The Role and Importance of the Reserve Study in Determining an Appropriate Reserve Fund

Matthew W. Heron, Esq.

Introduction

A well-run condominium can be thought of as having two components: (1) physical assets, which are the buildings, structures, and grounds on which the condominium is located; and (2) financial assets, which are the funds necessary to maintain the condominium’s physical assets. So long as the financial assets are adequate to meet the maintenance needs of the physical assets, then the condominium project itself stands a good chance to succeed. If the financial assets of a condominium are insufficient to meet the maintenance needs of the condominium’s physical assets, then there will likely be a decline in the overall condition of the condominium. A reserve study can be used to maximize the value of a condominium’s physical and financial assets by helping the board of directors evaluate a condominium’s overall financial health. This article provides a brief explanation of the role and usefulness of the reserve study.

The Reserve Fund

The financial assets needed to maintain a condominium’s physical assets come from assessments, and co-owners often do not like paying assessments. Increases in assessments are sometimes questioned and may be used against directors in upcoming elections. Maintaining artificially low assessments, however, will undermine the condominium’s ability to maintain its physical assets as to both regular ongoing maintenance and necessary capital improvement projects. A board that overlooks regular maintenance likely shortens the life span of the condominium’s physical assets, and a board that ignores capital improvement projects likely shortens the life span of its board tenure.

One of the most important tasks then for a successful board of directors is to find and maintain the balance between the physical and financial assets of the condominium. An adequate reserve fund to pay reserve expenses is an integral part of achieving this balance. Reserve expenses are infrequent larger expenses to repair or replace reserve items (certain common elements) and require sufficient advance planning. Examples of potential reserve items include roofing, roads, siding, decking, asphalt, and sidewalks. Ideally, the reserve fund is used to pay for these larger expenses as they occur over time in predictable intervals. If repairs are unexpected, or more expensive than expected, than the association may be forced to impose a significant additional assessment or even borrow money. This type of surprise can be viewed negatively and suspiciously by co-owners. If the cost and timing of these expenses can be predicted, then the association can collect assessments in regular intervals so that it has sufficient funds for both regular maintenance and improvement projects when repairs need to be made. The collection of assessments in regular intervals provides a consistency that is usually valued by co-owners.

Reserve Fund Requirements

To a certain extent the board’s responsibilities regarding a reserve fund are determined by statute and administrative rule. First, every condominium must have a reserve fund. The Michigan Condominium Act provides that “[a] reserve fund for major repairs and replacements of common elements shall be maintained by the association of co-owners.” MCL 559.205. Second, a reserve fund cannot be used for regular maintenance and cannot be less than 10% of the association’s annual budget. Administrative Rule 559.511(2) requires that the reserve fund “shall only” be used for major repair and replacement and that the reserve fund “at a minimum, shall be equal to 10% of the association’s current annual budget on a noncumulative basis.” R 559.511(1). This 10% threshold, however, has no relationship to the actual physical assets of the condominium. A board that simply maintains this 10% threshold without an evaluation of whether it is adequate will often need to rely on additional assessments to make up the difference when capital improvement projects arise. This is especially true for larger condominiums or condominiums with physical assets such as pools, streets, or aging buildings.

The Reserve Study

A reserve study is one of the most important tools available to the board in both determining an appropriate regular assessment and explaining the assessment to co-owners.

A reserve study is an analysis of the physical and financial assets of a condominium. With respect to the physical analysis, a reserve study will usually conduct: (i) a component inventory; (ii) a condition assessment; and (iii) a life and valuation assessment. A component inventory is a listing of the physical assets or reserve items of the condominium. A condition assessment is the evaluation of the condition of the condominium’s physical assets. A life and valuation assessment is an estimation of the useful life of the condominium’s physical assets along with estimated repair and replacement costs. This information is then used to conduct the financial analysis. For the financial analysis, the results of the physical analysis are first used to determine the ideal reserve fund. For example, if it is assumed that a reserve item has a 15 year useful life, and that at the end of its useful life the reserve item will cost $30,000 to replace, then as each year progresses the reserve fund should be increased by 1/15, or by $2,000 so that by the end of year 15 the reserve fund will have sufficient funds to replace that reserve item. At the end of year 1, the reserve fund should hold $2,000. At the end of year 10, the reserve fund should hold $20,000, and so on until by year 15 the $30,000 target is achieved. Once this ideal reserve fund is determined for all reserve items, it is then compared against the condominium’s actual reserve fund. If there is a shortfall between the two, then a funding plan can be developed to assist the condominium in bringing its reserve fund up to the level of the ideal reserve fund.

The use of a reserve study will assist the condominium board in determining both the ideal reserve fund for its condominium, and the level of regular or additional assessments necessary to maintain or achieve that ideal reserve fund. The reserve study’s findings can also be used to explain these amounts and any resultant increase in assessments to co-owners. The Community Associations Institute has made an effort to standardize the reserve study process and implemented a Reserve Specialist (RS) designation to help identify credentialed providers.

The Reserve Study and the Board’s Fiduciary Duty to the Association

There are additional reasons for individual board members to consider commissioning a reserve study. Under the Michigan Nonprofit Corporation Act, a director must discharge his or her duties “with the care an ordinarily prudent person in a like position would exercise under similar circumstances.” MCL 450.2541(1)(b). In discharging these duties, a director is “entitled to rely on information, opinions, reports or statements . . . if prepared or presented by . . . [l]egal counsel, public accountants, engineers or other persons as to matters the director . . . reasonably believes are within the person’s professional or expert competence.” MCL 450.2541(2)(b). Accordingly, a board that commissions a reserve study from a professional and uses that reserve study to establish its reserve fund should be able to defend against any subsequent claim that the reserve fund was insufficient to address the needs of the condominium project or that the board otherwise breached its fiduciary duty in maintaining the reserve fund.

Conclusion

The physical assets of a condominium are dependent on the financial ability of the association to maintain these assets. An adequate reserve fund is critical in both ensuring that a condominium’s financial assets are sufficient to maintain the condominium and in preventing sudden and unexpected increases in assessments. Though a 10% reserve fund is required by law, simply meeting the minimum requirement may not be sufficient to meet a condominium’s needs. A reserve study is a valuable tool that can be used by an association to determine the ideal reserve fund and maintain an appropriate balance between the condominium’s physical and financial assets. These steps, in conjunction with a sound reserve fund investment policy and with the advice of competent legal counsel, can help ensure the long term viability of the condominium project. If your association is considering a reserve study, our office can answer any questions that you may have.

Matthew W. Heron is an attorney with the law firm of Cummings, McClorey, Davis & Acho, P.L.C. where he focuses his practice on real estate litigation, dispute avoidance, condominium law, commercial litigation, land use, large contractual disputes, and title litigation. He has extensive litigation and trial experience in state and federal courts involving commercial litigation issues and real estate matters. He can be reached at (734) 261-2400 or mheron@cmda-law.com. You can also follow him on Twitter at @mwheron75.