Reserve Studies 102: The Financial Analysis

Robert Nordlund 0:08
I’m glad you’ve joined us here for our presentation on the reserve study financial analysis. Now, before the end of today’s short program, you’ll leave knowing how to tell if you should feel good or bad, or somewhere in between, about your reserve fund size, how that starting point influences your reserve funding, and why physically similar associations may have very different reserve funding recommendations. Well, this is the outline we’ll be using today, starting with an overview, then I’ll walk you through understanding your reserve funds strength, and then basic funding plan issues. Now it all starts with appreciating that we’re on a journey to the future, it’s going to be full of twists and turns, and bumps and obstacles. But we have a pretty good understanding of the journey ahead. You can see in the picture here that we see the road ahead, and so we can see at least part of it. So to the best of our ability, let’s create a plan to get to the future successfully. Arts are just around the corner. Every Association has a set of expenses in its future, predictable expenses, the roof will fail, the paint will dry and chip and peel the asphalt will crack and get potholes, elevators will break down more frequently. We know these things. And we can predict pretty closely how much they’ll cost. And when they’ll start to occur. We cover identifying all these expenses, the components appearing in your reserve study, in our reserves studies 101 webinar that’s available on our website and on YouTube. If you want to catch up and watch that program, and again, these are the questions we’re going to answer for you, in today’s program three things. So sadolin, adjust your volume, and follow along. We’re going to talk about where we are now. Are our reserves weak, fair or strong? How does the starting point affect what we need to do? And how can there be so many funding options going forward, and it’s an important discussion to have about getting to the future. But I want to talk about deterioration. And this was important even before the tragic collapse of champion tower South back in 2021. We’re gradually over 40 years the association fell significantly behind on us repair and replacement projects. Now for every Association, you need to understand that deterioration is ongoing and inevitable. And never takes a day off. It’s a formidable opponent. And it causes tremendous expenses. And we’re talking about funding reserves today. Because if your association is not actively fighting this ongoing battle, ignoring the reality of costs, and the battle damage you’re taking on every day, week, month and year, you are actually losing. But no worries, today, we’re going to arm you with the tools for success. Our starting point assumes that you have a reserve component list, we’re not going to be talking about that. And we’re going to assume that that component list has components wisely and appropriately selected according to National Reserve Study Standards. And that’s because all the financial part of the reserve study relies on having a component list a set of expenses that are established. And that helps you understand what does your journey to the future look like? So now let’s turn to the next topic, calculating reserve funds strength. I want to encourage you to think this not just looking at the cash in the bank that appears on your bank statement or balance sheet. But I want to help you gain meaning about if what you have is relatively a lot or a little Can you call it strong or is it weak. And that’s because you can look at pictures like this and you realize it’s not just in a condominium association. At this association. It’s a complex array of so many different projects. In this picture you can see at the top the roofing projects, then of course you can see the painting. You can see caring for the central courtyard, which involves resurfacing the pool painting and replacing that nice trellis caring for the balconies. And that’s just what you see in this picture you’re not seeing in the hallways, the elevators, the flat roofs behind the Tile Roof portions. If you’re a board member or a manager or a homeowner at this association, you know that these projects are ahead. This is I think when I took this picture, it was about two years old. So there’s a lot in the future that they’re gonna need to prepare for how you manage your finance This will determine your journey, if it’s going to be smooth or bumpy. And by bumpy, I mean full of special assessments, some deferred maintenance, or perhaps some steep assessment increases. So let’s start out this journey to the future by helping you understand where you are as a starting point, I was a good idea. Now, how can you get comfortable knowing that there is a definite answer to the question about your reserve funds strength, that’s an important thing for you to understand as Association leaders, whether you’re a manager or a board member, because it’s important for you to be able to communicate this to your homeowners. Now, it starts with a reserve component list outlining the projects that you expect to happen at the association. Here’s a simplified list, you see the description of the projects, you l is the useful life column remaining useful life is our UL, and the current cost is off to the right. Pretty simple. And we’re going to use this a number of times as we go through today’s program. And this should be a pretty solid list at your association hopefully assembled based on national reserves a standards and it’s a three part test that you see here. And if you’re not familiar with this concept, again, I recommend you catch up and watch our reserves study 101 webinar, and I’ll make sure there’s a link to that program in the outline. So how much cash and reserves your association would or should make you feel good. And again, just like that three part test national reserves a standard step in with a solution. And that solution gives us a reliable measuring system that works for all types of associations. It’s not a straight dollars per unit, or percent of unit value, or a straight cash number. It’s a calculation that compares your current reserve fund balance to your associations needs, telling you how well the reserve funds fit the needs of the association. And let me illustrate. Let’s start with a few simple examples. The first one is that first component from the sample component list I showed a moment ago, the pool furniture replacement as a five year useful life, remaining useful life has zero meaning it’s time to be replaced now, as current replacement cost is 4600. If you were a board member, needing to buy a new set of pool furniture, how much would you like to see in reserves ready to be spent at this time. So think for a moment. And if you’re thinking like most people, you’re thinking, I want to buy $4,600, where the old furniture I’d like to have $4,600. So yes, when the remaining useful life is zero, you want the money, you want to have it all available. So you should have at least that much in reserves. And let’s do it again. Now let’s talk about the pool resurfacing. This is a project that needs to be done about every 10 years. And it has five years of remaining useful life. So it’s about halfway used up. You don’t need $10,000. Now, because the cost is where the expense is actually still a few years away. But you have a current cost estimate of $10,000. So it’s halfway used up. What do you think would be a good reserve ballots for this component? Okay, again, you’re probably guessed correctly, with a life halfway used up. You ideally should have half the funds set aside. 5000 is a good amount for the association have set aside for the pool resurfacing, now that it’s halfway used up. So I’m going to do this in a little different way now, rather than showing you numbers are going to do it graphically. And eliminating interest in inflation. For simplicity. Let me walk you through what we’ve been talking about that will resurface project, new association here, how much should you have in reserves, what five years, it’d be logical to have $5,000 set aside, then as you step forward through the years, it’d be nice to gradually have more and more and more, until in that 10th year you have the $10,000. And that’s just the right amount to have set aside for the pool resurfacing. Right. So that’s the idea of what we’re trying to accomplish here. Now, after you do the pool resurfacing in the next year, you don’t want or need $10,000 In the next year. You just need one year’s worth of deterioration set aside because you’ve got another 10 years till the project happens again.

So in the last few charts, I showed that the reserve needs at your association go up and down over the years depending on the timing of your reserve projects. Your needs are not the total cost at reserve components. Now of course due to inflation, your reserve needs will generally trend upwards. But I want to make the point here that reserve needs go up as you’re anticipating a large project, and they go down after you’ve accomplished the large project. So your reserve needs to go up and down through the years. And doing what we’ve talked about is actually pretty simple calculation. It’s an equation done by your reserves a provider in the reserve study, and it’s literally a fractional age of the component times the current cost. The total cost of all those individual calculations is called the fully funded balance. And let me show you what that looks like. If you take that reserve component list that I showed a moment ago, and you add another column, over at the right, we’ll call that the fully funded balance column. That’s a calculation of the current needs of the association. We talked about the pool furniture needing $4,600, the pool resurface being at 5000. And you can see what’s going on here another easy one to see we’ll be building repaint, remaining useful life a one year, so it’s 90% used up 90% of $50,000 is $45,000. So you keep doing that same calculation, and you end up with the number of 154,100 off on the right. That’s the amount of money that would be nice to have at your association. That’s a good target point. We call that the fully funded balance. Okay. Now let’s talk about what that looks like, for getting some meaning out of that. And let’s think about the seesaw, you have the Association on one side and cash on the other side. And let’s try to learn from that comparison. Okay? When you compare the reserve balance to the fully funded balance your actual reserve cash to your fully funded balance, all of a sudden, you get a very interesting number. And that’s called a percent funded. And that’s a calculation again, done in your reserve study. And that’s going to reveal some very interesting things. Now, let’s do it for a few sample associations, same association here 154,100, fully funded balance, if you have $308,000, on hand, you’re going to be 200% funded. If you have only 77,000. In reserves, you have about 50% of that fully funded balance. And that starts to give you an idea of if you have a lot, or a little compared to the needs of your association, is still What does more or less or a lot or a little really mean what are the implications? Now we’re getting to some good stuff. This is how you can learn if your reserves are strong, fair or weak, it’s all about percent funded. And that’s a strong indicator of special assessment risk, do you have enough to do your reserve projects or not? That’s fundamentally what you want to know. And that’s fundamentally what percent funded tells you it’s a powerful risk indicator. Just like with your own health, you care about things like your weight, your cholesterol, your blood pressure. Over at the left hand side of the chart, when your percent funded is low, in the zero to 1010 to 2020, or 30. In the zero to 30% range, you have about a 40 or 50% chance of a special assessment. In any given year. If you want to try to accomplish a project meaning you have a high risk of special assessment. And on the other hand, if you’re at 70% funded or above, special assessments are rare. That means associations above 70% funded regularly have enough reserves to do their projects on time. Those boards feel comfortable that their reserves are strong. So where does your association fit. And again, percent funded should be a number calculated and reported in your reserve study. Now, like a grade in school, it’s nice to be near 100%. But unlike school, a score of 75% is still pretty good. Remember 70 and above is strong. So do your homework, find out where your percent funded puts you in the zero to 30% week range in the 30 to 70% Fair range, or in the above 70% Strong range. It’s not about your cash balance. It’s about fit the amount of cash your association has compared to its needs. And that’s important not only for the board and the homeowners, but knowing reserve funds strength also helps a manager understand the pressures and association is going to be feeling the financial pressures. And it’s also going to help outside parties like real estate agents and bankers will Learn if the association is well prepared for its own future. Or if a new owner is likely going to be facing a special assessment and an answer to the original profile question. This is the national profile of reserve fund strength. Many people are surprised to see how many associations are in the fair or strong range, you can see that out of all associations, the peak of the curve is bending over in the fair and strong rains, there’s a lot of associations that are doing arguably pretty well. Most people are surprised, because they’re thinking that every Association has weak reserves. And that’s not true. The truth is that about 30% of associations, little under 10%, the over 10%, a little more over 10%, about 30% of associations have weak reserves, about 40% have fair reserves and another 30% have strong reserves where special assessments are rare point I’ll make in this next section of the webinar, is now that you know where your association stands, you can create a multi year plan to improve your Association’s future. So now that we’ve learned about how to measure your reserve fund strength, let’s turn to a new topic. And that’s funding reserves. Now, starting with the big picture, remember that deterioration is happening. And it’s expensive, you can’t change those two things. There’s nothing you could do to stop or avoid deterioration. But at least it’s predictable. And that makes it just like any other bill at your association that you need to prepare to pay. And paying this bill generally takes four forms and associations across the country. budgeted reserve transfers, catch up special assessments, loans, or the net last year pocket book from declining property values. And what I’ll focus on for the next few minutes is the least expensive way. And that’s also the fairest way to offset reserve deterioration. And that’s budgeted transfers, and notice that I’m not calling them contributions, they are not voluntary, they are not optional. This is not charity. Reserve deterioration is as real a cost as any other cost your association faces. It’s real, it’s predictable. So let’s call them reserve transfers, reserve requirements, reserve funding needs, things like that, with our words, talk about the reality that it’s a bill just like any other bill. So just like your reserves, a provider did some calculation to find your percent funded, we’re gonna do some other calculations to figure out your path forward with the funding. But they’re different calculations, the calculations done to measure your reserve fund balance are different than the calculations you do to prepare your association for the future. So remember that separation, I got two different portions to this webinar. The reserve fund strength is a current cost calculation that is trying to establish where are we now, whereas funding plan calculations deal with costs into the future? So funding plan calculations typically do incorporate interest and inflation, and reserve funds strength reveals where your association is now. And reserve funding affects the kind of future you’ll have at your association. But I want to suggest that they are related. And so we’re going to pose an important question. What’s the purpose of this year’s reserve funding? Is it for this year, the here and now? Or is it for the future? Think for just a moment?

Okay, I’m going to suggest that it’s important to understand the reserve funding you’re doing now pays the monthly bill of ongoing deterioration. If you pay that monthly bill of deterioration on an ongoing basis. Deterioration doesn’t accumulate at fall onto the shoulders of some or future owners as a special assessment, forcing them to pay for deterioration that occurred likely years before they ever owned a home in the association, the expenses. Yes, they are indeed in the future. But that deterioration is an ongoing daily occurrence. reserve funding this year, offsets this year’s deterioration. And if this year’s funding offsets this year’s deterioration, and next year’s funding offsets, next year’s deterioration. Doing that way the future is going to take care of itself. All right. Also, all the owners end up paying their fair share of the ongoing deterioration that happened while they owned a home with the association. No special assessments to fear everyone pay their own way. And this is important to communicate to your homeowners, they’re not setting aside funds. For other owners in the future. It’s not charity for the future. This year’s reserve funding pays for this year’s reserve deterioration. And I use this image to try to emphasize the point that you need to see reserve funny as paying the roof deterioration bill or the asphalt deterioration bill, you’re going to have a lot more success as a manager or a board member communicating with homeowners. When you communicate reserve obligations this way, these are present costs, that everyone is responsible to pay their fair share. All right. Now, I’m going to totally shift gears and talk about swimming, you’ve probably seen a race on television where the world record pace is shown. And you can see swimmers trying to keep up if they’re gaining ground or losing ground. And that’s just like reserves, your association, your assets are all deteriorating at a predictable pace at your association. Question is if you’re keeping up, or falling behind, remember that your percent funded tells you where you are in the race, whether you’re ahead of pace, or behind pace. And your rate of funding is going to tell you if you’re gaining ground, or falling further behind. And here’s how it works. This chart shows the same components we’ve seen before. But instead of calculating the fully funded balance on the right, let me show you a little trick, we’re going to calculate the deterioration rate, the cost per year column over here on the right. If you divide the cost, by the useful life, you get the annual cost of deterioration, it’s easy to see in the second line will resurface $10,000 every 10 years means it’s deteriorating at the rate of $1,000 per year. Another easy one is asphalt sealcoating $5,000, every five years is another $1,000 per year, do that same calculation for all the components and then sum the total. And in this case, you get $20,170 per year of ongoing deterioration, your reserve funding is going to need to be pretty darn close to that value 20,170 per year is this associations a baseline this year, I went I showed you the slide of the swimmers in the pool with a baseline. This is what I mean, this is the pace of ongoing deterioration that your association needs to keep up with. All right, we’re going to use this graph to begin to show you how your reserve fund strength is related to your reserve funding rate. I’m going to plot reserve funds strength over time going from now into the future left to right. And as I indicated earlier, a strong reserve fund is over 70%. That’s the green portion on the top. And a weak or underfunded reserve fund is the zero to 30% range. I didn’t want to do dark red, but I use kind of a pink color here. And so the 100% line, I want to make it easy to see. So I’ve just got a mark over here on the right showing where 100% is. All right. Well, let’s see what different reserve funding rates do at an association. Let’s start it out like a typical Association at about 50% funded and ignoring interest and inflation just to keep this example simple. Let’s presume they are funding their reserves at the pace line 20,001 70 per year, matching a deterioration rate we just calculated funding their reserves at that rate is going to keep up with deterioration Sakineh caused the reserve fund to gain in strength up to the green zone, or drop and strength down to the red zone. Just some bouncing around as the fully funded balance goes slightly up and down over the years. This association is keeping up with deterioration that’s going on at their association, like in this swimming pool. They’re not catching up, but they’re not falling further behind. Now, let me show you. What happens if they step on the gas a little bit. What if they are funding reserves more than 20,001 70 per year they’re going to start to catch up they’re going to strengthen their reserves is going to trend upward, lowering the risk of special assessments. Now, associations that start out really weak. I have to do this to prepare for upcoming projects, one, two or three projects or pass a special assessment. But the idea is that if there are sharks called special assessments, they swim in this red zone. You want to be out of this red zone, if at all possible. It’s in your best interest to distance yourself from the sharks and here’s an association that is As funding reserves less than their rate of deterioration, your reserve fund is going to net drop in strength over the years. And associations that do this just fundamentally increase the risk of reserve related problems getting closer and closer to the sharks who have special assessments. And it’s really just a trade off lower reserve funding, or I could say lower reserve transfers. But I or transfer special assessments, the costs are the costs, they’re gonna pay the costs one way or another. There’s no escaping those costs. Many associations have been doing this unintentionally for years, just not looking at their situation. They’ve been underfunding reserves, allowing their projects to get closer and closer without building their reserve fund. These associations have just been kicking the can have a problem down the road, pushing that problem onto the shoulders of future homeowners. And I want to make an interesting point here with the next couple of slides. Here’s what it boils down to. If you learn it, reserves are weak, and you need to be doing some catching up to prepare for upcoming projects, you need to step on the accelerator. And that’s going to be expensive, raising your reserve funding requirements to catch up for years of underfunding. But if prior boards and prior homeowners have funded reserves responsibly, and you’re at a higher rate, it don’t need to be stepping hard on the accelerator, you know, maybe you can just stay at the paceline 20,001 70 per year in this case, you don’t have to do some strong catching up. So when people believe that strong reserve funds cost more money, the answer is no. Just a matter of what people have accumulated over time, there’s plenty of strong associations that are funding their reserves, just steady state just keeping going. They’re not in the expensive catch up zone. Remember, expenses are what they are. So it’s just a matter of finding reserves one way or another. And here’s a little perspective, no matter what type of association, this is. Interesting thing that we learned, no matter what type of association, we find out that reserve funding typically needs to be in the range of 25% of total budget. In order to offset deterioration. Some associations need a little bit more, some a little bit less. But for the purpose of this webinar 25% is a good number for you to remember. So if your reserve funding is significantly less than 25% of total budget, there’s a good chance you’re underfunding reserves and your reserve fund strength is gradually dropping, and you’re getting closer and closer to being bid by the sharks have special assessments in that red zone. So look at what your reserves said. He says, define your current percent funded and look at your current percent of reserves being transferred compared to total budget, see what that fraction is. But sometimes you don’t need to look at your reserves it to see what underfunding looks like there’s plenty of associations that look like these two were spotty cracked pool deck. And this is likely because they’ve been skipping money setting aside enough reserves in the past, and they don’t have enough cash to take care of the property. This is the most expensive way to pay for underfunding reserves, when it affects sales price, and the sales price for homes in your association begin to fall behind associations in your city that are better maintained. And you’ve heard it before curb appeal is real. Okay. Deterioration affects home values, it’s worth two slides. So you can see in this cartoon where a real estate agent is showing this association to some prospective buyers, they’re not going to pay top dollar to become a member of this mess of an association. So you need to do what you need to do. And if that means raising assessments, do it, your property values will rebound after just a few years, and return all that reserve funding you’ve made and more by higher own values. Now it’s time to wrap up today’s program and summarize the lessons we’ve learned about measuring reserve funds strength and how reserve fund rate of mature funding either strengthens or weakens that reserve fund strength position. But I gotta tell you, there’s a lot more to funding plans like which goal fits your association best. And this has to do with how much tolerance you have for the risk of special assessments. How much margin you want or need for the uncertainties of the future. Do you want to be at 100% funded? Do you want to be in that fair range Do you want to be touching into the red range and the difference in your reserves? funding between these three goals, whether weak, excuse me, whether just barely cash positive, or somewhere in the middle or pursuing the 100% funded, that can influence your reserve funding transfers by about 15%. Not really a whole lot. But notice today, we also didn’t address different funding calculation methods, components and cash flow, which are also known as straight line and pooled. Those choices can influence your reserve funding needs by factors of two, or three. So we have a choice here as much more significant than just the different funding goals, we’re going to have a very strong recommendation. And you’ll hear about that in our reserves days 103 program. And we tie that in with the answer to the question, how can that be with exactly the same expenses? So what down on your calendar? July 10, we’ll be presenting a program reserve sage 103, that funding plan answering all those questions, will take another 3545 minutes and answer those questions. In between. We’re going to have a webinar on June 25. Call the future proofing your reserve font, setting it up so that it is going to take good care of your association. Over time over decades show you’ll be able to do the incremental improvements that will help your older Association. Keep up with the new developments in your city or town. Okay, August 7, we’ll also be preparing the webinar for you called airing for financial resilience. That’s strategies for dealing with interest and inflation, always changing economic landscape. And that’s probably especially important this year with a presidential election year, and the changes that might make in our interest and inflation rates. And you’ll be able to sign up at our website that’s reservedstudy.com At the bottom of any page, scroll down to the bottom of any page and you’ll be able to sign up for our email list. And at the homepage, top right, you’ll be able to click on a link to get a free reserves a proposal for your association. To get Association reserves on your team help you get to an improved future. And also on our website will be a deep library of additional written and video resources. Or you can go directly to YouTube for even more videos on reserves on our YouTube channel. And speaking of additional resources, if you’re a board member, we highly recommend our weekly 30 minute podcast called common sense or common areas. Again, 30 minutes once a week with guest experts and regularly featured board member heroes, equipping and encouraging you in the hard work you do leading your association forward to sign up on your favorite podcast platform or go to the podcast website at hoainsights.org And we also have another resource book available to help you with your reserve lending decisions called Understanding reserves. And it’s designed to be an easy desktop reference summarizing components funding and with helpful hints on communicating with the homeowners. Get download chapter one for free on our website to get an idea if you’d like to order the book and get a sneak preview. Well, I hope we’ve left you today feeling better prepared to make wise decisions for your association, planning for the very predictable expenses that are coming your way. With our years of experience here at Association reserves. We’ve been down this trail many times. And whether through free webinars, our podcast, or our professional reserves a services. We guide 1000s of associations each year just like yours, safely and successfully down the path to an approved future.