Hearty Reserve Fund Critical for Timeshares Industry

Why is it important to fund reserves? To fully appreciate why a common interest realty association (“CIRA”) must put money aside in reserve, you need to understand its responsibilities as defined in the CIRA’s governing documents (such as the declaration, articles of incorporation, bylaws, etc.). The governing documents, as a rule, require the CIRA to maintain, repair and replace all portions of the common areas within the community. Common areas generally include the parts of the community-owned jointly by those who purchased a residence there with a right to use (such as pools, clubhouses, parks, fountains, spa facilities, and so on). The types of amenities included in the common areas vary depending on the community.

What happens when a community sustains large or unforeseen expenses? For example, entry gates and fencing need to be replaced, the clubhouse needs renovating, or the pool needs resurfacing. Whereas you might have rainy day fund to pay for large or untimely expenses, such as replacing a garage door or car repairs, a CIRA usually maintains a reserve fund for large, extraordinary, or unanticipated common area expenses. Having a healthy reserve fund helps ensure the community has the funds available to handle these types of situations when the time comes.

CIRAs must come up with the right amount to allocate to the reserve fund. It is generally recommended that CIRAs hire an independent consulting or engineering firm to conduct a reserve study, which provides a long-term funding plan for anticipated repairs and replacements. The reserve study will guide CIRAs regarding the necessary repair and replacement costs over the next 30 years and should be regularly updated (typically every three to five years). For example, if the reserve study projects that the HVAC system will need to be replaced in 15 years, the study’s schedule will allocate the estimated replacement cost over the 15-year period, and recommend that the CIRA collect sufficient maintenance fees to set a specified amount into reserves each year.

It is natural for the reserve fund balance to fluctuate, with expected peaks and valleys. In some years, the fund’s balance will be high, but after planned expenditures, the balance will be low and replenishment is necessary. These low levels are usually incorporated into the reserve study and are not a cause for concern on their own. However, any year when the balance is low is a significant year because the CIRA lacks the ability to pay for unexpected repairs or replacements without seeking alternative means (such as a loan or special assessment).

It is important to note that a reserve study is only a guide based on assumptions and data available when prepared. Educated guesses are a basis for amounts and dates of work required in the future. These forecasts may end up being inaccurate, depending on what happens in the future. For instance, poor maintenance decisions can result in the community having to replace components earlier than anticipated or there could be emergency repairs or replacements needed not encompassed by the study. Sometimes the Board is able to postpone certain repairs or replacements, within reason, which can skew the timing of expenditures in the study.

The laws about reserves and how often the CIRA should conduct a reserve study vary by state. In Florida, condominium associations must follow specific rules governing reserves. State statutes require Florida condominium associations to fully fund reserves in all proposed budgets and require a reserve study every three years. Those reserves must be funded in full unless the members of the association vote to waive or reduce them. If a Florida condominium association doesn’t waive the reserve funding requirement, it must collect for reserves. Statutes mandate reserves for any item that costs more than $10,000 to repair or replace. Assume an elevator’s estimated useful life is 30 years, and it would cost $300,000 to replace it. Divide 30 into $300,000 and you get $10,000 a year that the condominium association should reserve for the elevator. However, the statute allows associations to spend reserve funds for repairs if it extends the life of the asset by more than a year, so members of the association almost always vote to waive the reserve funding requirement because it’s likely they’ll have a major repair that will extend the useful life for several years.

Why is it important for current owners to contribute to a reserve fund? The mentality is that CIRAs should keep costs low for current owners, however that can lead to underfunding in the near-term and future special assessments. Instead, CIRAs should strive to spread out assessments over the period recommended by the reserve study. Board members are responsible for the long-term financial stability of the CIRA, which means planning to properly fund upcoming expenditures evenly over time. Owners, however, may know that they will not be living in the community five to ten years from now so they may be financially motivated to postpone expenditures as much as possible, thus leaving the financial burden on future owners.

The goal of any CIRA should be to achieve 100% funding, meaning the reserve fund balance is equal to what is recommended by the reserve study. The risk of a special assessment is linked with less than 100% funding. According to data provided by Association Reserves, Inc., a reserve fund that is 70% to 100% funded is considered strong with a low risk of special assessments and deferred maintenance. Anything less than 70% means that the CIRA has not saved enough. If large expenditures are still a long way away, the CIRA has time to get on track. But if large expenditures are imminent, there’s not much time for corrective action and a special assessment is more likely. Having a fully funded reserve fund is indicative of a CIRA that is properly saving for its long-term expenditures. Lower funding levels represent current and past owners who have underpaid, and the property has depreciated faster than they’ve contributed to reserves. They’re hazardous because ultimately the expenditures aren’t avoidable and eventually someone will have to pay for them. Failing to fund reserves is not a way of eliminating costs; it’s just shifting them to future owners.

Unfortunately, underfunded reserves are a common problem and one of the reasons that some mortgage lenders may consider CIRA’s a risky investment. Sometime in the future, the mortgagor could be hit with a large special assessment they can’t afford which in turn could put the loan at risk. Some lenders might take a closer look at the financial health of the CIRA as a whole (not just the individual borrower) when deciding if they will approve a loan. This includes the reserve fund and the CIRA’s ability to make future major repairs without the need for special assessments.

Regardless of whether or not the state you live in regulates reserve funds, you should be concerned about whether the CIRA in your community maintains adequate reserves. If not, you can expect a major increase in regular maintenance assessments or a large special assessment later on.

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Withum provides clients in timeshare, whole and fractional ownership associations and other industries with assurance, accounting, fraud reduction, and tax compliance services. For further information about Withum or to see how these matters affect you and your business, contact Lena Combs (lcombs@withum.com) at (407) 849-1569 or visit www.withum.com.