California Department of Real Estate Guidelines, Methods of Funding & Ideal Levels of Reserves

Reserves -- Civil Code Sections 1365 & 1365.5, California Department of Real Estate Guidelines, Methods of Funding & Ideal Levels of Reserves.

Since the governor of California signed into law Civil Code Section 1730 on September 11, 1983, "reserves" and "reserve funding" for Common Interest Developments (CIDs) have changed dramatically. Civil Code Section 1730 later became a part of what is known today as Civil Code Section 1365 of the Davis Sterling Common Interest Development Act. Almost 10 years have passed, and the industry seems to grow increasingly confused over the proper procedures for meeting all applicable guidelines. Current code sections now conflict with each other and do not parallel the California Department of Real Estate guidelines. Additionally, the standards set for practitioners by the American Institute of Certified Public Accountants, as of August 31, 1991, have made the issue even more complex.

Preparers of reserve studies within the industry are confusing the public further by establishing differing procedures and methods for calculating reserves and then naming these methods, each according to their own interpretations. Terms such as the "cash flow method," the "straight-line method," the "segregated method," seem to be in use as common place, well-understood terms, while in fact, no such agreement in the industry exist! One can pick up any issue of an industry newsletter and see an advertisement or article touting one method over the other. Recently, a single article has added the "straight-line segregated method", "pooling method" and "time value of money method" to the list, along with the merits of each. This is done with the authority as though these terms have agreed upon meanings and well-defined computational procedures. Another article in a Northern California publication effectively stated that if you use the "cash flow" method, you will always be "ideally funded" because you never have less than zero dollars ($0) in reserves. A sharp rebuttal followed in a subsequent issue by one of the key players in the development of current legislation and its intent.

As the largest reserve analysis preparer in California, and perhaps the nation, the policies and software development procedures used by our company, affect a great many people. The decisions and policies made by those of us in this industry, need to be made with the best interest of all served. Those served are not only the "current members" within communities and other forms of CIDs, but, by the very nature of our business, must include "future members" in these associations.

The purpose of this document is to explore some of the conflicting statutes, guidelines, and statements made by practitioners within our field, and suggest possible solutions. Overall, an ideal is to open a professional dialogue in this industry that will lay a path for future improvement. Copies of this document may be made and distributed as the reader desires. Anyone wishing to comment on any aspect of this document is encouraged to do so. Hopefully, with input from the industry, reasonable guidelines can be established which will ultimately benefit all involved.

The California Department of Real Estate "Operating Cost Manual for Homeowners Associations" is the guide that is used by preparers of pro-forma budgets for Common Interest Developments, which are submitted to the Department of Real Estate. These budgets are usually prepared many months in advance of the initial construction of the project, and usually are prepared for all phases of development at the same time.

The guide has been published 9 times over the last 18 years since 1975. The most recent guide available to budget preparers is dated August 1990. This guide states on page 1: "The cost data is considered reliable as of early 1990." It further states that, "Inflationary influences should therefore be considered in budget preparation, particularly for those budgets which are prepared more than a few months in advance of the operating period covered by the budget."

During the course of our business, we have seen numerous budgets prepared by most of the professionals in this industry. Cost of living adjustments are rarely considered by the preparers. Budgets prepared today, for projects which will be developed over the next several years, will almost always be based on cost data which will be excessively outdated by the time the budget is in effect.

The guide also states, "Occasionally, a common interest subdivision will include a common facility which is not covered in this manual." This is a major understatement at best! The guide continues, "One of the first tasks of the governing body or management agent of an association is the preparation of a complete inventory of the areas and facilities to be maintained. Preparing an inventory is both difficult and time consuming. An inventory which is patiently and systematically performed, however, is usually good for the lifetime of the project with minor additions and deletions as changes are made." As indicated before, these budgets are usually prepared many months or even years in advance of the initial construction of the project. Complete and accurate inventories are difficult to obtain when the project does not exist and only blueprints are available to the preparer. Often projects are never actually constructed as originally intended.

Most of the budgets prepared for or by developers of associations, do not include components which are not covered and listed in the "Operating Cost Manual." Associations which later rely on the completeness and accuracy of these initial inventories have found themselves in deep financial trouble as major components begin to wear out and for which no funding plan has been set in place.

The guide further complicates matters by stating, "The reserve factors in this manual are based upon new building components and equipment. Therefore, these factors should not normally be used for an existing development or for the conversion of an existing structure."

Combined, outdated costs, inaccurate and incomplete inventories, and the inability to use the "Operating Cost Manual" as an effective tool to update the association's reserve budget, has left many associations with underfunded reserves. Many have initiated lawsuits against their developers who in turn look to the original budget preparer. The developer is suspect as incomplete inventories and outdated costs effectively lower the reserve budget allocation and reduce the overall assessments, thereby making the project seem more attractive to a prospective purchaser.

The developer and budget preparer should take all precautions to assure that the budget prepared for the association is as complete and accurate as possible. After all, the claims that are being made by associations are that they are experiencing financial hardship precisely as a result of incomplete and inaccurate budgets.

The Department of Real Estate should take steps to insure that the publications they produce for use by developers and budget preparers, to meet the Department's own regulations, are as complete and current as possible. Revisions to the "Operating Cost Manual" should at a minimum be annually and revisions should be incorporated so as to allow users of the manual to apply formulas and cost data on existing associations as well as new ones. Simple computational information should be provided so that the user can make cost of living adjustments as the manual recommends.

Developers should, as soon as possible after construction of the initial phase of the project, obtain or complete an updated reserve study incorporating all aspects of the community or project.

Developers and budget preparers who can demonstrate that a good faith effort was made to provide a complete and accurate budget will limit their liability, however it will not eliminate it. Unfortunately, simple omissions in the final product can result in liability down the road. This liability can extend to volunteer members in the community or other professionals who may later revise or update the budget. Legislation could be considered amending the civil code, as follows:

Persons responsible for the preparation of the study of the association's reserve account requirements, as required by subdivision (d) of Section 1365.5 and subdivision (a) of Section 1365, shall have no liability based upon any alleged failure in the preparation of said study, so long as there was no intent to mislead or defraud the membership of the common interest development and that the preparer acted in good faith, in a manner believed to be in the best interest of the present and future membership, and with such care as an ordinarily prudent person or professional providing such services in like position would use under similar circumstances.

Currently no clear statement exists defining the purpose of reserve funding and what items should be included as reserve components vs. operating expenses. The determination of whether an expense should be labeled an operational expense, a reserve expense, or excluded altogether from a budget is sometimes subjective. Since this labeling may have a major impact on the financial plans of the association, subjective determinations should be minimized. Current statute simply defines reserve accounts as "moneys that the association's board of directors has identified for use to defray the future repair or replacement of, or additions to, those major components which the association is obligated to maintain". California statute should address these definitions directly to alleviate as much guesswork and subjectivity as possible.

As used in this section, "operational expenses" and "operational budget" shall be defined as expenses, which are identified by the Board of Directors, as occurring on an annual or greater frequency, no matter the size of the expense, and are considered by the Board to be effectively budgeted for on an annual basis. They are characterized as being reasonably predictable both in terms of frequency and cost. Operational expenses normally include all minor expenses which would not otherwise adversely affect an operational budget from one year to the next.

As used in this section, "reserve expenses" and "reserve budget" shall be defined as expenses, which are identified by the Board of Directors, as major expenses which occur other than annually and which are budgeted for in advance in order to provide the necessary funds in time for their occurrence. Reserve expenses are reasonably predictable both in terms of frequency and cost, however, they may include significant components which have an indeterminable but potential liability to the development and which may be demonstrated as a likely occurrence. They are expenses, that when incurred, would have a significant effect on the smooth operation of the budgetary process from one year to the next if they were not reserved for in advance.

Reserve budgets for associations normally do not include repairs or replacements of assets which are deemed to have an estimated useful life equal to or exceeding the estimated useful life of the facility or development itself, or exceeding the legal life of the development as defined in an association's governing documents. Also excluded are insignificant expenses which may be covered either by an operating or reserve contingency, or otherwise in a general maintenance fund. Costs which are caused by acts of God, accidents or other occurrences which are more properly insured for, rather than reserved for, are also normally excluded.

A copy of the operating budget shall be annually distributed not less than 45 days nor more than 60 days prior to the beginning of the association's fiscal year.

Except as provided in this section, the association shall levy regular and special assessments sufficient to perform its obligations under the governing documents and this title. However, annual increases in regular assessments for any fiscal year, as authorized by subdivision (b), shall not be imposed unless the board has complied with subdivision (a) of Section 1365 with respect to that fiscal year, or has obtained the approval of owners, constituting a quorum, casting a majority of the votes at a meeting or election of the association conducted in accordance with Chapter 5 (commencing with Section 7510) of Part 3 of Division 2 of Title 1 of the Corporations Code, and Section 7613 of the Corporations Code. For the purposes of this section, "quorum" means more than 50 percent of the owners of an association.

Our experience indicates approximately seventy percent of all common interest developments in California have fiscal year's which coincide with the calendar year. With a fiscal year ending December 31, the deadline for sending the pro-forma budget to their members consist of a 15 day window on or between November 2nd and November 17th (December is composed of 31 days). Failure to meet this condition effectively punishes associations under the provisions of Subdivision (a). Section 1366, whether or not such failure was the fault of the association.

This requirement places undue burden on Boards of Directors, management companies, and reserve analysis preparers, who must prepare, approve, and then publish this information within a 15 day time frame for a vast majority of associations. For some larger management companies, even coordinating the printing of the material to be distributed is burdensome. For reserve analysis companies, it is almost impossible meet every deadline for every Common Interest Development. Effectively, we are left with a "tax season" with no possibility of filing an extension. California Civil Code Section 1365, Subdivision (a), Paragraph (4), could be changed as follows:

A copy of the operating and reserve budget shall be distributed, at a minimum annually, and not less than 45 days nor more than 90 days prior to the date that the budget is to be in effect.

This change also would permit a Common Interest Development to have a budgetary cycle which is different than the fiscal year if so desired, and to change the budget mid-year should it be necessary.

Civil Code Sections 1365, subdivision (a), paragraph (2) and subdivision (c) requires the information be prepared in bold type. This is unnecessary and in our opinion actually makes the report more difficult to read. If the intent of statute is to make the information more easily readable, then statute should simply state that the document should be legible and leave it at that. If you wish to pursue a further refinement, perhaps type size such as 10 or 12 points may be suggested. However, all type styles are not the same. A 12 point, Times Roman typecase is not the same size, height or width, as 12 point Helvetica typecase. Further all type styles are not equally legible. Specifying the exact type style by manufacture and size will render production of the document impossible on some equipment.

As indicated previously, there are many "methods" being offered as how to best calculate reserve requirements. Articles and advertisements regularly appear in industry publications advancing one method over all others. Associations are left with a maze of names to choose from, "cash flow method" and "segregated method" topping the list. Associations also must determine if they should choose a company that uses inflationary factors and interest yields in their formulas, or listen to the vendor that says they offset each other and are not necessary. It would be convenient to suggest that one method is just as good as another, however, the truth is that differences in the calculating process can result in dramatic differences in the required contributions. Just because a "method" results in lower contributions to reserves does not make it the best choice.

In light of the complications in the calculating process, focus in the industry should be in the results and not the reasoning behind the process. There needs to be a benchmark established by which the effect of a process can be ultimately judged. The concept advanced, originally by this author, is that of being "ideally funded". Thirteen years later, and after reviewing the merits of the methods advanced to date, this author still feels this is still the best measure of an association's progress. The concept is simple and can be applied as a measure against any reserve funding method, and is illustrated in the following paragraphs.

The basis of funding for reserves is to distribute the cost of the replacement over the life of the component in question. If you have a major component which is expected to have an estimated useful life of 10 years, you would set aside approximately one-tenth of the replacement cost each year. At the end of 3 years, one would expect that three-tenths of the replacement cost would have accumulated and if so, you would be "ideally funded". The important aspect of this model, is that it is a measure of the adequacy of an association's reserves at any one point of time, and is independent of any particular "method" which may be used for future funding. The formula is based on current replacement cost, and is a measure in time, independent of future inflationary factors.

AGE

IDEAL LEVEL OF RESERVES =
X CURRENT REPLACEMENT COST

USEFUL LIFE

The argument is that no matter which "method" one uses, at the end of the process, the result should leave an association in better financial shape than at the beginning of the process. The "cash flow" method, arguably a good approach, is the most popular "method" in use, however, it has been subject to funding abuse. This method sets up a "window" in which all future anticipated replacement costs are computed, based on the individual lives of the components under consideration. The process is simple and can be performed with any spreadsheet program. One need only to determine the minimum reserve contribution requirement necessary, based on the association's beginning cash reserves and anticipated expenses during the "window" or period of time considered, so that the cash balance, in any one year, does not drop below zero dollars.

Dramatic differences in the annual contribution requirement can be obtained by simply adjusting the size of the window. Some firms considered "windows" as low as 5 or 10 years. Major replacements, such as roofing costs, would not appear in the "window" and therefore, no contributions would be considered for many years. Current statute now requires a window of 30 years because of this. However, with the "cash flow method" one can project a contribution requirement over a 30 year period, while never running out of money, which at the end of the period will leave the association with little or no moneys in reserves. This model can allow an association to become increasingly underfunded, while never running completely out of money. However, it can also be use to insure that an association becomes "fully funded" by testing contributions, which overall improve the association's financial position. Current statute seems to point in this direction, however, it is not clear.

Civil Code Section 1365, subdivision (a), paragraph (2), subparagraphs (B) & (C) indicate information which is to be distributed to the membership as part of the Section requirement. The wording is confusing and currently is as follows:

(B) As of the end of the fiscal year for which the study is prepared:

(i) The current estimate of the amount of cash reserves necessary to repair, replace, restore, or maintain the major components.

(ii) The current amount of accumulated cash reserves actually set aside to repair, replace, restore, or maintain major components.

(C) The percentage that the amount determined for purposes of clause (ii) of subparagraph (B) is of the amount determined for purposes of clause (i) of subparagraph (B).

Let's say I am preparing a reserve study in September 1993, for an association with a December 31 fiscal year end, and the study is for the calendar 1994 fiscal year. Does "As of the end of the fiscal year for which the study is prepared" mean the year in which the study is prepared, 1993, or the report year for which the study is prepared, 1994? How does an association determine the "accumulated cash reserves actually set aside" in clause (ii) if that point in time is, in either case, in the future?

Clause (i) as currently worded, is entirely subjective as to what is meant by the "current amount of cash reserve necessary." As recently demonstrated by one budget preparer, I could simply assume a position, that if I have no expenses anticipated today, then today I need no money and therefore no amount of cash reserves is "necessary to repair, replace, restore, or maintain the major components." Therefore, I am 100% ideally funded! Subparagraph (C) is completely confusing. This section needs to state clearly what its intention is. Rewording for this is suggested as follows:

(B) As of the first day of the budgetary year for which the study has been prepared, the association shall:

(i) Estimate the ideal level of accumulated reserves for each major component by identifying its age proportionate to its estimated useful life and multiplying by its current replacement cost.

(ii) Total all components considered in clause (i) including a provision for a contingency if applicable.

(iii) Estimate the amount of accumulated cash reserves which is projected to be set aside for all the major components considered.

(C) The association shall identify the percentage it projects it will be ideally funded per subparagraph (B), clause (ii) and clause (iii).

Note: The formula outlined in clause (i) is detailed in the Department of Real Estate's publication, "Reserve Study Guidelines for Homeowner Association Budgets", page 22.

At least once every three years the board of directors shall cause a study of the reserve account requirements of the common interest development to be conducted if the current replacement value of the major components which the association is obligated to repair, replace, restore, or maintain is equal to or greater than one-half of the gross budget of the association for any fiscal year. The board shall review this study annually and shall consider and implement necessary adjustments to the board's analysis of the reserve account requirements as a result of that review.

Civil Code Section 1365, subdivision (a), paragraph (2), subparagraph (A), describes that the "current estimated replacement cost, estimated remaining life, and estimated useful life of each major component" is to be a part of the information which is to be distributed annually to the membership. These two statutes conflict with each other.

Civil Code Section 1365.5, subdivision (a) requires:

(a) Unless the governing documents impose more stringent standards, the board of directors of the association shall do all of the following:

(1) Review a current reconciliation of the association's operating accounts on at least a quarterly basis.

(2) Review a current reconciliation of the association's reserve accounts on at least a quarterly basis.

(3) Review, on at least a quarterly basis, the current year's actual reserve revenues and expenses compared to the current year's budget.

(4) Review the latest account statements prepared by the financial institutions where the association has its operating and reserve accounts.

(5) Review an income and expense statement for the association's operating and reserve accounts on at least a quarterly basis.

This entire subdivision is unnecessarily burdensome and confusing. Some associations are of such size and nature that quarterly reviews are just not necessary. Others may choose to review the information more often. The point is, do we really need a statute mandating this? Paragraph (4) is unclear as to what "review the latest account statements prepared by the financial institutions" means? All in all, portions of Section 1365 and 1365.5 overlap and could be merged as a single section.

The board of directors shall not expend funds designated as reserve funds for any purpose other than the repair, restoration, replacement, or maintenance of, or litigation involving the repair, restoration, replacement or maintenance of, major components which the association is obligated to repair, restore, replace, or maintain and for which the reserve fund was established.

Does this mean that an association can only designate reserve categories for items that require "repair, restoration, replacement or maintenance", or for litigation involving "repair, restoration, replacement or maintenance"? If so, associations no longer could designate a reserve fund for any new improvements within a community that previously did not exist. Nor would associations be able to designate a "legal reserve" fund.

	AGE
IDEAL LEVEL OF RESERVES =		X	CURRENT REPLACEMENT COST
	USEFUL LIFE