Why Reserves? If We Have a Surplus, What Then?

Why Reserves? If We Have a Surplus, What Then?

Q: I am the attorney for several community associations, and there are two questions I am always asked.

l. Why should we budget for reserves? How much reserves do we need? Is there any legal requirement as to the amount of reserves we should keep? Where can we invest these reserves?
2. If the association is successful and has a surplus at the end of ITS fiscal year, what can be done with these funds?

A: The answer will be “Condo l01”; but it is worth repeating as often as possible. There are too many associations that do not have sufficient reserves, and when an emergency occurs, they literally scramble for assistance. And unfortunately, in a few instances – such as when utility are not being paid and the association is threatened that services will be turned off –bankruptcy is the only answer.

Reserves are a critical component of every community association budget, whether a condominium, cooperative or a home owners association.

Reserves are to be used for emergencies to the common elements, such as roof leaks, elevator breakdowns or repairing pot-holes on privately owned roads. Reserves are also to be used for long-range repair or replacement projects, such as replacing carpets, painting common elements and fixing swimming pools and tot-lots.

Lenders who make mortgage loans on homes within a community association look carefully at reserves. For example, FannieMae requires a minimum reserve of 10 percent of the association’s annual budgeted assessment income.

Boards of Directors must exercise good business judgment as they pursue their functions on behalf of their community associations. It is good business judgment to have a reserve account; in my opinion, it is not good business judgment if the Board does not address reserve issues in their annual budget.

How does one determine how much is necessary for reserves? The simplest method is to obtain an Architectural & Engineering (A&E) study at least once every 4-5 years. Such a study should include a “reserve analysis”, which the Board (and management) can rely on in preparing the annual budget for the association.

Generally, the reserve analysis portion of an A&E study will look like this:

ComponentCostUseful LifeYearly % for Reserves
Roof replacement$15,0005 years$3,000
Painting$3,5007 years$500
Elevator$29,0008 years$3,625
Tot-Lot$8,5002 years$4,250
Trash Compactor$7,8005 years$1,560
Total:$12,935

Thus, in our example, the Board — at the very least — should include a line item of $12,935 in the annual budget to properly fund reserves. Each unit owner will be assessed — as a part of his/her association fees — a portion of the replacement reserves.

Where can the Board invest these funds? We all know that interest rates are still quite low, while the stock market has until recently been booming.

If the Board wants to invest reserves in the stock market, and if one hundred percent of the unit owners and mortgagees give their written approval and the legal documents do not prohibit it, the Board can so invest those funds. Indeed, if everyone in the Association authorized the Board to invest the money in a lottery ticket, while this would be highly unusual, it would be an acceptable investment.

Obviously, the Board will not get this 100 percent. The Board has a responsibility to reasonably — and prudently — invest association funds, while at the same time obtaining a decent rate of return. The Board must invest such funds in a secure investment; the most secure are investments which are insured — or guaranteed — by the Federal government. Such funds would include treasury bills and notes, certificates of deposit up to $100,000, or other similar government-backed securities.

The Board must review the governing documents of the Association first, to determine if there are any limitations on their investment rights. The Board should then consult with both its management agent and a financial consultant to get various options. Then, of course, the “buck stops with the Board”, and only the Board can make the final investment decision.

Let’s look at your second question, namely what can the Board do if they successfully have a budget surplus at the end of a fiscal year. Again, it is important to look first at the governing documents of the association.

Your state’s association law also must be addressed. For example, the Maryland Condominium Act does give us some guidance.

Unless the documents of an association spell out a different process, the Maryland Condominium Act gives the Board three specific choices:

1. disbursed directly to the owners;
2. credited to the owners for future assessments, or
3. used for any other purpose as the council (not the Board) of unit owners decides.

This means that the Board should make a recommendation, e.g., the surplus goes into reserves, and have the recommendation voted upon at an annual or special meeting by all owners.

Reserves are a very important aspect of community association living, and Board of Directors must make sure that they are available, secure and adequate.






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