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What is an HOA Reserve Study and Why is it Important?
by SCOTT M. DRUCKER, ESQ. on OCTOBER 28, 2016
According to the Community Associations Institute, there are approximately 338,000 community associations in the United States, housing roughly 68-million Americans. These common-interest communities are prevalent throughout Arizona, meaning that prospective buyers must often consider what it means to live in a community governed by a homeowner’s association (HOA).
In evaluating an HOA, buyers should always consider the association’s financial viability. While that evaluation should include reviewing the HOA’s reserve study, many buyers simply do not know what that is and why it is important.
Underfunded HOAs pose a myriad of problems to homeowners within the community. Absent adequate reserves, HOAs may be required to impose a “special assessment,” two of the most dreaded words in the minds of HOA owners. Damian Esparza, CEO/Owner of Barrera & Co., performs in excess of 1,200 reserve studies a year on the West Coast.
According to Esparza, roughly 22-percent of those associations are underfunded at the time of the reserve study and projected to impose a special assessment at some point over the next five years. Fortunately, reserve studies performed at appropriate intervals can enable an HOA to anticipate future expenses and budget accordingly.
A typical reserve study consists of two parts: a physical analysis and a financial analysis. By way of the physical analysis, the condition of common area, building and grounds components are evaluated. The remaining useful life of each component is determined and the repair or replacement cost is estimated. By way of the financial analysis, the reserve study compares the association’s current reserve funds to what should be set aside to ensure that the association has adequate funds to cover such repairs and replacements.
The concept by which the amount of reserve funds is estimated is referred to as percent funded. Percent funded is the ratio of what an association has set aside for reserves as compared to the total depreciation of all the association’s components, known as the fully-funded balance. For potential buyers, percent funded is one of the most important numbers to look at when reviewing an association’s reserve study. The higher the percent funded, the more financially stable the HOA.
The ideal amount of money an association should set aside is known as 100% funded. Unfortunately, as the percent funded decreases, the risk of special assessments and deferred maintenance increases. Esparza generally recommends that condo associations place 30 cents of every dollar received into reserves, and that associations comprised of single family homes place 25 cents of every dollar received into reserves.
Prudent buyers should consider the amount of the association’s reserves, knowing that a lack of reserves is a red flag signaling the potential for onerous assessments. Similarly, the lack of a reserve study may be a signal of poor planning.
Arizona maintains no statutes requiring an HOA to prepare a reserve study or fund reserves. Arizona does, however, maintain statutory requirements obligating the association to deliver to a purchaser, or their authorized agent, specific information. This includes, but is not limited to: (i) the total amount of money held by the association as reserves; (ii) a copy of the association’s most recent annual financial report; and (iii) a copy of the association’s most recent reserve study, if any. See A.R.S. § 33-1806. Prospective buyers should ensure that they receive and review this information.
When HOA assets are properly maintained, property values tend to increase. But it takes money to maintain assets, perform repairs, and replace outdated components. Fortunately, reserve studies performed every three to five years should enable the association to plan accordingly and set aside on enough money an annual basis to offset anticipated reserve expenses.
Scott M. Drucker, Esq., a licensed Arizona attorney, is General Counsel for the Arizona Association of REALTORS® serving as the primary legal advisor to the association. This article is of a general nature and reflects only the opinion of the author at the time it was drafted. It is not intended as definitive legal advice, and you should not act upon it without seeking independent legal counsel.