The Board’s Dilemma

How Can Community AssociationsAvoid a Funding Crisis?

Tyler P. Berding, Esq.

The Board’s DilemmaHow Can Community Associations Avoid a Funding Crisis?

Tyler P. Berding, Esq.Berding & Weil, LLP

Alamo, CaliforniaMay 2008

Berding | Weil3240 Stone Valley Road WestAlamo, California 94507Tel: 925-838-2090Fax: 925-820-5592www.berding-weil.com

© 2008 Tyler P. BerdingPrinted in the United StatesMay 2008

ContentsSection Title Page

Introduction The Board’s Dilemma 3

Chapter One The Failure of Voluntary Reserve Funding 6Revisiting the hard facts—associations need cash.

Chapter Two When Market Value Slips Out the Back Door 12Should owners take equity that they didn’t pay for?

Chapter Three Is Your Reserve Budget Just an Illusion? 19Adequate reserve funding requires diligence,not magic!

Chapter Four Will New Lender Rules Make Condos Harder to Sell? 20Paying the price for under-funded reserves

Chapter Five Is Mandatory Reserve Funding the Answer? 30Hawaii tried it, sort of. Is it California’s turn?

Chapter Six Stealth Reserves 30Tapping unused assessment authority.

Chapter Seven Community Maintenance Trusts 30

Chapter Eight The Reserve Crisis—Readers Respond 35

Conclusion 38

How does the board of directors ofa community association protect the interestsof the owners? Is its primary duty to eachowner or to the association as a whole? Thatdilemma has become increasingly difficult toresolve as the cost of properly maintainingand repairing aging homeowner associationprojects increases and the funds available tocarry out these tasks decreases. What stepscan a board take to adequately provide forthe future while protecting the owners fromoverwhelming assessment increases? Is thateven possible?

These and other questions havebeen raised by managers and boards of direc-tors who are trying to carry out their duties inthe face of diminishing resources. This collec-tion of articles is a sequel to our previousessay: The Uncertain Future of CommunityAssociations.1 That discussion forecast anunhappy end to those community associa-tions that did not adequately budget forfuture maintenance and repairs. But it had a

more troubling theme—that the very struc-ture of a community association, relying as itdoes on voluntary funding of reserves, isinherently flawed and probably could not befixed under the present statutory scheme, cer-tainly not in California, and probably not inother states as well.

We discuss the genesis of thereserve funding crisis, its consequences, andoffer suggestions on how to prepare a budgetthat properly anticipates the future, alongwith other ideas for avoiding a shortfall inreserves—deferred assessments and commu-nity maintenance trusts, as examples—unusual solutions but worthy ofconsideration.

In doing this we explore the dilem-ma facing every board—to raise assessmentsand adequately fund for the future, oracknowledge and acquiesce in the members’reluctance to pay higher assessments. To startthis discussion, let’s look at one example.

The Board’s Dilemma

The Board’s Dilemma 2

1 Berding, Tyler P. TheUncertain Future of CommunityAssociations —Thoughts onFinancial Reform, 2005.

I had a call the other day from awoman (let’s call her Mrs. X) who was verytroubled over recent increases in her home-owners’ association assessment. “I probablycan’t live here much longer if this keeps up!”she said. Turns out the board of directors hadraised the assessments by 20% on top of sim-ilar increases a year ago. They also levied aspecial assessment to fix some unexpectedproblems with the buildings. “Do you knowwhat they did when I complained?” She said,“They handed me your book and said to readit!” She was referring to The Uncertain Futureof Community Associations, a discussion ofthe perils of under-funding associationreserves. According to my caller, the boardwas using the book as at least part of the jus-tification for assessment increases.

Mrs. X was concerned because theassessments for her association were higherthan “comparable” associations in her neigh-borhood. We talked for a long time about thisissue. Her worry about rapidly increasingassessments pricing her out of her home wasnot misplaced. This particular assessmenthad now reached close to $500 a month, not

an insignificant sum, especially when addedto the occasional special assessment. For ayoung buyer, or a person living on a fixedincome, rapidly increasing assessments canbe frightening, especially in a down economywhen wages may not keep up with inflation.

What was happening here?According to Mrs. X, her association was wellmaintained and, at least from her perspec-tive, didn’t seem to need much in the way ofrepairs. So why the sudden need to increaseowner contributions? The board’s referenceto “The Uncertain Future” would indicatethat they were worried about under-funding.A casual glance around a well-maintainedassociation may not reveal the source of suchconcern. Perhaps they had been forced toplay “catch-up” from years past when aseries of boards had taken the easy way outand failed to gradually increase the reservecontributions. Or, possibly, a newly discov-ered issue with some building componenthad caused them to ratchet the assessmentsup rapidly to deal with the new problem.

We don’t know what the reasonwas, and, unfortunately, neither did Mrs. X,

4 The Board’s Dilemma

but those reasons, and numerous others, caneasily create a budget shortfall. And that’sthe dilemma that many associations face—dowe do what we should and increase ourfunding to keep up with inflation, or to takecare of a newly discovered repair problem ofsome sort, or to make up for years of fundingneglect—or do we take the politically expedi-ent course and ignore the problem? Whateverthe reason, if assessments are raised quicklythe owners are not going to like it and theboard will undoubtedly take flak because ofit. Board members know that some ownerswill have difficulty finding the extra fundsregardless of how worthy the cause, andsome may eventually be priced out of theirhomes as a consequence.

However, if the increased assess-ment represents the true cost of operatingand maintaining the property, how can theboard do otherwise? Mrs. X was right—thecost of living in some associations is risingrapidly, but the board is also right in doingwhat it’s doing, if the estimates upon whichthe increases are based are correct. If so,what these rapid increases actually represent

is the realization, pure and simple, that thetrue cost of ownership has been understatedfor a long time.

What we fear is that examples likethis one are just the tip of the iceberg andthat there will be many owners priced out oftheir homes over the next decade or so asmore boards face the real cost of maintainingthe association’s property. Ignoring that fortoo long is probably what got them to thispoint and the fix is going to hurt. It’s a realdilemma, to be sure.

The Board’s Dilemma 5

For almost ten years, we have beenwriting that common interest developmentsare infected with a fundamental flaw—theinability to raise adequate capital.2 We posit-ed that this flaw is structural in nature, inthat it arises from the basic political and eco-nomic nature of community associations,coupled with the legal environment in whichthey exist in California. These conditionsinclude the statutory limits on assessments,the diverse self-interests of individual own-ers, and the real cost of long-term mainte-nance and repair. We have suggested thatthese elements are responsible for a seriouslack of cash reserves. It is now apparent, fol-lowing two surveys done three years apart,that California’s system of voluntary reservefunding has failed.

The statutes that regulate commu-nity associations rely not on strong legislativedictates, but rather on the good will of devel-opers and the good sense of boards of direc-tors to accomplish necessary reserve funding.California law requires only disclosure offinancial condition, not mandatory funding ofreserves. Not only that, once an associationbegins to accumulate a reserve fundingdeficit we encounter the rule that “the boardof directors may not impose a regular assess-ment that is more than 20% greater than theregular assessment for the association’s pre-ceding fiscal year or impose special assess-ments, which in the aggregate exceed 5% ofthe budgeted gross expenses of the associa-tion for that fiscal year without… theapproval of a majority of the owners.”3

And there you have it—Californiahas a system of voluntary funding ofreserves. What follows will show that thissystem has failed to keep pace with need.Our opinion is based on evidence obtained inthe course of our practice over many years,on conversations with numerous industryprofessionals, and two surveys.

Notwithstanding the fact that there has beenalmost unanimous agreement that this phe-nomenon as we have described it is real,until recently there was little empirical evi-dence supporting that conclusion. That “datagap,” if you will, was called into question bySenator Tom Torlakson in his comments onthe study of Common Interest Developmentsperformed in 2003 by the California ResearchBureau, wherein he noted a lack of “objectiveevidence” on the financial condition of CIDs.

While few doubt that the problemis as we describe it, until recently it had notbeen statistically verified. To remedy that,Berding & Weil and Levy, Erlanger & Co.CPAs, in conjunction with ECHO, embarkedon a survey in 2003 of 687 community associ-ations to collect statistical evidence of thestate of association reserve funding.4 Whatwe found then was not pretty. Overall, for the687 associations surveyed the average per-cent funded was only 54%. This means thatthese associations had approximately half ofthe cash in the bank that they should havehad at that time to adequately fund theirreserves!5 In 2006, the size of the survey wasincreased to 1,254, primarily NorthernCalifornia community associations, usingdata prepared by independent reserve studycompanies.6 The 2006 survey produced asimilar funding percentage—53%; but whenthe survey results are broken down, it wasclear the problem is getting much worse.

The average size of this reserve“gap” was approximately $1,400 per unit in2003. In 2006, that figure ballooned to$5,600, or four times the shortfall of justthree years before. If these results are accu-rate for all California community associa-tions, computed at an average of 104 unitsper association, this represented a combineddeficit of approximately $5.1 billion in 2003.However, in 2006 that combined deficitwould have grown to $25 billion! This is no

6 The Failure of Voluntary Reserve Funding

The Failure of Voluntary Reserve Funding

2 Berding, Tyler P. “TheUncertain Future ofCommunity Associations,”ECHO Journal, May 1999.Berding, “Back to theUncertain Future,” ECHOJournal, August 2002. Berding,“The Uncertain Future ofCommunity Associations,Thoughts on FinancialReform,” Ibid.

3 California Civil Code Section1366(b).

4 “The Uncertain Future,” Ibid,page 25.

5 This observation was alsocorroborated in a discussionwith one Southern Californiareserve study company thatobserved, based on more than7,000 reserve studies preparedby that firm over 20 years, thatthe average percent funded hasremained in the mid-fifty per-cent range over time.

Revisiting “The HardFacts: AssociationsNeed Cash!”

longer a theoretical problem. These surveyswere conducted with data available to theauthors of the study. It may or may not bestatistically representative of all of the associ-ations in California, but coupled with otherobservations and evidence, many communityassociations in this state would appear tohave been in serious financial trouble in 2003and in a worse financial condition in 2006.The following sections compute percentfunded by association type, age, size and byreserve study company.

In both surveys, results were sum-marized on the basis of: type of development(condo [includes condo conversion], planneddevelopment); age of development (1–5 yearsold, 6–10 years old, 11–15 years old, 16–20years old, 21+ years old); size of develop-ment (2–25 units, 26–50 units, 51–100 units,

The Failure of Voluntary Reserve Funding 7

Development Type Year No. ofAssociations

Avg. PercentFunded Avg. Unfunded

Condominium Conversions 2006 71 44% $ 7,700

2003 –

Condominiums 2006 579 46% $ 6,300

2003 400 52% -

Planned Unit Development 2006 530 63% $ 3,600

2003 248 59% -

Table 1 Percent Funded by Type of Development

Figure 1 Percent Funded by Type of Development

6 A simple example will illustrate the methodology used by themajority of reserve study practitioners in California:

Component Roof Paint Paving TotalUseful life 18 years 7 years 6 yearsRemaining life 5 years 3 years 2 yearsCurrent replacement cost $180,000 $140,000 $60,000Estimated annual wear $10,000 $ 20,000 $10,000 $40,000Estimated Obligation (EO) $130,000 $80,000 $40,000 $250,000Estimated Cash Reserves (ECR) $150,000Percent funded (ECR/EO) 60%

All representations of percent funded included in this survey havebeen computed using the “straight-line” computation of percentfunded. Effective July 1, 2005, the method of computing percentfunded had to be disclosed in the annual pro forma operatingbudget. For the few reserve study companies included in this sur-vey which did not compute percent funded on the “straight line”basis, such computations were performed based on the replace-ment cost data (estimated current replacement cost, estimated totaluseful life and estimated remaining life) developed by those reservestudy companies.

101–150 units, 151–325 units, 326–500 units,501+ units); and reserve study company (12companies in 2006 and 13 in 2003, board/management and other). For the 2006 survey,condominium conversions were broken outas a separate type of development.

Type of Development

Percent funded was computed forthree types of developments: condominiums,condominium conversions, and planned unitdevelopments. The results by developmenttype are shown in Table 1 and Figure 1.

The percent funding for condo-miniums (not conversions) was much worsein 2006 than three years before—droppingfrom 52% in 2003 to 46% in 2006. In the2006 survey, condominium conversions havethe lowest percentage of all—44% funded onaverage. Again, that means that such projectshave only 44% of the funding required bytheir reserve study actually on hand. This isespecially worrisome since many of thoseprojects have been converted recently andfunding requirements are based only on theDRE approved component list which is

8 The Failure of Voluntary Reserve Funding

Age Year No. ofAssociations

Avg. PercentFunded

Avg. UnfundedPer Unit

1–5 years 2006 119 75% $ 3,200

2003 19 80% -

6–10 years 2006 138 70% $ 2,800

2003 87 81% -

11–15 years 2006 136 60% $ 4,200

2003 90 77% -

16–20 years 2006 197 53% $ 9,200

2003 154 63% -

21+ years 2006 658 45% $ 6,500

2003 330 43% -

Table 2 Percent Funded by Age of Development

Figure 2 Percent Funded by Age of Development

almost always inadequate to assess the needsof these older apartment buildings now con-verted to condominiums.7

Planned developments, includingtownhouses, duplexes, and other attachedhousing that are not condominiums, haveactually improved their funding percentage inthe past three years from 59% in 2003 to63% in 2006. This may be because in suchdevelopments the community association is

responsible only for the exterior “skin” of thebuilding—paint and the roofs—as well as thecommon area streets and landscaping. Theyare not responsible for many of the veryexpensive replacement items in many condo-minium projects: siding replacement; woodbalcony rot; wood entry structure replace-ment; and termite and mold damage. Theseitems rarely appear in a reserve budget untilthey are identified for repair; hence, an

The Failure of Voluntary Reserve Funding 9

Size Year No. ofAssociations

Avg. PercentFunded

Avg. UnfundedPer Unit

2–25 units 2006 195 47% $ 10,300

2003 87 43% -

26–50 units 2006 283 47% $ 6,300

2003 131 51% -

51–100 units 2006 326 55% $ 4,400

2003 186 55% -

101–150 units 2006 183 57% $ 4,600

2003 108 59% -

151–325 units 2006 201 59% $ 4,000

2003 119 51% -

326–500 units 2006 29 54% $ 3,500

2003 26 42% -

501+ units 2006 35 65% $ 800

2003 30 64% -Table 3 Percent Funded by Size of Development

Figure 3 Percent Funded by Size of Development

7 The California Department ofReal Estate basically treats con-versions like new constructionand consequently, the compo-nents for which they requirereserves are the same onesfound in new construction.

immediate shortfall results because there areno funds earmarked for this purpose.

This situation is exacerbated incondominium conversions because many ofthose components require replacement, notin 15 to 20 years after the project is first soldas with new construction, but in many casesalmost immediately since the buildings areoften 20–25 years old with a decade or moreof deferred maintenance when they are con-verted and first sold as condominiums.

Age of DevelopmentPercent funded was computed for

five age groupings: 1–5 years, 6–10 years,11–15 years, 16–20 years and 21+ years. Theresults by age grouping are shown in Table 2and Figure 2. The 2003 data indicated—to nosurprise—that the older an association is thegreater the under-funding of reserves is likelyto be. Hence, it was projected that the under-funding of reserves was likely to continueand/or worsen, and the 2006 informationshowed that this problem had indeed gottenworse. In 2003, the newest associations,those 1–10 years old, hovered around 80% oftheir required funding. The 2006 surveyshowed a marked decrease, with the newestassociations then showing only about70–75% of necessary cash on hand.

At the other end of the range—those associations over 21 years of age—thepicture was much the same as in 2003. Theoldest associations had about 45% of thecash on hand that their reserve programsrequired. The funding situation for those inbetween, from 10 to 20 years old, haddecreased, from 63 to 80% in 2003, to 53 to70% in 2006.

Size of DevelopmentThe data based on size of the

development seems counter-intuitive. Largerassociations are better funded than smallerones as Figure 3 shows, although none ofthem have anywhere near the requiredamounts of cash in the bank.8 Larger associa-tions, those with more than 100 units,

showed funding figures for 2003 that are verysimilar to the figures for 2006—59% to 64%,compared with 57% to 65%. Smaller associa-tions, those under 100 units, were between43% and 55% funded in 2003 and between47% and 55% in 2006. Based on develop-ment size, the funding percentages werenearly the same in 2006 as they were in 2003.

Percent funded was computed for7 groupings of development size: 2–25 units,26–50 units, 51–100 units, 101–150 units,151–325 units, 326–500 units, 501+ units.The number of units is based upon the built-out number of units for the project.Accordingly, especially for the larger projects,the unfunded dollars per unit may be under-stated if the project is phased and not yetfully built out. The results by size are givenin Table 3 and Figures 3 and 4.

The most startling fact is theamount all developments are under-fundedon a per-unit basis. Larger associations areunder-funded in the range of $3500 to $4600per unit, although the very largest show onlyan $800 per unit shortfall. The very smallestdevelopments, however, those with 2–25units, show under-funding equal to $10,300per unit. This contrasts remarkably with thegraph in Figure 4 from the 2003 survey,which shows a range of per unit under-fund-ing from about $500 in the largest develop-ments, to just under $6,000 in the smallest.

Comparison of Funding byReserve Study Company

The percent funded by reservestudy company is summarized in Table 4.Percent funded results were computed for 12reserve study companies studies based on 18or more reserve studies per reserve studycompany. This information does not neces-sarily indicate that under-funding is the resultof the reserve study itself. Reserve studiescalculate the amount of cash that a particularassociation should have in the bank. There isno requirement in California law that theassociation actually put that money aside.Boards of directors have to make that deci-

10 The Failure of Voluntary Reserve Funding

8 It may be that larger associa-tions enjoy greater cash flow,which allows them to makemore use of professional con-sultants and managers, and insome cases, in-house repairteams. Also, the very largestassociations are often planneddevelopments where the asso-ciation’s maintenance respon-sibilities to the buildings areminimal.

sion, and very few choose to fully fund theirreserves.

The foregoing results appear toindicate that boards or their managers areless conservative than most outside reservestudy firms. This tentative conclusion, how-ever, is based on only 37 associations, whichprepared their own reserve study or approxi-mately 3% of the population surveyed. It isalso true that these results do not take intoaccount the actual recommendations of thereserve study company, which may havebeen more or less conservative than whatwas later adopted by the board of directors. Italso relies on the actual cash in the bank, andnot the actual recommendations of the com-panies themselves.

ConclusionsIn most respects, this survey

speaks for itself. Smaller, older condominiumassociations tend to be worse off than larger,newer planned developments. That does notmean, however, that the newer, larger associ-ations do not face capitalization problems. Itsimply means that their obligations probablyhave not matured to the point where thefunding shortfall is critical. The 2006 surveyclearly shows what common sense tells us—

when you convert a 25-year-old apartmentbuilding with lots of deferred maintenance toa condominium, the owners will most likelynot be able to afford necessary maintenanceand repairs and an immediate financial crisisis likely. What the survey also indicates isthat the trend is the same for all types ofcommunity associations. It also suggests thatin most cases, the funding crisis is just a mat-ter of time.

What to do? As we have statedbefore, each director of a common interestdevelopment must insist on a realisticappraisal of the condition of the project andthe cost of future maintenance. Any tempta-tion to underplay these elements to keepassessments low must be resisted if the asso-ciation is to have any chance at financial sta-bility. The long-term financial security thatwould result from an aggressive increase infunding will be worth whatever adverseshort-term political consequences mightensue. Those boards of directors that havethe courage to put such a program in placewill strike a blow for sound fiscal manage-ment. For those who do not, the financialconsequences seem increasingly ominous.

The Failure of Voluntary Reserve Funding 11

Figure 4 Unfunded Dollars Per Unit by Size of Development

Company No. ofAssociations

Avg. PercentFunded

R1 183 67%

BOARD 37 56%

R3 158 56%

R4 36 52%

R5 18 51%

R6 126 62%

R7 69 50%

R8 61 50%

R9 28 51%

R10 220 50%

R11 194 42%

R12 33 46%

R13 29 28%

Table 4 Percent Funded by Reserve Company

We have already talked a lot aboutthe state of reserve under-funding and whatit can do to a community association. Formany years, we have tried to focus attentionon the long-term effects of failing to save ade-quately for the inevitable reconstruction orreplacement of major building components.Nevertheless, we still see every day examplesof what happens when a board fails to budg-et to meet these needs. As noted above, asso-ciations with less than half of the funds need-ed for a major reconstruction project arecommon. Associations with no funds at allare less common, but becoming more so allthe time.

With the evidence of under-fund-ing so widespread, what we have not beenable to understand fully is why more ownershave not raised this issue with their boards.Why hasn’t the subject of failing to fundproper maintenance and repair been raised atelection time as a reason for turning out theboard? After all, a properly funded budgetand a well-maintained project add real valueto all of the units in the project.

The answer is simple. No one likesto spend money, no one likes higher monthlyassessments, and the condition of the reservefund is often too esoteric to be understoodfully by either boards or owners. Also, thepressure to keep assessments low easily out-weighs any concern that might exist over thecondition of the building until it gets so badthat no one can hope to sell their unit at any-thing close to market value. We recently ranacross the following quote in a memo fromthe Department of Real Estate:

“All condominium associationsface the problem of high and ever increasingcosts to maintain a condominium project,including reserves. To compound the prob-lem, a number of condominium boards can-not, or will not, make ‘hard and unpopular’

decisions of raising maintenance fees to meetthis problem and facing any criticism.

“The law requires condominiumassociation boards to study the project’s par-ticular maintenance and replacement needsof the common elements and to collect andestablish reserves so that funds will be onhand when repairs and replacements areneeded as well as emergencies. The law wasenacted to provide relief for the vast majorityof condominium associations, although agood number of well-managed condominiumassociations were already providing forreserves. If the reserves are properly calculat-ed, each owner’s share should only be whatthe owner ought to be putting aside eachmonth for the true cost for repairs andreplacements. The law tries to prevent ownersfrom taking value out of a condominiumproperty by under-funding reserves, sellingout, and leaving subsequent purchasers to payfor the under-funding…

“Any delay in confronting and con-trolling reserve situations will not change thecondominium association’s need for repair orreplacement or the common elements nor theneed for funds. The Commission’s researchreflects that those condominium associationsdeciding on 50% funding of reserves and/orare substantially under-funded, especially ifthey face major common area repairs andreplacements in the near future, will have todramatically increase maintenance fees,make special assessments and/or take out aloan.” (Emphasis added) Pretty timely stuff—right?

No. The Hawaii Real EstateCommission wrote that memo in 1995. Theproblem has obviously been around for along time, and not just in California. Twostatements from that memo stand out. Thoseassociations that have decided to only fundtheir reserves at 50% or less had better startlooking for alternate funding. It cannot be

12 When Market Value Slips Out the Back Door

When Market Value Slips Out the Back Door

Should Owners TakeEquity That TheyDidn’t Pay For?

put off forever, and under-funding cannotusually be made up by merely increasingmonthly assessments alone. It’s too late forthat ten years down the road. Special assess-ments coupled with bank loans (which alsorequire monthly payments) are usually neces-sary, making the financial hit on the thenowners that much greater and make unitsharder to sell.

But the statement that really hadan impact on me was this one: “The law triesto prevent owners from taking value out of acondominium property by under-fundingreserves, selling out, and leaving subsequentpurchasers to pay for the under-funding…”That’s exactly what happens when an associ-ation bends to political pressure and toleratesan assessment level that is less than what isnecessary for predictable maintenance andrepair. The board allows current owners totake value out the back door by passing onthe liability to future owners. The seller hastaken value by failing to pay his share of themaintenance and repair costs.

You could argue that the conditionof the building and the budget will be reflect-

ed in the sales price. Perhaps it will be, if theseller’s disclosures are adequate and/or thebuyer is sophisticated enough to ask the rightquestions or employ the right professionals toinspect the buildings. However more oftenthan not, none of this is apparent to the aver-age owner who simply assumes everything isas it should be, and no discount on the ask-ing price is demanded. Under fundingshould, however, be quite obvious to boardmembers and managers who have a betterworking knowledge of the true financialhealth of the association. Their duty is topresent and future owners when determiningthe proper level to set reserves.

So how do boards discharge thisduty? By not permitting owners to walk awaywith value they didn’t pay for. The way to dothat is always the same: raise monthly assess-ments enough to reflect the true cost of own-ership regardless of political pressure.Anything less is the easy way out.

When Market Value Slips Out the Back Door 13

Law firms have seen an increase inclaims for defective budgets in recent years.These claims arise when associations find outthat what they thought was a solid budgetturns out to be an illusion. The financial pro-tection they expected has vanished uponcloser inspection. Budget claims to develop-ers most often arise in conjunction with con-dominium conversions, but we have alsoseen them associated with newly built proj-ects. Because the damage that a communityassociation can sustain from a budget thathas not been adequately prepared can be sig-nificant, we have delved into the budgetprocess to give our readers a look at the pro-cedures and issues that accompany reservebudget preparation.

How many of you can say thatyour community association’s reserve budgetis adequate? Think about that for a moment.Ok, a show of hands. Now, everyone whoraised his or her hand, tell me this: how doyou know? Have you reviewed thoseaccounts yourself? Could you prepare one ifyou wanted to? What criteria would you use?Where would you get the numbers? Do youknow if the figures used in that budget arebased on solid facts, or did someone justwave a magic wand over them and hope forthe best? We’ve written a lot on these pagesabout how many reserve budgets lack neces-sary funding to meet their stated goals, buthere’s a new one: what if your budget is fullyfunded but the goals have been under-estimated?

To know the answers to thosequestions, and unless you are a CPA or areserve study professional, you probablyneed to know a lot more about what goesinto the preparation of an association reservebudget than you do now. For starters, youshould know what the State of Californiarequires. You should also know how a profes-sional goes about creating a budget—what is

typically done, and what is not done. Finally,you should consider how often the budgetshould be revised.

But first, why would a manager,board member, or member of the associationneed to know this stuff? Isn’t that what wehire other professionals for? Yes, but budgetpreparation requires a broad array of skillsand experience—accounting, construction,cost estimating, property management, andmaybe even a little law thrown in—and fewindividual professionals possess every one ofthose skills. Someone has to be sure that allthe bases are covered, and that responsibilityoften falls to managers or board members. Ifyou are among that group, then having abasic understanding of reserve budget prepa-ration, and the pitfalls associated with it, is agood idea. A little time spent now in gainingan understanding of the critical issues inreserve budget preparation might make a bigdifference a few years down the road.

To gather material for this chapter,we discussed reserve issues with John D.Beatty, owner of John D. Beatty & Company,professional reserve analysts and construc-tion managers. I also spoke with Tim Nerby,who for 17 years was an Appraiser with theCalifornia Department of Real Estate in theSubdivision Department. Among otherthings, Mr. Nerby’s job at the Department ofReal Estate was to review the submittals bydevelopers to determine whether they metthe DRE standards. He now works with JohnBeatty doing budget analysis and budgetpreparation for community associations.

Department of Real Estate BudgetGuidelines—Solid Standardsor Magic Wand?

Most association reserve budgetsstart life with the California Department ofReal Estate. Developers of new constructionand condominium converters cannot selltheir properties to the public without

14 Is Your Reserve Budget Just an Illusion?

Is Your Reserve Budget Just an Illusion?

Adequate ReserveFunding RequiresDiligence, NotMagic!

approvalfrom theDRE. To getthat approval,the developerhas to submit anannual budget for thefuture association thatmeets the standards of theDepartment; and that includesthe reserve budget. The DRE guide-lines for reserve budget preparation arefound in the Operating Cost Manual andReserves Worksheet published by theDepartment. That document provides the cri-teria by which the department will evaluatethe developer’s proposed budget. If the sub-mitted budget meets the criteria, the budgetwill be approved and eventually a FinalPublic Report will be issued, allowing thedeveloper to market the property. This firstbudget is then provided by the developer tothe new association.9

Missing Components. This wouldall be fine if the DRE criteria were adequatein the first place. For various reasons they

maynot be. Thefirst problem is the failure to include somecomponents with an obvious service life. TheOperating Cost Manual for HomeownerAssociations lists those components that itrecommends for inclusion in a reserve budg-et. One of the most problematic buildingcomponents in any condominium or planneddevelopment project is exterior wood. Thiscan be found in siding, balconies, entry struc-tures, and trim. On some common interestdevelopments, the entire exterior is wood.

Is Your Reserve Budget Just an Illusion? 15

9 Our thanks to John D. Beattyand Tim Nerby for the gener-ous contribution of their timein assisting this writer tounderstand some of thenuances and pitfalls to beencountered in reserve budgetpreparation and the policies ofthe California Department ofReal Estate.

We all know that wood deteriorates quickerthan say, stucco; so, it is very important thatthe association maintain all of that woodproperly. Proper maintenance includes peri-odic painting, but also repair and, eventualreplacement. But that takes money, and thefunds for caring for all of that wood shouldbe found in the reserve budget. So let’s lookat how the California Department of RealEstate prepares an association for woodmaintenance and replacement.

Look at any aging association withexterior wood and it will be clear that woodproducts decay and will eventually need tobe replaced. We have never talked to a singlearchitect or contractor who believes thatwood siding or balcony rails or staircases willlast forever, even with periodic painting. And,if you look at the typical apartment buildingconversion that is already 20–30 years oldwhen it’s converted to condominiums, thewood on the building will definitely show itsage and it is obvious that most, if not all ofthe exterior wood is in sight of the end of itsservice life.

Knowing this, you would expectthat the Department of Real Estate wouldinclude the replacement of exterior woodcomponents within the scope of its OperatingCost Manual and the Reserves Worksheet.Right?

Wrong. The only reference to exte-rior wood is in Section 301—“Painting.” Thecost for exterior painting is shown as $1.12per square foot and if what is being paintedis wood (whether siding, balconies, stair-ways, etc) you are to add an additional $0.20per square foot. That’s it. There is no sug-gested reserve for repair or replacement. Inother words, the California Department ofReal Estate believes that exterior wood willnever have to be replaced if it’s painted atcertain intervals. There is nothing in theDRE’s guidelines for the eventual replace-ment of any exterior wood component. Now,wood fences are given a 10-year useful lifeand a reserve for eventual replacement. But

not wood siding or any other exterior woodcomponent on the building.

Cost Estimates. The budget mayproperly include a component, but strictlyfollowing DRE guidelines may lead to under-funding in other ways. The estimated replace-ment costs, for example. The Operating CostManual identifies the cost to replace a com-position shingle roof at $2.60 per square footin 2007. Prior to that, the number was $1.80per square foot. Mr. Nerby advises that theactual cost of removing and replacing a com-position shingle roof is closer to $4.38 persquare foot, which does not include any peri-odic repair or maintenance costs if requiredby the age or condition of the roof.10 If so, anassociation that strictly followed the DREguidelines would start life with a roof reservethat, unless modified, would never accumu-late enough to replace the roof.

And up until now, we were justdiscussing the roof covering and associatedsheet metal pieces. Roof replacement onolder buildings can also require replacementof some of the structural components of theroof as well—principally roof sheathing, theplywood deck that underlies the roof mem-brane. The cost to replace portions of that, orworse, to add such design elements as ade-quate slope on flat roofs, will raise replace-ment costs appreciably which we have neverseen included in a DRE-approved budget.

The Department does includesome cautionary notes in the manual, forexample: “The reserve section of this manualonly includes components or costs for itemsmost frequently found in common-interestsubdivisions. Reserve items for your budgetmay not be limited to those found in thismanual. Your budget should be tailored to fityour project and include necessary reservesfor all appropriate items.”11 There is appar-ently no enforcement or oversight of theseconcerns by the Department, and if the devel-oper chooses to stay within the Department’sminimum standards, its budget will beapproved.

16 Is Your Reserve Budget Just an Illusion?

10 Mr. Nerby offers the follow-ing information applicable toconversions: “It should bepointed out that the reservefactors in both of these operat-ing cost manuals ‘are basedupon new building compo-nents and equipment.’ Bothmanuals go on to say:‘Therefore, these reserve fac-tors need to be adjusted if theyare to be used for an existingdevelopment or for the conver-sion of an existing structure.For existing structures youwould normally divide the costof replacing the component byits remaining useful life.’”

11 California Department ofReal Estate, Operating CostManual for Homeowner’sAssociations, Revised April,2007.

The Department also states: “It isrecommended that associations consider veri-fication and, if necessary, correction of theirmajor component inventory after projectstart-up.”12 Even more interesting, anotherDepartment of Real Estate publication states:“Many an association has found that, despiteits existence, an item such as a sidewalk orset of balconies has not been mentioned ineither the CC&Rs or the developer budget. Asite analysis by knowledgeable personsshould result in a comprehensive list ofreserve items for which the association is, ormight be, responsible.”13 That publicationalso devotes a great deal of space to othercautionary tales such as why an associationshould consult with multiple cost manuals orother contractors to be sure that such thingsas cost estimates and quantities are accurate.The publication, Reserve Study Guidelines forHomeowner Association Budgets, is availableat: www.dre.cahwnet.gov/pdf_docs/re25.pdf.

This is all well and good, but bythe time a new board member has a chanceto read any of these publications or caution-ary notes, the budget has long been in con-crete, the homes are sold, and the homeown-ers have purchased on the strength of theassessments included in the original budgetand represented to them at the time of sale. Ifyou read the Reserve Study Guidelines, youwill see page after page of recommendationsthat go far beyond the minimal requirementsemployed in the project approval process. Itis truly amazing that the DRE can devote anentire publication to what an associationshould do to avoid reserve budget pitfalls,while its own budget review process ignoresmost of those recommendations and leavesmajor budget decisions up to the developerpromoting the project! There’s somethingvery wrong with that picture, or maybe theCalifornia Department of Real Estate is notclear on its mission.

There is little reason for a prospec-tive homebuyer to challenge a financial planthat appears to be blessed by the State of

California. This renders moot any cautionarynotes issued by the DRE and leaves anyunder-funding to be dealt with by the associ-ation board. In other words, by the time own-ers read the provisions of the Operating CostManual or Reserve Study Guidelines, thedeveloper is usually long gone, and it is toolate to correct its initial mistakes or intention-al under-funding. What these various publi-cations do tell us, however, is that theDepartment of Real Estate is well aware ofmany of the concerns that we have long beendiscussing. Perhaps one day it will imple-ment enforcement.

Which Wizard Prepared Your Budget?The accuracy of your budget will

often depend upon who prepared it. A devel-oper or converter does not want high month-ly assessments compared to comparableproperties in the neighborhood. Higherassessments may make its product less mar-ketable and fewer buyers will qualify to buythose homes. So a developer will likely pushback on initial reserve calculations if theyresult in an assessment that is too high forthe market. There are numerous ways toinfluence this as we have seen. Leave outcomponents, lower unit costs, lean towardrepair rather than replace, and lengthen use-ful lives. Unfortunately, it is the future buyer,and not the developer, who will have to dealwith any under-funding that results fromthese maneuvers.

The association board members,while always under pressure from owners tokeep assessments from rising too fast, never-theless are also owners of the property andwill eventually want to sell their interests.Buyers are becoming increasingly moresophisticated in the financial and physicalhealth of condominium and planned develop-ment projects and will want to know not onlythe condition of the buildings but that of thebudget as well. So, a gamble on reserve fund-ing may not be the smart move in the endand boards of directors, working with theirbudget professionals, have the best opportu-

Is Your Reserve Budget Just an Illusion? 17

12 Ibid.

13 California Department ofReal Estate, Reserve StudyGuidelines for HomeownerAssociation Budgets, April2004.

nity to correct the developer’s mistakes. Thisis especially true early in a project’s life andthe reserve study done after the developer’sdeparture is a good place to start.

In the end, there are many thingsan association can do to offset the problemspresented by an original budget that fails toadequately prepare the association to main-tain and repair its common area. The lack ofoversight by the DRE or the mistakes of adeveloper, intentional or otherwise, can beovercome with diligence and attention toguidelines and statutes. All associations, oldand young, can get the budget back on trackif they obtain realistic estimates and areready to tackle the difficult political issuesthat come with raising assessments.

Looking Beyond the Crystal Ball—The Anatomy of a Reserve Study

As you can see, an association thatcontinued to follow the DRE guidelineswould most likely never accumulate suffi-cient reserves. That’s not surprising since theDRE admits that its guidelines are minimal.14

Unfortunately, as we have said, many devel-opers have been all too happy to adopt thisminimalist approach. The Legislature, howev-er, has seen to it that if the original budget isdeficient, there are ways to correct it.California Civil Code Section 1365 requiresthat a board state its budget annually, includ-ing any deficiencies in the reserve funding,and distribute copies to the members.

But more important, CaliforniaCivil Code Section 1365.5 requires: “At leastonce every three years, the board of directorsshall cause to be conducted a reasonablycompetent and diligent visual inspection ofthe accessible areas of the major componentsthat the association is obligated to repair,replace, restore, or maintain as part of astudy of the reserve account requirements ofthe common interest development… Thestudy required by this subdivision shall at aminimum include… identification of majorcomponents that, as of the date of the study,have a useful life of less than 30 years.” This

is what is commonly known as a “reservestudy,” which is a legal requirement for allassociations. The reserve study also includesan estimate of the cost of repair and theamount necessary to be contributed annuallyto insure adequate funding.

What’s Included in the Budget?Good budget professionals will

modify or augment the initial DRE budget inseveral ways. First, they will likely add morecomponents to those in the original budget.Second, they use cost estimates that reflecttrue market prices. Professional reserve ana-lyst John Beatty says that new associationsshould seriously consider having an initialreserve study done, not at the three-yearpoint, but rather in the first year after thedeveloper turns over the project to theassociation.

What else will the expert budgetwizard do to assist your association in con-ducting a reserve study and preparing thebudget? It won’t be done with smoke andmirrors. Good professionals will insure thatthe physical inspection of the project is ade-quate to confirm or reject the assumptionspassed on to the association by the developer.They will use that information to add to thelist all building components that have anidentified service life of less than 30 years.

What’s Not?Inspections performed as part of a

reserve study will typically not include inac-cessible portions of a building such as wallcavities, attic spaces, and enclosed founda-tion areas, especially where portions of thebuilding may have to be removed for access.The statute doesn’t require it, and the typicalreserve study follows the statute. But where asurface inspection indicates that there mayhave been leaks through exterior walls, theroof, or moisture accumulation under build-ings, a more intrusive inspection may be nec-essary to determine if any of this moisturehas led to rot or other deterioration in theseinaccessible areas. This is especially true for

18 Is Your Reserve Budget Just an Illusion?

14 Mr. Nerby states that duringhis tenure with the DRE, thedepartment considered allbudget numbers in theOperating Manual to be theminimum required and lookedto developers and their budgetpreparers for any modificationsthat might be necessary.

older buildings. Also, reserve inspectionsmay not include plumbing lines that couldrequire replacement during the life of thebuilding.15 If your association is more than,say, 25 years old or if there has been evi-dence of leaks, ask your reserve study profes-sional if a more intrusive inspection into cer-tain areas is recommended.

The Calculations. After inspec-tion, the reserve professional will calculate afunding plan that sets appropriate and realis-tic goals based on true market costs. Andunlike the developer, who tries to make thebudget fit a pre-conceived assessment inorder to qualify buyers and sell units, thegood budget professional will make the fund-ing plan fit the association’s real repair andreplacement needs to give the board an accu-rate picture of its funding requirements. Theboard can then decide whether to raiseassessments or not. But only with an accu-rate picture of its financial needs can a boardof directors make informed fund-raisingdecisions.

Making Your Own MagicYou can improve your associa-

tion’s chances of surviving a reserve-fundingcrisis by checking the following factors:

1. Double Check the List ofComponents. The Department of Real EstateReserve Checklist includes 30 major compo-nents that it suggests should be included in areserve budget. Beatty’s list contains 81 com-ponents, indicating that the more modernview is to be over-inclusive to avoid surpriseslater on.

2. Confirm Unit Costs. Roofing ismeasured in square feet, or sometimes“squares” (100 square feet) and a cost torepair assigned to that unit of measurement.As we stated above, the Department of RealEstate cost manual appears to offer unit coststhat in some instances are substantiallybelow market. It is important that the costthat is applied to each unit of measurement isan accurate reflection of the true cost of

repair and is periodically updated to reflectinflation.

3. Question Estimated UsefulLives. Another factor that can throw off areserve budget is an over-estimate (or under-estimate) of the useful life of a building com-ponent. If the life of a roof is estimated at 25years but it only lasts 15, the association willbe faced with a big roofing replacement costlong before it has saved enough cash to dothe work. This is not as much of a problemfor new projects as it is for conversions. Withnew construction not only does the associa-tion have many years to correct any estimatedeficiencies, but the expected life of a newroof, or new paint, or new asphalt is reason-ably predictable based on industry standardsand averages. Furthermore, the Departmentof Real Estate lists suggested useful lives formany major building components (not woodsiding, however, as mentioned above). Butthe remaining useful life of a 15- or 20-year-old roof, for example, on a 35- or 40-year-oldconverted apartment house may be difficultto estimate accurately. This is one reasonwhy a reserve study at developer turnoverand every three years after that is so impor-tant. If nothing else, it serves as a log of thecondition of the building so that previousassumptions can be evaluated and correctedif later history proves them wrong.

4. Check Quantities. How do youknow that the number of square feet of roof-ing shown in your reserve budget is an accu-rate calculation? Architects or engineers cancalculate such things using the drawings forthe project, assuming the drawings are an“as-built” set. Be sure that someone has spot-checked the quantities shown in the initialbudget to be sure they are right. If the roofingor siding quantity shown in the budget is lessthan actually exists on the project, your fund-ing plan will not work.

5. Repair vs. Replace. Even whena component is included in a reserve budget,different budget preparers have differentviews on what to do with that component.

Is Your Reserve Budget Just an Illusion? 19

15 It should be noted that theDepartment of Real Estatebelieves that plumbing willnever need a reserve.

Virtually all reserve budget professionals andmost contractors agree that at the end of aroof’s useful life it should be completelyreplaced. Now, there may be instances wherea partial replacement is adequate, but that’srare. However, some experts might disagreeabout whether you should tear off the oldroof first, but most budgets you will find willcall for complete replacement of a roof at theend of its useful life. Not so with other com-ponents. Take exterior wood, for example.Some experts will call for complete replace-ment of wood siding at the end of its estimat-ed useful life, while others will provide onlyfor periodic repair of a small percentage ofthe wood—say 5% to 25% over a 10- to 20-year period. The “repair” approach assumesthat a substantial portion of the siding willnever need replacement since if you repaironly 5% every 10 years you are never goingto get to all of it.

With components like wood sidingor other exterior wood, a decision to simplyrepair a small percentage every ten years,rather than to provide for complete replace-ment, say, 30 years into the future, will resultin the association suffering a major shortfallshould replacement become necessary. Onthe other hand, augmenting a paint budgetwith additional funds for “miscellaneous car-pentry” every five years will allow an associ-ation to do periodic repairs in conjunction

with repainting, and on some projects thatmight be good enough, and clearly betterthan what is suggested by the DRE.Budgeting for full replacement is conserva-tive—but costs more. Providing for repaironly is a gamble but can result in lowerassessments. Our opinion is to take the con-servative route. In the unlikely event that youfind you have too much money in reservesyou can always give some back!

6. Straight Line vs. Cash Flow.This refers to two different accounting meth-ods used to prepare a funding plan for areserve budget. I will not pretend to under-stand the nuances of these two systems, butsuffice to say that the advocates of each arenot hesitant to defend them. The differencesbetween them and their respective philoso-phy would offer enough material for an arti-cle on this issue alone. But let me try toexplain why each might be important to anassociation. The “straight line” methodassigns a funding goal to each component inthe reserve budget separately without regardto the accumulation of funds for other com-ponents. It’s like having an individual reserve“account” for each component—roofs, paint,asphalt, etc. The balance in one component“account” is not considered available to satis-fy the funding requirements of another com-ponent. The cash in each of these separate“accounts” is compared to the funding

20 Is Your Reserve Budget Just an Illusion?

requirements of each when determining theadequacy of the association’s funding,according to David Levy, CPA.

The “cash flow” method focusesinstead on the total cash available to addressall pending repair issues at any one momentin time. Nerby states, “…part of creating anacceptable cash flow method is to anticipatethe expected expenses for many years tocome (usually at least 30 years) and to annu-ally fund enough money in reserves to coverall the annual expenses no matter in whatyear they occur. In addition to the reservefunds needed each year to cover expendi-tures, there should also be a “cushion” estab-lished that will define the lower limit (of thereserve account).” In other words, if there issufficient cash on hand to deal with whateverobligations are maturing in the present fiscalyear along with the expense projections andnecessary cushion for future years, theamount in the reserve account is consideredadequate.

Advocates of the straight-linemethod say that projecting future cashrequirements for each component separatelyresults in a more accurate funding plan whenthe budget is viewed as a whole—a moreconservative approach that carries less risk offuture under-funding for the association.Advocates of the cash flow method claim thatstraight line fails to project accurately the

timing of the cash requirements of an associ-ation, resulting in cash accumulations thatmight not be used, which in turn wouldresult in greater expense to the members ofthe association.16

As we have said many times, ourown view is that associations should adoptwhichever method is less likely to result in afunding crisis down the road. That usuallymeans saving more money, not less; sowhichever method results in more total cashbeing accumulated over time would be theone we would choose.

Final CommentsOne obvious conclusion is that an

association should not rely on most develop-er-prepared budgets. The developer’s short-term need to sell units does not necessarilysquare with an association’s long-term budg-et goals. A second is that a reserve study,conducted in the first full year of an associa-tion’s operation, will help to adjust deficien-cies early and allow the board the maximumamount of time to add any necessary fund-ing. A third is to hire good professionals andmake sure they rely on independently deriveddata in calculating your reserve requirements.Finally, you can never have too much moneyin reserves. Following these guidelines withdiligence will insure that you don’t have torely on magic when its time to replace amajor component.

Is Your Reserve Budget Just an Illusion? 21

16 Our thanks to David Levy ofLevy, Erlanger & Co, CPAs, forhis valuable time and assis-tance in helping us understandstraight-line accounting.

Let’s consider the question: “Willthe sub-prime crisis impact community asso-ciations?” It’s pretty clear that mounting fore-closures of condominiums and town homeswill greatly impact community associationbudgets as owners abandon properties leav-ing unpaid assessments. Lenders holding firstmortgages on these properties would have noobligation to homeowners associations tocover these deficiencies, leaving large gaps inassociation funding when the units were soldby the banks.

Now, a new issue is looming,again involving lenders. Rules for govern-ment-backed mortgages and some private

mortgage insurers are being re-written totoughen lending standards for condomini-ums. A recent article in the Wall StreetJournal describes steps being taken by FannieMae and Freddie Mac; as well as mortgageinsurer AIG United Guaranty.17 These newstandards will clearly make it more difficultfor condominium owners to sell their unitsand for prospective buyers to close purchas-es—and they could have some other conse-quences as well.

The new rules promulgated by AIGinclude a form of “redlining” or rejection ofloan applications for properties in certain zipcodes that have been designated as having

declining marketconditions;

higher downpayments;

and aban

on

Will New Lender Rules Make CondominiumsHarder to Sell?

17 Harney, Kenny “Condoloans just got harder,” WallStreet Journal, April 20, 2008.

Paying the Price forUnder-fundedReserves

22 Will New Lender Rules Make Condominiums Harder to Sell?

projects where more than 30% of the unitsare investor-owned. These rules alone couldhave a major impact on the sale of condo-miniums, which are typically bought by lowto mid-income buyers who already find it dif-ficult to qualify for a loan. The redline provi-sions will make it impossible to obtain a loanon properties within those particular zipcodes. As Harney states: “The ban is irrespec-tive of applicants’ credit scores, assets orequity stakes.” If the property is located with-in those zip codes or if non-owner occupantsexceed 30%—there will be no loan—period.

These rules took effect on May 1,2008. Normally buyers with 20% or more toput down will not be affected by new privatemortgage insurer rules, however.

Government insurers Fannie Maeand Freddie Mac have also issued changes intheir procedures that could have a dramaticeffect on condominium loans. Under recentlypublished guidelines, lenders requesting gov-ernment loan guarantees will be asked totake responsibility for investigating the fiscalhealth of homeowners associations.According to Harney: “Under Fannie Mae’schanges, most of the due-diligence researchon condominium projects’ key characteris-tics—their legal documentation, the adequa-cy of condo association operating budgets,percentage of unit owners who are late onassociation-fee payments, percentage ofspace allocated to commercial use, and per-centage of units owned by investors—mustnow be performed upfront by loan officers.”

He continues: “Not only is thistime-consuming and costly, but under thenew procedures, Fannie Mae expects thelender to warrant the accuracy of its research.Some condo project legal documents run intothe hundreds of pages of text, yet lenders aresupposed to take legal and financial responsi-bility for their accuracy.” This responsibilitywould also include making certain “that atleast 10% of a condominium project’s currentoperating budget is reserved for “capitalexpenditures and deferred maintenance.”

Now those rules will keep manylenders awake at night! First of all, holding toa fixed percentage means that there is noroom for interpretation. Harney quotes areserve budget expert who states that thisstandard means that non-physical items, suchas insurance, in a reserve budget will notcount toward the 10%. “Some loan officerswill simply look at the ‘reserves’ item and, ifits below the 10% mark, might reject thewhole building and refuse to take loan appli-cations on individual condo units.”

If the rule only requires calculatinga ratio between reserves and the operatingportion of the budget, it will result in largelymeaningless information. But if a real deter-mination of adequacy is required that’s some-thing else again. And if so, it’s going to bedifficult to meet these standards with newly-developed projects, much less with olderassociations for all of the reasons that wehave been writing about for years.18

But more to the point, if lendersare going to have to warrant the adequacy ofa reserve program, you can expect a bigincrease in lender scrutiny and questionsabout budget disclosures.

The California Civil Code man-dates that a reserve fund be provided for anycomponent that has a projected service life ofless than 30 years.19 With new construction,the number of components falling into thatcategory is relatively small—roofing, paint-ing, asphalt, etc. It’s not until a propertybegins to age that other major componentsbegin to fall within that 30-year window. Butwhen they do, they can be a costly addition.As stated above, a building component likewood siding, for example, often has a 40-50year service life when new, and doesn’t usu-ally fall into the 30-year window then. Butafter 10 or 15 years, that component wouldbelong in the reserve study. Given that ahuge number of condominium projects arenow in excess of twenty years old, manyexterior wood components, and such thingsas plumbing or electrical components that

18 Tyler P. Berding, TheUncertain Future of CommunityAssociations, January, 2005.

19 “At least once every threeyears the board of directorsshall cause to be conducted areasonably competent and dili-gent visual inspection of theaccessible areas of the majorcomponents which the associa-tion is obligated to repair,replace, restore, or maintain aspart of a study of the reserveaccount requirements of thecommon interest developmentif the current replacementvalue of the major componentsis equal to or greater than one-half of the gross budget of theassociation which excludes theassociation’s reserve accountfor that period.

The board shall review thisstudy annually and shall con-sider and implement necessaryadjustments to the board’sanalysis of the reserve accountrequirements as a result of thatreview.

The study required by this sub-division shall at a minimuminclude:

(1) Identification of the majorcomponents which the associa-tion is obligated to repair,replace, restore, or maintainwhich, as of the date of thestudy, have a remaining usefullife of less than 30 years.

(2) Identification of the proba-ble remaining useful life of thecomponents identified in para-graph (1) as of the date of thestudy.

(3) An estimate of the cost ofrepair, replacement, restora-tion, or maintenance of thecomponents identified in para-graph (1) during and at theend of their useful life.”

California Civil Code Section1365.5(e)(1)

Will New Lender Rules Make Condominiums Harder to Sell? 23

previously were not in the reserve budget,now should be. But evaluations like that aredifficult to make, even for trained communityassociation professionals, so how are lendersgoing to undertake them if that’s required?

First, they will have to understandthat components listed on the original devel-oper reserve budget won’t necessarily be theonly components that should be there in anolder project. After that, they have to developthe means of evaluating them. They alsohave to understand that just addressing visi-ble components may not be enough in anolder building. What about damage to theinterior framing in areas that are not accessi-ble, or corrosion in plumbing lines, or electri-cal service that cannot keep up with newloads that have been put on it. These areproblems that are beginning to appear in themany conversions that have been sold in thepast few years—components that are notalways “visible and accessible” are beginningto show damage requiring repair or replace-ment, skewing the original budget andincreasing assessments. And just as conver-sions often involve older apartment build-ings, so too does the reserve analysis of oldercondominiums.

That lenders will willingly take onsuch responsibility is not likely. “It’s ridicu-lous,’ said Phil Sutcliffe, principal of ProjectSupport Services of Lansdale, Pa, who helpsput together condominium project financingsfor developers. Not only does this shift hugepaperwork and time burdens on lenders andbrokers—who may not have the staffresources to handle the extra work—but alsoforces them to make ‘absolute judgments onthings that are not absolute.”20

In the end, if lenders are going tobe held responsible for the adequacy of anassociation’s reserves, either they are goingto quit lending on condominiums, or theywill begin to ask some very tough questionsof management and the board of directors.And some of those questions may have merit.If a board has ignored the warning signs of

deterioration in an aging building and hasnot expanded the scope of its investigationsto look at components which are not just“visible and accessible,” lenders may startdoing it for them and the results may forcesome difficult decisions—do we raise assess-ments sufficiently to accommodate compo-nents which were either not in the originalbudget or which have proven more costly tomaintain than originally projected; or, do wenot do that and take the risk that our projectwill be rejected for mortgage insurance?There’s that dilemma again.

This dilemma is not new.21 Boardshave been wrestling with it for years, but sev-eral things have happened to force the prob-lem to critical mass: (1) An aging condostock has begun to reveal components with alimited service life that were not previouslydetected;22 (2) We have just gone through anew phase of condominium conversionswhich, unlike previous phases, involve olderbuildings in greater need of repair which has,in turn, focused more attention on potentialbudget under funding;23 and (3) New lendingrules will now force much closer scrutiny ofthe financial and physical condition of com-munity associations that boards of directorscan no longer ignore if they want to preserveany semblance of market value for the unitsin their project.

These new rules are a direct conse-quence of the sub-prime mortgage crisis andcould have a very real impact on communityassociations. They will undoubtedly put pres-sure on boards of directors to re-evaluatetheir reserve budgets; to re-visit the issue ofCCR restrictions on non-owner occupancy;and to take more aggressive steps to collectdelinquent assessments in order to keep theirprojects marketable.

24 Will New Lender Rules Make Condominiums Harder to Sell?

20 Harney, Supra.

21 Berding, “The Board’sDilemma,”www.condoissues.com, April12, 2008.

22 Low-rise, wood frame, con-dominium projects were con-structed in quantity in theUnited States starting around40 years ago. That means thatmany buildings are beginningto show their advanced agethrough rot, corrosion, andobsolescence, issues whichwere not apparent when theprojects were newer.

23 “CondominiumConversions—Owner Equity atRisk?” www.condoissues.com,December 27, 2007.

The prediction that we made in1999,24 that association reserve accountswould fail to keep pace with growing costs ofrepair, was accurate. It is no longer fairlydebatable that the unfunded repair liabilitiesin many community associations now exceedeven the most optimistic balance in thereserve accounts. The experience of the pasttwo decades has given us numerous exam-ples of associations’ inability to raise the nec-essary funds to properly maintain and repairthe buildings.

Associations have found it increas-ingly necessary to rely on bank loans andextraordinary special assessments to fundmajor rebuilding projects. Many have beenunable to overcome these deficits at all witheither borrowed or owner-contributed capitaland continue to defer necessary reconstruc-tion projects.

The long-term effect of this phe-nomenon can now be viewed in the present.Failed or failing community associations thatare flirting with markedly reduced living con-ditions and maybe even eventual condemna-tion are here now. Anyone who works regu-larly in the community association industryknows that and has seen at least one. So, ifwe are faced with the prospect of associa-tions that are financially paralyzed, what dowe do about it? The easy answer is:

• Do reserve studies religiously;

• Push the inspection of components beyondjust the reserve line items; and

• Fund early and often.

The problem is that by the timemany of the really expensive repairs areuncovered, it is late in an association’s lifeand too late to fund them in small incre-ments. Nevertheless, when even the knownand expected repairs are under-funded, itdoesn’t take much to push the associationover the financial edge.

There are guidelines for reservefunding. There are also statutory disclosurerequirements. However, California law onlyrelates to an association’s obligation to dis-close its funding practices; it does not requirefunding at any level. Hawaii, however, doeshave a mandatory funding statute. TheHawaii statute requires immediate funding ofreserve shortfalls to at least the 50% level byassessment if the association uses a “straight-line” reserve projection or 100% if it followsthe cash flow (“just in time”) method. Inaddition, the association must collect, eachmonth, all reserve assessments required bythe funding plan. Any owner can enforcethese provisions.

It has been suggested that similarlegislation in California is necessary toimpose discipline on reserve funding to pro-tect owners’ equity and the very large inven-tory of affordable housing. But what wouldbe the consequences of such legislation?Would it provide the funding that the presentvoluntary system has failed to achieve?

DefinitionsFirst, let’s define our terms. By

“voluntary” we do not mean that the ownersget to decide whether to pay or not. What wemean is that the board of directors decideswhether to fully fund the reserve program, ornot, and the owners get to decide whether toapprove “extraordinary” assessments, or not.A “mandatory” reserve statute is one thatrequires funding at some prescribed level. InCalifornia, the only reserve program that ismandated by the state is the one blessed bythe California Department of Real Estate atthe inception of the project. After the projectleaves the hands of the developer, the Davis-Stirling Act takes over. As stated, that statutedoes not require funding at any level.

Under California law, the board ofdirectors decides whether or not to follow thefunding recommendations of the reserve

Is Mandatory Reserve Funding the Answer? 25

24 Berding, Tyler P., TheUncertain Future of CommunityAssociations, Ibid.

Is Mandatory Reserve Funding the Answer?

Hawaii tried it, Sortof. Is it California’sTurn?

study and the owners get to decide whetheror not to approve regular assessments thatexceed the prior year by more than 20%.They also get to approve special assessmentsthat exceed a certain percentage of the budg-et. If boards of directors have funded “earlyand often” as discussed above, these statuto-ry caps should not impede a board’s effortsto maintain a “fully-funded” reserve pro-gram, since extraordinary increases in regularassessments or large special assessments willnot be necessary. It is pretty clear that the20% discretionary increase would be quiteadequate if the boards would use it.

It is only where, as is increasinglythe case, the board has failed to stay evenwith the funding plan, or where unexpecteddamage to a major component is discoveredlate in the project’s life, that special assess-ments requiring owner approval will be need-ed. It is at that point that the true “voluntary”nature of the California assessment scheme isunderstood. If the owners approve the specialassessment, fine. But very often owners vote“no” on large special assessments, as it istheir privilege to do under California law. Itthen becomes apparent that althoughapproved assessments are mandatory,approval is optional. Hence, under this defini-tion, California has a voluntary assessmentscheme.

Hawaii’s StatuteHawaii’s regulation does not give

owners or the board of directors the discre-tion to fund the reserves or not. It does, how-ever, allow an association to choose whichaccounting method it wishes to follow. If itchooses the “straight-line” method, (whereall useful lives of major components aredivided, separately, into the cost of repair andafter interest on deposits is factored in, youarrive at an annual funding plan for eachcomponent) the statute allows the associationto fund at only 50% of the plan. On the otherhand, if it chooses the “cash flow” method(or the “just in time” method) wherein thefunding plan looks at the amounts needed for

repairs in each ensuing year, then the statuterequires the board to fund that method at100%. Since the 2006 survey found that theaverage California association is about 50%funded, a statute like Hawaii’s would forcemany associations to increase their assess-ments, especially if they use the “just intime” accounting method.

Collection of assessments is, how-ever, not an option. The Hawaii statute sim-ply says: “For each fiscal year, the associationshall collect the amount assessed to fund theestimated replacement for that fiscal yearreserves, as determined by the association’splan…” Notice the operative phrase is: “shallcollect” as in: “no discretion.”

It also says: “(d) No association orapartment owner, director, officer, managingagent, or employee of an association whomakes a good faith effort to calculate the esti-mated replacement reserves for an associa-tion shall be liable if the estimate subse-quently proves incorrect.” This is fine as faras it goes, but this can also be viewed in sev-eral ways. First, it implies that if you don’thave a good excuse for why your reserve planis wholly inadequate, look out. Second,please note that it doesn’t say that “goodfaith” will protect you if you fail to collect thereserve assessments. Only an honest, albeitfaulty, estimate of need confers immunityfrom liability under this statute.

According to our sources inHawaii, implementation of this statute waspretty chaotic in the beginning but settled inlater on. Associations that know and under-stand the law appear to be complying with it.Hawaii’s mandatory reserve program has notcaused mass default by condominium own-ers. This statute came into effect in 1993; sothere was considerable time for associationsto bring their reserve program into compli-ance with state law. The statute’s 7-year com-pliance window was instrumental in avoidingmass default or non-compliance.

Would mandatory full fundingwork in California? That depends on at least

26 Is Mandatory Reserve Funding the Answer?

two important factors: The patience of thelegislature with the pace of compliance andthe basis for the reserve investigation. Ashort-term 100% compliance law would sure-ly cause chaos in an industry that is onlyabout 50% funded right now. If it adopted a7-year phase-in like Hawaii’s, then Californiacommunity associations could graduallycomply. But don’t forget, the 50% shortfall(the flip side of being only 50% funded!) thatour survey discovered is as of today. Duringthe 7-year period, not only would the existingshortfall have to be made up, but also futurefunding would have to be 100% of thereserve plan. Hawaii’s requirement for 50%funding of reserves computed by the straight-line method appears inadequate to us. Asstated, the average association in Californiaalready meets that goal if it uses straight line.A better standard would be something closerto 100% for all accounting methods, perhapswith a longer phase-in—say 10 years. Afterall, the goal is to educate boards of directorson the necessity of sound financial planning,not to introduce chaos.

The other factor is the nature ofthe reserve study investigation that would berequired. A comprehensive investigationundertaken as the basis for reserve funding iscritical. The present California statute onlyrequires that there be a “…visual inspectionof accessible areas… which the association isobligated to maintain and repair.”25 A greatmany very expensive problems are not visibleuntil they have caused major damage. Theyoccur in areas that require the removal of sid-ing, or stucco, or trim boards or sheetrock, tosee. Water intrusion may not be seen until ithas caused significant damage to interior wallcavities.

Plumbing corrosion on the interiorof pipes will not be discovered until numer-ous leaks begin to occur. Dry rot in the sub-areas beneath the floor will be unknown foryears. Each of these problems requires occa-sional intrusive investigations to uncover. Areserve study that includes this intrusive test-

ing will be able to predict costs associatedwith such hidden problems in time for theassociation to fund it. Wouldn’t such a com-prehensive reserve investigation just increasethe amount of the assessments for reservesmaking it harder to comply with full funding?Yes, but the choices are find it and fund itearly or find it late and not be able to fund itat all. Full funding of a repair projection thatmisses the most expensive repairs is not “fullfunding.”

ConclusionIt costs a lot to maintain property

in first-class condition. But that level of main-tenance is necessary if community associa-tions are not to be just temporary housing.Full funding of reserves at levels that allowfor proper maintenance and repair will testthe resolve of owners and managers alike toconfront the inevitable issues that such legis-lation would promote. If nothing else, howev-er, mandatory, full-funding legislation, andthe debate leading up to it, would educate usas to the true costs of home ownership.Ignorance of these expenses will only perpet-uate an illusion of ownership as the ever-increasing reserve shortfall erodes owners’perceived equity. The inflation of the value ofmost community association properties willnot likely keep pace with the inflation of thecost of repairs and the growing gap in reservefunding. Full funding would both protect thelong-term interests of the owners of theseinvestments as well as insure that our inven-tory of low to moderate-income housing willnot be depleted. It deserves consideration inCalifornia and any other state with similarissues.

Is Mandatory Reserve Funding the Answer? 27

25 California Civil CodeSection 1365.5(e)

In this book we detail the conse-quences of under-funding the long-termmaintenance and repair accounts of commoninterest developments. As shown, the latestsurvey confirms that reserves required forlong-term repair obligations are shrinkingindustry-wide, and that the average commu-nity association reserves are only 53% fund-ed. The result of this is that vital repairs—roof replacement, painting, repair of sidingand trim, and similar work—may be eitherdeferred or done in a substandard manner, allbecause of lack of necessary funding.

The Genesis of a Financial CrisisCommunity associations in this sit-

uation may not realize that they have a prob-lem. The average person can look at a roof allday and not see anything wrong with it; so aplan to re-roof by a particular deadline maynot seem critical—until the roof starts toleak. And if some knowledgeable expert isnot available to explain the situation or toencourage necessary repairs, it is easy for the

board to ignore the problem as long as thereare no owner complaints. Delaying necessaryrepairs means that the cost to do them will behigher when they are done, deepening thefunding quagmire. Once a problem has arepair price tag that exceeds the availablecash in reserves, the board may not be ableto solve the problem easily.

Borrowing to do necessary work isprevalent in the association industry and canbe an excellent solution as part of a well-thought out funding plan as long as repay-ment of the borrowed funds is part of theplan and does not deprive the association ofcontributions it must make for future reserveexpenses. If the plan is that the loan for anew roof is to be repaid using contributionsto the future re-roofing reserve, for example,your association is probably already, or soonwill be, in financial trouble.

Owner Resistance and Home EquityAll of this usually stems from fail-

ing to reserve sufficient cash on a regular

Stealth Reserves

Tapping UnusedAssessmentAuthority

28 Stealth Reserves

basis to pay for future repair projects. Andthe reason most associations fail to do this isthat raising the amount of the owner’smonthly assessments is guaranteed to drawcriticism from members who often do notunderstand the economics of the situation.What they see is their monthly statement,and the check they write for perhaps three orfour hundred dollars every month, which willnow go up. While they are generally awarethat a portion of those assessments areintended for long-term projects, they are notas well informed as the board on these mat-ters and someone will surely object if theboard raises assessments appreciably. Hence,boards are often deterred from doing this andassessments stay the same.

Sometimes, the plan is that ifmajor repairs should be needed, the boardwill propose a special assessment. But unlessthat special assessment is small (generally nomore than 5% of the prior years budgetedgross expenses), a majority of the ownerswill have to vote to approve it. And if thatmeans the owners must approve specialassessments that are more than nominal, say

several thousand dollars each, obtainingapproval is uncertain. Projecting memberapproval of a special assessment as the pri-mary method of funding a critical repair proj-ect is a risky business plan.

So given this double whammy—owner resistance to increasing monthlyassessments and similar, if not greater, resist-ance to approving a substantial specialassessment—many boards take an easier wayout and borrow the money. But, as statedabove, it is ill advised to repay the loan usingcash that would otherwise be used for futurereserve contributions. Also, a bank loan mayrequire that the members approve a specialassessment to secure the loan, which mightstill be difficult to achieve even though thepayments are spread out over time.

But an association may have morecash resources than it realizes. Consider thefollowing alternative.

Monthly Payments vs. DeferralCalifornia real estate increases in

value over time. Regardless of the cycles thatinfluence the immediate prices of some

homes in some areas, over time that facthas been reaffirmed year after year. If

you can bridge short-term downcycles by holding the property for

several years, there is almost nogamble on the outcome—your

equity will increase. And oftenit increases in part because itis located in a well-main-tained community. Mostowners realize this andbelieve that regularinvestment in keepingthe property in goodcondition will yielddividends at sale time.They just don’t wantto have to increasetheir monthly pay-ments to do it.

Manyboard members

Stealth Reserves 29

believe that if they assess an owner’s sepa-rate interest the assessment must be collectedin the short term. There is nothing in the lawthat requires that—but it is a popular belief.Associations also do not want to jeopardizetheir income stream with lax enforcement oftheir assessment rights. In addition, theboard must insure cash flow to pay for regu-lar operating expenses—water, garbage, land-scape maintenance, management, just toname a few. But reserves are a differentstory—reserves are used for projects that areoften planned years in advance. And, exceptfor emergencies, they can be funded onlonger cycles, much longer than the monthlycycles used for operating expenses. The cashflow accounting method basically recognizesthis and allocates the cash contributed byowners to coincide with the timing of variousprojects. But even this method does not dealwith the question of when payments must bemade by individual owners and assumes thatthey will be made monthly like all regularassessments.

Because reserve contributions aretied to the operating budget, and becauseoperating expenses usually must take prioritywhen funds are limited, natural owner resist-ance to increasing the amount of monthlyassessments drastically limits the board’sability to fund reserves adequately. However,if collection of the reserve contribution werehandled separately and owners were provid-ed an alternate, less painful means of fundingreserves, it could prove to be a boon to com-munity associations. As we said, owners usu-ally recognize the connection between a well-funded reserve account and property values;they just don’t like, and many cannot afford,to make higher monthly payments.

Tapping Unused Assessment AuthorityOne answer might be for an asso-

ciation to defer collection of part of that por-tion of the annual assessment that representsthe reserve contribution, to a later date—specifically to the date of sale of the unit, andcollect it from escrow when owners have

more cash available to them. Most ownerswould be less inclined to resist higher reservecontributions if they could pay it out of equi-ty instead of from monthly cash flow. For onething, equity is, in a sense, “found” moneythat accumulates due to the gradual rise inproperty values and the reduction in mort-gage balances. It is not specifically earmarkedor needed for anything other than perhapsthe down payment on another home or emer-gency expenses. Also, even with many yearsof deferral, the accumulated total of assess-ments owed would not represent a very highpercentage of the owner’s total equity, so thepayment “pain” would be minimal.

This source of funding could rea-sonably be labeled “unused assessmentauthority” since common interest develop-ments in California have the statutory right toincrease monthly assessments up to 20%over the prior year’s assessment but, for thereasons stated above, rarely do it. If an asso-ciation had an annual assessment of, say,$4800 per unit, the board could, without avote of the members, increase that assess-ment to $5760 the following year—anincrease of $960 per unit. Now a board wouldnot likely impose assessment increases ofthat magnitude on a regular basis, but it illus-trates the point—that boards of directors ofcommunity associations have sufficient statu-tory authority, right now, to make meaningfulcontributions to reserves if they chose toexercise it. And there is nothing that requiresthat increase to be spread across the entirebudget pro rata; it could all go to reserves, solong as provisions were made for operationalemergencies. If the present reserve contribu-tion were, say 20% of the total annual assess-ment, a 20% increase in assessments woulddouble the annual contributions to reserves!It wouldn’t take too many increases inreserve funding like that to make up mostroutine shortfalls.

But assessing and collecting areclearly two different things, and that’s why apolicy that permitted an owner to defer pay-

30 Stealth Reserves

ment of some or all of the reserve portion oftheir annual assessment until they sold theunit might be a powerful incentive to boardsto increase the amount of those contributionsand for owners to be right with it, therebyavoiding a potentially disastrous deferral ofneeded repairs. Various studies have placedaverage turnover of homes in California atright around seven years. With condomini-ums, that time is likely much shorter. Buteven a 7-year cycle of turnover could providea reserve cash flow sufficient to fund long-term repair and maintenance, if the projectswere well planned and the amount of deferralpermitted was synchronized with the planand the expected turnover rate for thatassociation.

Of course, the CC&Rs would haveto be reviewed for any constraining languageand amended if necessary, and steps wouldhave to be taken to obtain adequate securityfor the deferred amounts in the form of anassessment lien that stays current with theamounts owed. The board would also have toreserve the option of ending the deferral ifemergencies arose or if a unit remainedunsold for too long, and that option wouldhave to be carefully explained to themembers.

The association’s accountant mustreview any plan to defer collection of assess-ments to be sure that planned deferrals donot interfere with the board’s ability to con-duct the business of the association properly.Also, legal counsel should be called upon tofashion an agreement or amendment to thegoverning documents that specifies the con-ditions and obligations attached to any defer-ment and prepare a deferral agreement,which each owner would acknowledge.Deferred obligations would have to remainsecured by appropriate liens on the owner’sinterest, and associations would have to bediligent about putting payment demands intoescrow; but those procedures do not repre-sent anything very different from what isnow done in collecting regular assessments,

and all of this could be accomplished mostprobably without any change in existing law.

Deferral Mandates Increasesin Assessments

We are not suggesting deferringcollection of a portion of the monthly assess-ment if it is presently at a level that alreadydoes not adequately cover the reserve contri-bution. Only if the board were willing to useits untapped assessment authority to increasethe association’s contribution to reservesdoes deferring collection make any sense.Using deferral when collections are alreadyinadequate would just make matters worse. Adecision to defer must be accompanied by awell-researched plan that takes into accountthe association’s true future reserve needs,along with the political will to raise monthlyassessments sufficiently to meet those needs.Deferral is just a collection tool that couldassist boards in collecting more funds thanmonthly collection presently allows, sincecollection would coincide with a greaterincome stream. Deferral as outlined here is inessence a loan by the board to an owner,secured by that owner’s equity. Like any loanthe deferred amount should bear interest toat least keep up with inflation. The consider-ation for the board’s willingness to defer,however, has to be a greater contribution tothe reserve account to justify extending thisoption to owners.

The shortfall in reserve funding isincreasing annually and it has made itselfknown already in many associations thatcannot afford to make essential repairs.Cutting the owners some slack through pay-ment deferral could help a board realize thebenefits of its substantial unused assessmentauthority and encourage it to fund the associ-ation’s reserves adequately.26

26 This idea is not withoutcontroversy. See Chapter Eight,“The Reserve Crisis—ReadersRespond.”

Stealth Reserves 31

It isn’t often that a complex prob-lem can be solved with a relatively simplesolution, and the criticism of skeptics isexcused until the problem is truly solved-buta simple solution that could save some com-munity associations may be at hand.

The cost of maintenance and theinability to raise necessary funds to meetthese costs is leading to gradual obsoles-cence, as discussed in prior chapters. Manyof these issues have been documented onthese pages over the last five years. Briefly,the lack of funds stems from boards of direc-tors who sometimes do not understand thenuances of the extensive repair and mainte-nance work that is required, coupled with theresistance of owners to regular contributionsof the additional capital necessary to fundthese projects. Further, the projects are smallin the scheme of things, and lack substantialnegotiating strength or knowledge of newand better methods and materials.

These circumstances could begreatly improved if we were able to combinemany of these community association proj-ects into a single, well-funded, professionallyoperated, community or services district towhich the responsibility for maintenance andrepair, including warranty repairs, could bedelegated. This type of organization is notwithout precedent. On the government side,we provide for special districts to administerand maintain all kinds of real estate.Landscape and lighting districts; reclamationdistricts; water districts; and redevelopmentdistricts are examples of single-purpose gov-ernment entities formed to maintain or serv-ice privately owned property. These districtsare governed by directors elected by the own-ers of the various properties within the dis-trict. A further advantage to a Special Districtis its ability to raise funds through the sale ofpublic bonds.

In the private sector we havemutual insurance companies that are basical-ly a community of property owners who havejoined together to provide financial assuranceagainst certain identified catastrophes. Largecommunity associations, which may includea dozen or more “neighborhoods”, are proba-bly some of the best known examples ofcombining several smaller projects under theumbrella of a “community” in order to pro-vide more efficient and. comprehensivemaintenance. Such well-known Californiacommunities as Rossmor in Walnut Creek,Sun-City in Roseville, The Villages in SanJose, and Leisure World in Laguna Hills areexamples of a group of smaller individualprojects which share the benefits inherent ina large mutually owned entity. Of course,large community or property owner associa-tions are usually formed from contiguousparcels, but there is no legal reason why non-contiguous properties could not be aggregat-ed for certain specific purposes without inter-fering with basic ownership interests.

If the combination of, say, 20 or 30non-contiguous community associations intoa mutually owned and operated “mainte-nance community” could be achieved, itcould bring substantial benefits to each of themember projects. Not only would negotiatingpower be greatly enhanced when contractingfor services, there could be pooling of fundsto provide greater liquidity, and form, essen-tially, a maintenance “insurance” pool to dealwith the ongoing repair needs of the membercommunities. A large group of associationscould afford more sophisticated engineeringand architectural expertise to insure thatmaintenance and repair projects weredesigned and executed properly.

There are several types of organi-zations that would suit this purpose. In thepublic sector, the obvious choice would be a“special district.” In the private sector, trusts

Community Maintenance Trusts

32 Community Maintenance Trusts

Community Maintenance Trusts 33

or non-profit corporations could be used.Whatever it’s legal nature; its purpose wouldbe the same-to provide an organization thatwould accept the delegation of maintenanceand repair obligations for a community ofnon-contiguous common interest develop-ments. We’ve coined the term “CommunityMaintenance Trust (CMT)” as one example ofsuch an entity.

Builders and owners alike couldderive substantial benefits from this arrange-ment. New construction would have to beinspected by the Trust before the projectwould be accepted for membership. Thereserve requirements for future maintenancewould be determined, and the builder wouldbe required to deposit several year’s ofreserve contributions. Existing projects would

have to be appraised and their future mainte-nance and repair needs estimated, beforethey would be allowed to join the communi-ty. They would then have to “buy in” with asum of money determined by the mainte-nance and repair appraisal but once in, futuremaintenance and repair expenses would beborn by the Trust which in turn, would befunded by owner assessments.

There are many, many issues thatwould have to be worked out before actualimplementation, but a CMT would endowmany associations with a level of profession-alism and experience that is presently lackingin a single association.

The author receivedthe following twoletters about thematerial in the fore-going chapters. Thefirst, from Mr. Hohs,is on the generalpremise of this book,i.e. that associationsgenerally fail to ade-quately fund futurerepair obligations.The second, fromCPA Gayle L.Cagianut, takes issuewith our “deferredassessments” idea inChapter Six. Werespond below.

34 The Reserve Crisis—Readers Respond

Dear Mr. Berding,We have corresponded in the past.

I agree with your article assessment… that:1. ALL (or if not the VAST MAJOR-

ITY) of condominium associations in the 20to 30 year age range are unprepared for therough times ahead.

2. ECHO’s basic thesis “Get anexpert,” while nice in theory, does not workwell in fact. Having been the victim of watch-ing numerous projects throughout myAssociation with so-called “experts,” I (alongwith other board members) have learned thehard way that the board needs to almostbecome an on-site supervisor of the project.And, it is a prerequisite that some boardmembers use some “common sense” to theextent of almost becoming an “expert” inconstruction management. Even with a con-struction manager “supervising” the job, sur-prisingly often the Association is paying fornonexistent supervision. The end result isthat the Association quite likely is paying forunsupervised work at a contract that allegessupervision.

3. There are NOT enoughAssociation members that are willing to becompetent board members. It probably takesat least two, probably three years; before onecan competently say that “he knows what heis doing.” “Knowing what you are doing”consists of more than showing up to a boardmeeting.

4. Most board members are unwill-ing to give out bad news. The few boardmembers that I trust are the ones that arewilling to take an unpopular stand; i.e., raiseHOA dues. While my dues of $260 per monthfund the reserves, I would feel more comfort-able with higher dues. It gets increasingly dif-ficult (particularly now new owners probablyhaving negative equity willing to abandonthe property) to find the financial resourcesto do repair work.

5. The vast majority of thedeferred maintenance is avoidable. The bestlong-range solution is to start managing thecondominium HOA like a commercial proper-ty. Have a handyman go building by buildingtaking care of little stuff before they becomebig problems.

6. Owners worry too much aboutminor issues; i.e., parking instead of majorissues; i.e., dry rot repair. I had one annualmeeting with owners complaining about non-existent parking issues, leading to myresponse of “If we DO NOT take care of thedry rot in the next couple of years then wecould be looking at MAJOR BILLS.”

No easy solution exists. It wouldbe nice if one could mandate mandatoryfunding for adequate reserves. The obviousproblem is one could get into a long windedissue of what constitutes “adequatereserves.” Unfortunately, the vast majority ofassociations appear to take the attitude “Notmy problem about issues five year hence.”Mine is one of the few and it is often to getthe consensus of “It is the Associationresponsibility to leave for the next purchaseran Association adequately maintained with-out needing special assessments.”Stephen M. Hohs

Mr. Stephen Hohs is a resident of a condo-minium association in Napa. He has beeninvolved with activities in that association forthe past 30 years, including 10 years as aboard member and three as board president.

Dear Mr. Berding:With all due respect to your indus-

try knowledge and the creativity that youcalled upon to come up with the idea in yourarticle of assessing homeowners for addition-al reserve funding monies to be paid at thetime of escrow closing (when a home sells), Isee nothing but disaster for such a plan. Hereare a few of my concerns:

1. What about the numeroushomes that have no equity and are just barelyhanging on without going into foreclosure? Iwould think that this would be another greatreason to walk away from the home. I realizethat if the special assessment were levied allat once, the same thing could occur; howev-er, if the board works out a reasonable pay-ment plan, they might get payments as longas the homeowners choose to stay in thehome.

2. Would a lien be filed immediate-ly on the home to ensure that the assessment

The Reserve Crisis—Readers Respond

is advance of any additional mortgages thatmight come along? Would the assessmentneed to be repaid if the owner refinanced?

3. How would a reserve preparereven begin to do its cash flow planning? Howwould they be able to ascertain when thefunds would be available to the association?At a minimum, there would need to be a sun-set date when the monies would be due andpayable.

4. As Robert Nordlund states,reserve studies are an “art and a science.” So,what if the projections are wrong and themonies are needed sooner rather than later?Do you special assess again, give credit tothose people that have already paid, andassess just the ones who have not paid?

5. You mention that interest shouldbe charged on this “loan.” Do you realizethat management company accountingdepartments are already dealing with assess-ments, late charges, other fees, specialassessments (for everything from specificitems to bank loans) and now they will haveto compute interest on a receivable that is notcollectible for years to come?

6. For collection purposes, thecomputerized accounting system would haveto be sophisticated enough not to apply pay-ments to this “assessment” and not to sendforeclosure notices on this past due amount.Or, are you suggesting that this be kept “offthe books”? If so, what is the chance that themanagement company will remember to col-lect the money in escrow if it is not part ofthe A/R balance at the end of the year?

7. When associations change man-agement companies, we find difficulties intransferring the knowledge of what is dueand payable on special assessments thatsecure bank loans. The transition is rarelysmooth and we find unit owner payoff bal-ances incorrectly carried over from one man-agement company to another. I can imaginethat this scenario would result in the sametype of issues.

Anyway, these are a few of myvery quick thoughts. I hope that you comeout in the next Journal and say, “just kid-ding!” I do not think that this is a good busi-ness decision nor do I think that the currentindustry is ready for the accounting night-

The Reserve Crisis—Readers Respond 35

mare that this could cause. However, I thinkthe homeowners would vote for this and notconsider the ramifications of their decision.Gayle L. Cagianut, CPA

Ms. Gayle Cagianut is a well-known CPAwith an extensive accounting practice forhomeowner associations. Her firm has officesin Ventura and the Seattle and Spokaneregions of Washington State.

The Author RepliesHello, Gayle,

No, I actually wasn’t kidding.First and foremost, please under-

stand that I do know and appreciate the vul-nerabilities of most community associationsthat you describe and the danger that any-thing that gives someone an excuse to fore-stall the inevitable might be abused. On theother hand, after 34 years of watching associ-ations march deeper into the quagmire ofdeferred maintenance, mostly by default, I’mpretty well convinced that without some radi-cal new ideas a lot of housing is destined todeteriorate to the point of zero value. Thereare several reasons for this.

The present system of assessingfor future repairs is almost entirely subjectiveand voluntary. Boards are only required toinclude components that have a demonstrat-ed useful life of less than 30 years. The deci-sion to include a component in reserves inthe first place (less than 30-year life,) andthen accurately assess both its projected lifeand the eventual cost of repair is, and here Iwould paraphrase Robert Nordland, “art andnot even close to science.” I have seen plentyof examples of reserve budgets so far off themark as to be mostly irrelevant. So right offthe bat we are deep into speculation as tohow much an association should be puttinginto the bank. Therefore, even the fundingthat a board does choose to adopt may beinadequate.

Second, and more important, evenif a board does obtain accurate predictions of

necessary funding, it is rare that they willsummon up the resolve to meet those obliga-tions by imposing periodic increases in regu-lar assessments or by imposing allowablespecial assessments even to just keep pacewith inflation. Our statistics show that aver-age funding is roughly half of the requiredamount, which means that there will benowhere near enough money to do majorrepairs at the appropriate time. That resultsfrom a combination of inflationary increasesin the repair costs coupled with growingshortfalls in prior funding goals.

Boards are reluctant to approachthe members for significant contributionsuntil the need is of crisis proportions andthen it is usually too late and too much.Members, on the other hand, even when aboard has campaigned aggressively to raisethe necessary funding, will more often thannot refuse to accept the board’s or manage-ment’s recommendation if it means paying asubstantial additional assessment. The conse-quences of these demonstrations of humannature are gradually diminishing reserves,leading many projects to the point of failure.

So against this background wesearch for other ways to accomplish what’sneeded—funding sufficient to maintain acommunity association for the rest of its per-petual life. I say ”perpetual” because thecode only discusses individual building com-ponents that have less than 30 years to live.There is no “service life” assigned to anentire project, hence no legislative considera-tion whatsoever that a community associa-tion might become obsolete. As a result,there is absolutely no practical exit strategyunder California law. This will eventuallyleave some owners with no options.

Yes, it would be great if the ownerscould be convinced to approve a monthlyassessment that would get the job done, butwe are wasting our breath if we think that isgoing to happen other than sporadically. Wecan ignore the inevitable, wait for the legisla-ture, or look for options. As you know, I

36 The Reserve Crisis—Readers Respond

choose the latter course because theLegislature cannot be relied upon to tightenfunding requirements at all, and frankly, thedeferral option is not as offbeat as it mayseem. We have entire communities for whichthat is a major source of funding. Retirementcommunities, where a fixed income is thenorm, realized a long time ago that raisingsignificant funds through monthly assess-ments wasn’t going to cut it and haveallowed the owners to “endow” the associa-tion with funds payable when the unit issold. Yes, the demographics of that particulargroup make funding a little more predictable,but it does serve to provide cash flow at arate that over the years has fairly welladdressed the needs of the association.

No, I haven’t even begun to workout the details, and perhaps I am remiss forputting the cart before the horse; but I see myrole as one of stimulating thought and raisingawareness, and clearly, we have done that.But let me address, as best I can, the con-cerns stated in your letter.

No Equity. The option of deferringall or part of a special assessment to somelater date would not be without regard to theowner’s ability to secure that obligation withhome equity, any more than a lending institu-tion would lend without security. But as youpoint out, special assessments are levied allthe time without regard to security; so if weactually got some security in return for adeferral for a defined period of time, whyaren’t we better off? Especially if it can bemade to fit our cash flow requirements and isthe difference between passing the specialassessment or not passing it?

Liens. There would be no deferralunless the owner agreed to give the associa-tion the necessary security in the form of alien on the property, the same as any lenderwould require. Yes, a refinance or a salewould trigger payment.

Cash Flow Predictions. Yes, therewould have to be some outside payoff date ifthe home did not sell first—just like any loan.

Cash Flow “Surprises.” Unknownhow we would deal with this and there isn’ta lot of experience with it since it doesn’thappen very often that a special assessmentis approved and then another is needed soonafter. I suspect, however, that there wouldhave to be, going in, some discussion withthe members about the number of “deferrals”that could be accommodated; and that if toomany owners indicated that they wouldapprove, but elect to defer, it may be that theassessment could not be approved unlessmore agreed to pay currently.

Interest. I’m not as concerned asyou are about this and have used outsidecompanies to service loans; and if manage-ment or the association’s accountant couldnot do it, a servicing company could be used.

Collections. Again, a mechanicaldetail that would have to be worked out, butnot a deal killer.

Management Changes. Perhapsthe answer to your concerns in paragraphs 5,6 and 7 is simply to assign servicing of defer-rals to an outside agent equipped to serviceloans which would transcend any manage-ment changes, or, as another option, sell thegroup of deferred assessments to a lender forcash and let them deal with collection,accounting, etc.

Nevertheless, I don’t mean to min-imize the concerns of an accountant foraccounting problems when that is not what Ido. But right now, I’m focused on the con-cept and not the mechanics as you can see;and so far I haven’t heard any argumentscompelling enough to snuff out further explo-ration of the idea. Thanks for the stimulatingreply and the opportunity to flesh out thisproposal. Let’s keep in touch.

The Reserve Crisis—Readers Respond 37

It should be apparent that theproblems of reserve under-funding are realand that there are some solutions whichassociations can use to avoid a financial cri-sis. What it takes, however, is for the associa-tion’s board of directors to resolve the“dilemma” and that, frankly, takes guts.There are few directors who wish to incur theire of their neighbors over raising assess-ments sufficiently to begin to eliminate anyreserve shortfall, however it won’t be longbefore the failure to do that will translate intoobvious lost equity. When this was writtenthe housing market was in freefall, largelydue to what has been dubbed the “sub-primemortgage crisis.” Just think of a crisis of simi-lar magnitude occurring with communityassociations when they can no longer main-tain basic habitability, where leaks, rot, failedplumbing, and eyesore conditions dominatethe project. Everyone will then wish that theproblem had been addressed sooner.Consider this a wake up call and take advan-tage of the time that is still available to cor-rect reserve shortfalls. Hire good profession-als to advise you and do whatever you can toconvince your neighbors that the sacrifice isworth making.

38 Conclusion

Conclusion

Tyler Berding is a foundng partnerof Berding & Weil, LLP, located in Alamo,California. He and his law firm have repre-sented hundreds of common intertest devel-opement over the past 30 years. He has par-ticipated in the development of legislationaffecting community associations through hiswork with the California legislature inSacramento. He frequently testifies beforelegislative committees considering the meritsof community association legislation. He hasserved as a member of the CaliforniaDepartment of Real Estate’s Task Force onCommon Interest Developments and recetnlylead a statewide coalition of communtiy asso-ciation attorneys drafting alternative disputelegislation for construction defect litigation.

Mr. Berding has authored numer-ous aritcles and columns dealing with thesubject of community association manage-ment and operations, and specifically issuesof financial stability and owner equity preser-vation. Mr. Berding received his J.D. in 1974from the University of Califrnia at Davis. Hereceived an M.A. and a Ph.D. in Governmentfrom Claremont Graduate School in 1971.

The Author can be contacted at Berding &Weil at tberding@berding-weil.com.

The material in this publication and otheruseful articles can also be found atwww.condoissues.com.

This publication was originally published asa series of articles in the ECHO Journal, amonthly magazine of the Executive Councilof Homeowners, Inc. 1602 The Alameda, Suite 101San Jose CA 95126 408-297-3246www.echo-ca.org

About the Author 39

About the Author

3240 Stone Valley Road West | Alamo, California 94507Tel: 925-838-2090 | Fax: 925-820-5592 | www.berding-weil.com