would have to save $1008 each month in reserves for roofs.
If the HOA doesn't do that and attempts to catch up for a previous failure to achieve the required savings rate, then the amount to save each month could be $2,000 or more. Add to that anything else that has languished in reserves. Also add make-up amounts for foreclosures, which include fees never collected, and legal costs for dealing with foreclosures, energy increases, maintenance cost increases, insurance increases, etc. and voila, we have the basis of the current fees and the annual fee increase.
Notes:
All dollar amounts are approximate and are provided as examples. It would be improper to assume that this post accurately depicts the reserve finances of the BLMH HOA. I have not rechecked all of the numbers for accuracy.
Note 1. In my example, which is simplified, I stated that if the rate of inflation and the rate of return on savings are equal, we should achieve our goal. That is inaccurate, but I simplified. In my example, we are attempting to accumulate $7,000 for something we assume will cost $7,000 20 years in the future. However, if we use 0.5% inflation as an example, then the current cost of something would be $6,300 and if it increased in price at 0.5% per year, it would cost $6981 in 20 years. we are attempting to save an amount equal to the projected cost of something 20 years in the future.
If something costs $7,000 today and inflation is 2.8%, then that same thing, be it a roof or whatever, will cost $11,829 in 20 years.
Note 2) The notes in my post dated January 11 included this information. Has "catching up" been a factor in the fee increases at BLMH since 1998?
- Fees for the initial 5 years of this association fees increased at an average of 19.2% per year. In my opinion this is not unusual. The transition from developer to HOA owners is frequently accompanied by some difficulties in determining actual annual budgets.
- For the period 1983 through 1992 the average increase was 3.2% per year.
- For the period 1993 through 1998 the average increase was 3.5% per year.
- With new professional management which used a different approach to budgeting for reserves the average fee increase was 8.575% per year for the period 1999 to 2007. I purchased in 2001 and closed in 2002. For the previous four years the average fee increase per year had been 9.25%.
- In 2008 with a partial board change the fee increase was reduced to 5.5%.
- In 2009 the fee increase was 5.1%.
- In 2010 with the transition to the new board fully accomplished, the fee increase was 0%.
- In 2011 to correct for budget shortfall and after a new reserve study the fee increase was 7%.
- In 2012 and beyond fee increases have averaged about 2.6% per year.
- For the 2014 budget the fee increase was 1%.
For calculating the future costs of capital projects, inflation rates of about 2.2% are frequently used. Of course, we can adjust over time. So savings for a 20 year future event should be reviewed about every 5 years. That is the role of the reserve study.
It's somewhat like driving a car. We look at where we are on the road and adjust the steering wheel. The reserve study accomplishes the same thing. At specific intervals a professional compares the savings for such things as roofs to the current condition of the roofs and to the anticipated cost of such roofs at the time of replacement. The amounts saved to date is subtracted from the anticipated future cost. The difference is divided by the number of years available to save that amount. That provides a rough idea of the annual savings required. The annual amount of savings achieved is determined by adding fees plus interest from CDs or other savings instruments.
What's an appropriate interval for a reserve study? It's a balance between spending the fees for the reserve study and the information gained. If the goal is to avoid reserve "surprises" which can result in large fee changes or special assessments, then a more frequent reserve study update is preferred. That's my opinion. It's also possible to over collect, but in HOAs where the emphasis is to "keep fees as low as possible" that's not likely. Some years ago and prior to the 2011 reserve study the board was considering a formal study by an outside consultant. Management cautioned that such a study might "open Pandora's box." I took this to mean that the consequences might be ugly; perhaps a special assessment would be recommended and/or a very large fee adjustment. Nevertheless, the board decided to proceed. I suspect this is the dilemma facing many HOAs which do no have a current reserve study. It's my opinion that the developer of any new condo or HOA development should be required to provide an initial reserve study prepared by objective professionals unattached in any way to the builder or management. Then HOAs would start on the right footing.
Note 3) When discussing savings for reserves, it's useful to know why those savings are necessary. We do expect the new roofs to achieve a life of at least 20 years. However, for planning purposes it's prudent to save for only a 20 year life span. If they last longer, great. If they require repairs at 20 to achieve a longer life, then the board at that time can choose to alter budgets and reserve contributions and put the funds into the Operations and Maintenance budget for a few years to handle repairs to extend the life of the roofs. In the end, overall fees may be the same. What will be different if current boards do a good job is the future board will have some flexibility, the association should be able to avoid special assessments and fee increases should be stable. That is assuming that future boards stay the course. Investors may see this differently and investors may some day control the board.
Note 4).Projects such as roofs and street replacement may occur once each 20 years. These projects are completed in increments because it is impractical to do all roofs or all streets in one year. Roofs are replaced with a project duration of about 8 years. Streets may be replaced over a period of 5 years. This provides the HOA board with a few years of "last minute" reserve adjustments. However, it's important to realize that the reserves are only a portion of the owner fees. Operations & Maintenance budgetary needs can put additional pressure on boards. If reserve accumulations are lagging and there are unusual expenses in a year or a few years, as could occur with water main breaks, emergencies or bad weather (double the anticipated snowfall or large price increases for snow melt, for example) then such forces, in combination, may result in spikes in fees.
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ReplyDeleteThank you for your comment and observations. In fact, I am a professional problem solver and communicator. In a HOA there are problems to solve and a need to communicate to the owners. I actually abhor writing. However, it is a necessity and a means to an end.
ReplyDeleteI do enjoy travel videos, and blogs about that. But anything and everything I do about HOA living, finances, operations, maintenance and projects is real work.