Understanding the Replacement Reserve Fund

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Written by Anthony Morelli

On November 16, 2018

Historically there has always been some measure of misinformation and misunderstanding in the community about how the Replacement Reserve Fund (RR) operates.  The RR is essentially a savings account specifically designed for the repair and replacement or deferred maintenance of all common area assets owned by the association.  Replacement Reserve funds are accumulated to assure availability of adequate cash to pay for replacement of Association-owned assets without requiring a special assessment from the membership when a large expense is necessary.

It is most fair to collect money gradually from owners who are using the assets while they are deteriorating.  A special assessment to collect needed funds from owners would require owners to unfairly pay for deterioration that occurred prior to their becoming owners.  Lake Holiday Country Club adopted the Cash Flow or Pooled Method of determining the required annual contribution to the RR in 2006.  It is the method recommended by most professional reserve specialists because it is easy to administer (doesn’t require an individual account for each project that will require repair) and is the most flexible because the funds are pooled and are available to be used as needed for a project when they are needed.

The Cash Flow Method uses a complicated mathematical model to determine the required annual contribution which is keyed to what particular asset may require replacement or repair in a given year over a timeframe of 30 years.  The contribution for the pool will differ each year, but because the fund is not always carrying a large unused balance in individual accounts for each project, therefore handling the money more efficiently, the average reserve balance can be lower while accommodating the exact same scope and schedule of expenses.  Thus the annual contribution rate will be lower than what is necessary under the straight line method of computing reserves and the contribution is spread more evenly over the owners over the years.

Since there are no individual accounts for each component in the pooled method, the question, “How much money is allocated and available for “x” replacement?” does not apply.  Because of the mathematical model involved in calculating the annual contribution, there simply is no way to answer that question.  The money is in a pool, and if accurate estimates of costs and useful life were entered into the model, sufficient funds should be available when needed to replace all components in the Reserve Study.

Project components that are included in the Reserve Component List qualify for Reserve budget funding by meeting the National Reserve Study Standards’ four-part test:  1) common area maintenance responsibility; 2) limited useful life; 3) predictable remaining useful life; and 4) replacement cost above a minimum threshold of significance.  These projects may take the form of total replacement, partial replacement, significant repair projects, or regularly anticipated common area expenses.   Assets not currently in existence should be funded via a Capital Improvement Fund, operating fund, special assessment, loan, excess working capital or any combination of the above.  The item is then included in the next Reserve Study plan.

Capital assets that were excluded from the last plan may still be charged to the Replacement Reserve fund.  Since reserve studies estimate common elements’ replacement costs, certain items may have been missed during the preparation of the plan or item replacement costs or conditions may have changed over time.  The Association will recoup the missing element’s cost and the deficit created by the expenditure through increased reserve funding.   Some projects such as tree trimming and painting may be Reserve projects at one association and operational maintenance projects at another depending on how they are handled.  This decision depends on the timing of the project (if done little by little on an ongoing basis or all at once every few years).

The bottom line is that there is no one master list of Reserve Components.  There is a “usually included” list, a “not usually included” list, and a “could go either way” list.   The Code of VA Property Owners Association Act requires the Association to conduct an annual review of the replacement reserve study.  The annual update is a status check on whether any changes need to be made to the currently approved component list (add or remove components) or the funding profile.  Any changes will require a re-computation of the required annual contribution amount using particular calculation software.  Preparing the annual review of the study is part of the annual budgeting process.

In 2014, Reserve Advisors, experts in reserve funds, performed a Replacement Reserve Study for Lake Holiday Country Club, Inc., including over a 100 page report about all common area assets, estimated replacement costs and timeframes for replacement.  It is the Board’s responsibility to approve a plan that meets the needs of the Association.

Running the Association does not require homeowners to agree to the funding plan or reserve expenditures.  Boards have a duty to act in the best interests of the Association.  Moreover, Directors are aware of business issues and the financial condition of the association and are in a better position to make decisions about reserves and how best to finance them.  The members elect Board directors to manage the affairs of the community.

~Dr. Pat Majewski

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