I am often asked about appropriate funding levels for reserves. The funding level of reserves can have an impact on the desirability of a property, impact property values, and the ability of buyers to obtain mortgages on property within an association (Fannie Mae recently revised its lending guidelines to require HOA’s set aside 10% of their budget to funding reserves in order for properties to be eligible for loans).

Some think reserves should be 100% funded.  However, a 100% funding level for reserves can be difficult to achieve without imposing a special assessment on the members, and can be a real burden on the association.

In requiring an HOA to periodically prepare a pro forma operating budget, Section 1365(a)(4) of the California Civil Code calls for identification of the methods of funding used to defray future repair, replacement, or additions to major components. However, a specific funding goal is not indicated in the law.  The truth is the right level of reserve funding depends on the HOA’s individual circumstances, and there is no “industry standard” as to the level of funding for reserves.  Often, the funding goal will depend on the methodology the board uses in developing a funding strategy.

Reserve funds are monies collected for the repair and replacement of major components of the property maintained by the HOA. They differ from operating funds which are collected to fund annually recurring expenses such as insurance, management and legal fees, common area utilities, janitorial services, and common area landscaping. An Association’s obligation regarding reserves and reserve accounts is typically found in the Civil Code. However, some Association’s governing documents also contain requirements which the Association must follow in maintaining and even funding reserve accounts. An example of such a requirement might appear in the CC&Rs and/or bylaws as follows:

Reserves, The Regular Assessments shall include reasonable amounts as determined by the Board collected as reserves for the future periodic maintenance, repair or replacement of all or a portion of the Common Area, or any other purpose as determined by the Board. All amounts collected as reserves, whether pursuant to this Section or otherwise, shall be deposited by the Board in a separate bank account to be held in trust for the purposes for which they are collected and are to be segregated from and not commingled with any other funds of the Community Association. Such reserves shall be deemed a contribution to the capital account of the Community Association by the Members

Types of Accounts. Assessments collected by the Community Association shall be deposited into at least two (2) separate accounts with a responsible financial institution, which accounts shall be clearly designated as (i) the Current Operation Account and (ii) the reserve account. The Board shall deposit those portions of the Assessments collected for current maintenance and operation into the Current Operation Account and shall deposit those portions of the Assessments collected as reserves for replacement and deferred maintenance of major components which the Community Association is obligated to maintain into the reserve account. The Community Association may expend funds from the reserve account only for the purposes set forth in Section 1365.5 of the California Civil Code

Because reserve funds are collected for specific purposes, they can only be used for certain types of expenses. The Civil Code states that reserve funds can only be used for the “repair, restoration, replacement, or maintenance of major components which the Association maintains” or to “pursue litigation involving the repair, restoration, replacement, or maintenance of major components which the Association maintains.” In addition, reserve funds can also be used to meet short-term cash flow needs. However, since borrowing from reserves means the monies may not be available for the purposes they were originally collected, before an Association can take money out of reserves to fund operating expenses, certain formalities must be met.

First, the Board must provide notice of a meeting to the members advising them of the intent to consider a transfer out of reserves. The notice must state (1) why the transfer is needed, (2) possible options for repayment, and (3) whether a special assessment may be considered to repay the amount transferred out of reserves. Lastly, the Board must discuss and approve the transfer during the open session of the properly noticed meeting. These requirements are designed not only to give members notice of the potential transfer out of reserves, but to offer them the opportunity to hear the discussion explaining why such a transfer may be necessary, as well as an opportunity to address the Board and state any concerns they may have over such a transfer.

Once the Board has made the decision to transfer funds out of a reserve account, the next consideration is with regard to repaying the funds. The Civil Code is specific with regard to repayment of reserve funds and requires that funds borrowed from reserves to meet short-term cash flow needs be repaid within one year of the initial transfer. While the time to repay the loan from reserves can be extended briefly, if the Association is not going to meet the one-year repayment requirement the Board must give the same notice of meeting to the members as it did before the initial transfer out of reserves was approved, and discuss the option of delaying the repayment during open session. The Board is also required to make a finding, supported by documentation, that a temporary delay in repaying the amount borrowed from reserves would be in the best interest of the Association. Such documentation should include some form of cash flow projection which shows the impact of the proposed repayment plan and the impact on the Association’s ability to meet its operating expenses over the time period which the Board is considering extending the repayment period. In addition, the Board must consider whether a special assessment would allow it to recover the full amount of the funds which must be repaid into reserves.

In light of the stringent requirements on borrowing from reserve accounts, and the requirement that an Association actually have reserve accounts, one would expect that the legislature would have imposed some minimum requirement on the funding levels for reserves. However, there is no statutory requirement to fund reserves to a certain level. All that is required is that the Board adopt a reserve funding plan in the open session of a meeting. The plan should indicate how the Association plans to fund the contribution necessary to defray the costs to repair, restore, replace or maintain the major components with a remaining useful life of less than thirty years. While there are no statutory requirements for minimum funding levels, the Association’s governing documents must also be reviewed to determine any requirements contained in the documents themselves.

Given the lack of any specific minimum reserve funding level requirement, the Board’s funding plan could conceivably consist of a special assessment being passed when the funds are needed. However, while such a plan would satisfy the statutory requirements, one could question whether such a plan would satisfy the Board’s fiduciary obligations to exercise prudent fiscal management in connection with the Association’s affairs. In light of the difficulties many Associations face in collecting regular monthly assessments, even if it complies with statutory requirements, failure to fund reserve accounts could expose the Board to claims of breach of fiduciary duties. Therefore, without a minimum funding level mandated by statute, a question arises as to how a Board determines the correct funding level for their Association.

The benefit of the lack of a statutory minimum reserve funding level is that the Board has flexibility in exercising its judgment when it comes to determining the funding level for an Association’s reserve account. The right level of reserve funding depends on the HOA’s individual circumstances, and there is no “industry standard” for funding reserves. Often, the funding goal will depend on the methodology the Board uses in their funding strategy.

There are several possible strategies a Board can consider in determining the funding level. These include:

• Fully Funded Model – setting a reserve funding goal which keeps the reserves at or near 100% funded
• Threshold Funded Model – setting a reserve funding goal which keeps the reserve balance above some predetermined threshold. This is generally more than “Baseline Funding” and less than “Full Funding”
• Baseline Funded Model – “Minimum Funded Model” – setting a reserve funding goal which keeps the reserve cash balance at the end of each year in the overall reserve funding projection at or above $0

Each of these models depends on an analysis of cash flows into and out of the reserve fund over thirty years. Once the funding model is determined, assessment calculations should then be made sufficient to reach the Board’s funding goals.

The stringent requirements on borrowing from reserve funds, as well as the Board members’ fiduciary obligations, require that the Board exercise prudent fiscal management in maintaining the integrity of the reserve accounts. Any Board contemplating borrowing from reserve accounts should seriously consider levying a special assessment to recover the amount needed to fund the reserves and also consider increasing dues to meet operating expenses. In addition, if not already part of the budget, the Board should consider budgeting for “bad debt” to ease the impact of late assessments on the overall financial health of the Association. Failure to do so puts the Association’s assets at risk and exposes the directors to claims for breach of fiduciary duties.