Reserves programs really are important

According to the 2001 Balance Sheet I was given just prior to my closing, this HOA put about $57,000 into reserves that year and had a reserve balance of about $295,000 at year's end.  That was not a good thing.

Here's a chart summarizing the fee situation at BLMH. This is from my personal files. Prior to 2009 I did what many owners do, which is to insufficiently question the decisions of the board, or I simply acquiesced to board decisions. By January 2009  that changed and I had taken an active role and shortly thereafter I achieved a board position despite the very forceful resistance of some owners and board members. There are additional charts later in this blog post.

Since 2010 I've spent a significant amount of time in financial planning and analysis for this HOA. The emphasis has been about condition of infrastructure, identifying problems, identifying and implementing solutions, setting priorities, reinvigorating dormant maintenance programs and developing viable financial plans necessary to achieve maintenance goals. This while avoiding the stressing owners, if possible. Some of this, such as the mega dollar roofing project, was begun by others and handed to me to complete.  The 2002-2003 street project was by others, but that failing street was passed to me, and it was up to me to get a board aligned in fixing our primary artery and replacing the water mains beneath it.

To get these things done I spent more than 700 hours in one year, and believe me, it was not a situation in which I "expanded the task to fill the available time". Quite the contrary as I was simultaneously working and doing all of the things we all do, and more.

The chart shows how fees climbed. On this chart the steepest increase was from 2001 to 2009, over which fees increased about 60%. These fee increases may have contributed to owner distress by 2008 but the "Great Recession" was the main event.  Later in the post are additional supporting charts.

A BLMH Example - Reserves really are important
It is difficult to make a point without providing data. So bear with me while I make the case that viable reserve financial programs coupled with pragmatic maintenance are really, really important.

By "pragmatic" maintenance I mean maintenance based on frequent physical surveys of infrastructure. That data should be collected regularly (annually) by management, certain board members and maintenance.

The information is assembled into "condition reports" and is a very useful tool for determining the actual current condition of the property as well as the rate of deterioration. This is made possible by comparing earlier reports to current ones. However, I need to point out that conducting these surveys is entirely voluntary and is a lot of work, and performing "work" is something some volunteers may dislike.  Furthermore, there is really no point to doing studies, etc. unless one is inclined to use the information for the betterment of the HOA.

An Example of how reserves are accumulated and why
Let's look at driveways, as an example. About three years ago about 80% of our driveways were rated as "good condition". This year, only 76% were rated as "good." Driveways have a useful life of about 15-20 years with good maintenance and we can expect 5% to degrade each year. It would be ideal to replace about 5%, or 6 per year, but in fact in some recent years 12 were replaced, while in other years none were replaced. As a consequence, the number requiring replacement varies from year to year.

A few years ago, manpower strapped and cash short boards apparently let such surveys "slide by". With few volunteers, too much to do, low reserves and  disinterested owners, I suppose doing these surveys was both frustrating and difficult. One might choose to use an approach called "out of sight, out of mind". That approach can build reserves, but it also creates maintenance backlogs. In other words, the apparent savings in the reserve funds can be deceiving if it represents unspent funds on capital projects which should be underway but are not. This approach can blindside and impede new boards who see a reserve amount, but are unaware of the costs of all of those undone infrastructure repairs which are waiting. At BLMH it has.

A new board, upon discovering this type of situation is in a real dilemma. It can attempt to address the problem, but without complete information the true magnitude can't be determined. In 2008 this HOA had just over $1 million in reserves. Compared to where it was 8 years earlier that seemed wonderful. However, it had not had a reserve study so a new board member would have great difficulty determining if this was sufficient or not. Furthermore, it had failing streets, a roofing project just underway and a variety of infrastructure had not been inspected for several years. As a consequence more than a few in the HOA thought fees were too high and "we have enough money". They were absolutely wrong.

There are different approaches
At BLMH the boards did everything possible to raise fees so as to avoid loans and special assessments. Not all HOAs take that approach and I recently spoke with townhouse owners in a HOA which took out a $1.5 million loan to do the major work required. That's one approach.  The loan repayment of principal and interest is added to the monthly fees.

Special assessments are another approach. A one lump assessment forces owners to dig down to come up with that amount. It could require some owners to get a loan. If the HOA makes the assessment but carries it, then owners are simply billed an amount each month on top of their normal fees. It may be a requirement that the owner pay off the assessment at the time of sale of his/her unit.

At BLMH boards made a number of decisions. Avoiding loans means there is no interest to pay to a bank. Even 5% is a lot of money if one borrows $1.5 million. Avoiding special assessments meant raising fees for reserves over a period of years. Recent boards have attempted to stabilize fees while maintaining the property. They have had good success.

Fundamental Reserve requirements at BLMH
In fact, BLMH reserves are comprised of funds for two types of infrastructure:

1. Core, major infrastructure such as streets, driveways, roofs, etc.
2. Other, lessor infrastructure including electrical, patios, decks,  walks, landscaping, streams, etc. 

It would be a mistake to assume that "lessor infrastructure" is less costly to maintain. It isn't. But is is easier to deal with 84 driveways which can be replaced in small increments, than with replacement of street and roofs which must be maintained if owners are to be dry and comfortable in their units, and can even drive to them in an automobile.

Accumulating reserves for these projects may take decades. In principle, doing so is straightforward. Each year a fraction of the replacement costs for each infrastructure item must be collected via owner fees and must be saved in the reserve fund.  For example, if we assume a roof has a 20 year useful life then our reserves should save an amount equal to 1/20 of the total cost of our roofs each year. Similarly, if our streets have a 30 year life, then our reserves must save an amount equal to about 1/30 of the cost of our streets each year. If driveways have a life of about 15 years, then we need to save 1/15th of the cost of our driveways each year. And so on for each common element. Add all of these annual amounts and then add a small amount for inflation. This gives us the amount to be saved each year for infrastructure.

How much is required for "core" infrastructure? At BLMH probably more than $125,000 per year is required.  That amount keeps a roof over the owners' head and allows them to drive in and out of the complex on functioning streets and driveways. Which is why I define this as "core".

To this amount add the reserves necessary for streams and waterfalls, decks, concrete patios, walks and landscaping and you get some idea of the amount to be saved each year to deal with the realities of maintenance of these common elements.

The reserves are not to be confused with the operations & maintenance (O&M) budget. That budget takes care of day to day maintenance such as painting, sealcoating of driveways. lawn care, snow plowing, electrical and water utilities, accounting, management, minor repairs, etc.

While this sounds easy, in practice it is not. For one thing, some HOA owners have no desire to pay for infrastructure maintenance which is going to occur 5 or more years in the future. They would prefer to roll the dice and hope to sell before that maintenance becomes necessary. Such an approach could result in special assessments, but prior to that they hope to sell their unit and be long gone. They are gamblers. For this reason some calculating owners will argue to keep fees low.  At BLMH some owners did their very best to resist these increases.

Boards are comprised of owners and so the board could have a similar position to  these owners. The board may also have a desire to be popular, positions or legacies/images to protect. Popularity and raising fees do not go hand in hand with owners.

And, as we discovered at BLMH some boards think they are a social club running a social club. Not much interest in doing work or being unpopular. Unpopularity can stress friendships, cause strife and so on. Running a business is not a popular thing. Running a business does require doing honest work and making difficult decisions.

BLMH may not be typical
BLMH is a large Private Urban Development comprised of 44 multi-unit buildings which are called "Manor Homes".  It owns about 2/3 mile of streets, lighting and three streams with waterfalls, etc.   It has extensive infrastructure which the HOA maintains.

After purchase I was able to determine that boards had begun to ramp up reserves contributions after new management came on board in 1998 or so. By running the numbers I concluded this was absolutely necessary, but I had no idea of the true magnitude of the reserve problem.

When BLMH began a major roofing project in 2002-2003 a street replacement/curb project occurred at about that same time. Boards can only use money the HOA has or can borrow. That will influence the quality of infrastructure solutions, the requirement for special assessments and loans, etc.  To achieve the goals set by the boards, fees increased steadily from 2001 to 2008. Most of the reserves money was spent on streets and accumulating funds to complete the roofing project at a rate of about 2 or 3 a year. But it was obvious that at that pace the roofing project would take another 14-22 years to complete by which time the oldest roofs would be at least 30 years of age. Not good for roofs designed for a life of 15-20 years.

Boards did not explain the reserve program. I really didn't know what the ultimate annual funding requirements would be. Nor was was I aware of any board discussion about what that target was. That was perhaps the most disturbing situation to me at the time. Imprecise goals and poor communications are not a good management approach. I could envision the possibility of fees reaching $375 per month by 2015 and I sympathized with the anger and confusion among owners in 2008. At that trajectory $500 per month was on the horizon.

In fact, the HOA was struggling to come to grips with its reserve balances and the new board of 2008 seemed to be disorganized and also incapable of running the numbers. So I began this blog.

What earlier owners and boards failed to realize was that focusing on overall fees was not really helpful. Earlier boards apparently focused on the Operations & Management budget with no formal reserve studies to guide them. I've concluded that the "Replacement Fund" was more of a dart board exercise than one in budgeting.  Some owners felt the "Replacement Fund" (reserves) were adequate, but they hadn't looked closely at the board's plan to replace more than 40 large roofs. Nor was anybody discussing the premature failure of several streets. I realized these would be very costly projects which would absorb more than was being collected. Other owners looked at annual fee increases and felt that if increases were 5% or more that was excessive and more than sufficient. Some think that 3% annual increases are sufficient because "3 percent sounds like a good number" and I've heard board members say about the same thing about 3 and 5 percent annual increases since 2002. In fact fee increases from 2002-2008 were actually about 7.5% each year. Boards were accruing reserve funds as fast as possible, but even that would not be sufficient and fee increases would continue to increase

What many owners failed to understand was it was the amount going into reserves each year that would determine the future fees. Nor did they realize that the money collected would go to replacing the roofs and the failing streets. It would all be spent in less than 5 years, while other infrastructure was left lacking of financial support.

The following charts serve as an example, and are gleaned from available information. However this is not a replacement for doing one's own research at their HOA. In fact at BLMH since 2010 this type of information and much, much more is presented to owners during each annual meeting. This information is provided here to provide some insights. I should point out that not all owners at BLMH attend the annual meetings. That is a choice, but I question the wisdom of owners who choose not to. Of course, owners who don't attend meetings are the first to complain.

Operations & Maintenance fees remained fairly steady with modest annual increases of only 1.5% per year.  This is what that looked like from 2002-2016:

Reserve fees, on the other hand, increased from less than 19% of the annual budget to nearly 29% of the budget from 2002-2008. Allocations for reserves was the major cause of the recent fee increases. The increases topped out in 2011-2016. Nevertheless the annual reserve fee increases averaged 7.0% each year from 2002-2016. 

The combination of fees for O&M budgets and reserves for the same period looked like this, and you can clearly see the influence of the increases of reserve budgets on fees.  One can also see that fees have stabilized in recent years. That is not an accident: 

Conclusion:

Owners may feel that it is not worth their time to attend HOA meetings. Or to study the documents prior to making a purchase, or even after making a purchase. At BLMH the first meeting I attended after purchasing had two owners in the audience. They were me and my spouse! BLMH has more than 330 owners. 

The quantity of owners present increased in 2007-8 when an resident posted a notice about "special fees for dog owners" and pet owners stormed a HOA meeting. It was "fake news". Attendance also changed when some owners decided the fee increases were "too much" and about 30 began attending the monthly meetings to voice their opinions. But even 30 is less than 10% of the HOA ownership!

Of course, in 2008 it was too late and that is my point and the point of these charts. Participating after the money has been spent or has not been saved is too late to have any meaningful influence about reducing fees.

 At the time 30 owners decided attend monthly meetings (2008) the streets had been replaced and the roofing project was underway with 6 roofs replaced, as I recall. The HOA was committed to a course of action, and boards after 2008 discovered that they were trapped by the financial decisions of the earlier boards and owners. Earlier owners had complained fees were too high and earlier boards had micromanaged the Operations & Maintenance budgets, but treated the "replacement fund" as an afterthought or worse. In fact, in 2001 I did an informal interview of a few owners prior to purchase and about half of the people we met and discussed the HOA with had a complaint about fee increases and the current level of fees.  In 2001 the average fee was about $189 per month. 

My suggestion to potential buyers at any HOA is to consider the following:

1. Do your due diligence and anticipate fee increases if you are considering a HOA purchase. Inflation cannot be avoided so the cost of things do increase year to year. 
2. Reserves are an important part of owner fees. They determine long term maintenance and must be considered.
3. I'm merely providing BLMH as an example.  What is useful is the fact that the budget situation at BLMH is today the consequence of the planning that occurred 20 years ago. That is true for each and every HOA.
4.  Each HOA is unique. Newly built may experience a grace period but that infrastructure has a finite life and begins wearing out on day one. Even newly built HOAs need to consider a reserve study and then begin accumulating funds for those long term capital maintenance expenditures. 
5. Failure to consider the reserve requirements will drive future fees.
6. Owners may be inclined to gamble. After all, as a homeowner one might say "I'll paint the pig and flip my house before the roof needs replacing or the refrigerator or hot water heater fails" and so on. HOAs should not operate that way. HOAs have boards which are required to maintain the common elements. That is in all owner's best interests and is required by statute in Illinois. However, boards are comprised of owners and they may be operating from a personal agenda. Furthermore owners may manipulate boards because boards are elected from the ranks of owners. A board member might put it this way "But, these are my friends." 
7. The situation at each and every HOA is a combination of past events, owner desires and board decisions. The current situation will determine your fees in the future as will unforseen events. We can't deal with the unknowable, but we should educate ourselves, plan and prepare. 
8. In some HOAs the preceding is far more the responsibility of owners than they are willing to provide. 
9. In some HOAs some of the owners are very irresponsible about financial matters. 

Note: In Illinois, the statute for HOAs is the Illinois Condominium Act. This is revised from time to time by the legislature. Check your state's statutes. 

Click to go to: http://www.ilga.gov/legislation/ilcs/ilcs3.asp

Not responsible for any errors or omissions. (c) N. Retzke 2017 All Rights Reserved.