How much should an association have in reserves?

At a minimum, Michigan law requires a condominium association to have a reserve equaling 10% of its annual budget on a non-cumulative basis (meaning, 10% of the budget, but not adding 10% each year).  However, as mandated by the regulations, “The minimum standard ... may prove to be inadequate for a particular project. The association of co-owners should carefully analyze their condominium project to determine if a greater amount should be set aside, or if additional reserve funds should be established for other purposes.”

Determining the proper amount of reserves is simple, but not easy.  An association should make a list of those items for which it has maintenance, repair, and replacement responsibility.  For each of those items, it should determine the remaining useful life of the item.  The association should then obtain an estimate of the cost of replacement of the item, and divide the cost over the remaining useful life.  For example, if a roof is an association responsibility, is five years old, has a life expectancy of 15 years, and will cost $10,000 to replace, then the association should be setting aside $1,000 per year for the next 10 years to have sufficient funds to replace the roof when it reaches the end of its useful life.

This will give a ball park estimate of the level of reserve funding an association should maintain.  Some capital items will fail before the end of their expected useful life.  Inflation will eat some of the purchasing value of the funds being set aside.  The association may earn some interest on monies held in reserves.  The point is that the board of an association has an obligation to take the long view of things and set up adequate reserves.  

There is a great deal of time and effort involved in doing the analysis.  There are companies which will come in and make a reserve analysis for an association and help the board to determine what it is responsible for, what the remaining useful life is, and how much should be set aside.  Search for “reserve study" on your search engine of choice to find these companies.

If there are not sufficient reserves when a capital item needs replacement, most condominium documents provide for the levying of an additional assessment to cover the shortfall.  Co-owners do not like these additional assessments.  One possibility is for an association to borrow the money to make the capital replacement.  There are several banks willing to loan money to condominium associations to fund capital replacements.  Bear in mind that there may be restrictions in the condominium documents requiring the board to obtain co-owner approval before borrowing money, and the condominium documents may have to be amended for the association to grant a security to the bank.

I am generally against associations borrowing money for routine capital replacements.  The preferred method is to fund these by setting aside adequate reserves or, if the reserves are not sufficient, levying additional assessments (even if they are unpopular).  An association has to pay interest on monies borrowed; it does not pay interest on additional assessments.  Also, borrowing money does not address the underlying issue:  the association has not been setting aside sufficient reserves.  

Suppose an association borrows funds to fix a roof, which is leaking.  Roofs in Michigan have an expected useful life of about 15 years.  The cost is $10,000.  The association does not have funds in reserves, so it borrows $10,000  at 4% over 10 years.  At the end of 10 years, the association will have paid $1,250 in interest on the funds borrowed, and made payments of $101.25 per month on the loan.  BUT, the association has not addressed the underlying problem, which is that no funds are being put into reserves to pay for the roofs, which at this point will need to be replaced in 5 years.  Assuming the cost of replacing the roof has not changed, at the end of the loan the association will need to set aside $167 per month in reserves to fund the next roof replacement.  

There are occasions when borrowing money makes sense for an association, as when the association faces a large, unexpected cost.  I had an association discover that the project had been wired throughout with aluminum wiring, all of which needed to be replaced after the wiring caused a couple of fires and the associations insurance was canceled.  The expected cost of replacement was going to result in a $10,000 per unit additional assessment.  In that situation, where the need to replace the wiring was unexpected (and therefore unbudgetable), borrowing the money was appropriate.

Can a board be held liable for failing to adequately fund reserves?  Bear in mind that some capital items, like roofs and roads, have fairly long expected useful lives, and the composition of the board may have changed several times in the 20 years or so before the item fails.  Which board members should be held liable for failing to make the proper reserves:  those elected in the past year who inherited the problem but had no time to fix it, or those from 20 years ago who failed to exercise foresight and for whom the statute of limitations may have run?

Most recent condominium documents contain provisions which shield volunteer board members from liability for bad business decisions such as failure to fund reserves and require the association to indemnify and defend those board members.  Rather than finger-pointing and trying to find someone to sue, most associations can better spend their time focusing on how to address, and fund, the needed repair.

© Steve Sowell 2018