Condos' reserve funds deserve more scrutiny
If you plan to buy into a condominium association -- or if you already own and plan to refinance the mortgage -- you should be aware of the new rules published by the Federal Housing Administration.
For years, the FHA was the forgotten stepchild among mortgage programs. Its procedures were cumbersome and its response time extremely slow. However, as a result of new laws -- and the current mortgage mess -- FHA-insured loans have come of age.
On Nov. 6, the FHA issued guidelines that will have significant effect on community associations throughout the country.
Although there are many aspects to these new guidelines, including such areas as the number of investor owners that will be permitted in a condominium before the FHA quits making loans to new buyers there, this column will only address the new reserve requirements.
First, what is a reserve? It means just what the word implies -- money that the association should have set aside "in reserve" to cover the cost of emergencies or major repairs. Maintaining adequate reserves is -- or should be -- an essential part of every community association's duties.
Under FHA rules, an association must demonstrate to the mortgage lender that the funding of replacement reserves for capital expenditures and deferred maintenance represents at least 10 percent of the association's budget. Although many community association property owners may not realize it, a community association is a business and must be run just like any other business. Indeed, many associations are very big businesses, with large incomes and equally large expenses.
Every year, the board of directors -- working through its management company, if there is one, must project its income and expenses for the next year. Often, this projection is speculative, based on previous years' experiences. However, there are ongoing operating expenses that must be paid, such as insurance premiums, water service, trash collection and payroll taxes. In order to project the next year's expenses, the board has to know approximately how much money will be available during the coming year. It should be obvious that the board cannot plan to spend more money than it will receive. Associations are not the federal government.
In addition to general operating expenses, boards are often called upon to make major repairs, alterations and even improvements to the common areas within the association. The driveway must be paved, the elevator must be overhauled, and the roof must be replaced. All of this costs money, and these additional expenses must come from somewhere. And all of the numbers must be incorporated into an annual budget.
How does the board project reserves? Over the years, the concept of a "reserve analysis study" has been developed, whereby qualified engineers perform an "A&E [Architectural and Engineering] Study" of the entire complex. These professionals will report to the board something that looks like this:
Item: Projected Useful Life/Cost to Repair/Annualization
Boiler 20 [years]/$35,000/$1,750; Elevator 5 [years]/$40,000/$ 8,000; Roof 12 [years]/$56,000/$ 4,666. Total: $14,416
This is just an example; obviously every association has different needs and different concerns. The bottom line is that your association -- in order to plan properly -- must add to the annual budget. In this example, the association needs to set aside $14,416 toward reserves. This money should be collected gradually from the owners as part of the overall monthly or quarterly assessment, and deposited in a secure, interest-bearing investment -- such as a Treasury bill or other government-insured fund.