With natural disasters causing catastrophic property damages becoming more common, associations must be prepared for unexpected expenses, such as a major roof repair, or the installation of a new heating and cooling system. These major capital improvement projects typically come at a great cost, and are rarely popular with residents, who must bear that cost. It's up to association boards to plan ahead and have contingency funds available to cover these types of projects but all too often, that doesn't happen.

But what exactly are capital improvements as defined by industry professionals? When talking about capital improvements as related to a residential community one is speaking of the property components that have a defined useful life and will need replacement at some point in the future. Experts point to such things as roofs, sidewalk pavement and roads, exterior siding and boiler and HVAC components as having a certain life span that over time will need to be replaced.

Failure to Plan

While usually well-intended, associations, regardless of location or residential income levels, tend to make common mistakes when it comes to budgeting for required improvements such as new roofs, windows or paving.

“The biggest problem boards face is not having the information they need to adequately budget and make critical decisions,” says Stuart Wilkinson with the Reserve Study Group, a national consulting firm. “Boards need to arm themselves with information, including a reserve study that helps them not only understand their current circumstances but what options they have moving forward.”

“Most educated boards and associations do understand the concept of budgeting for capital improvements,” says Mitch Frumkin, PE, RS, CGP, the president of Kipcon, an engineering consulting firm with offices in New Jersey and New York City.

The most common mistakes made by boards, Frumkin says, deals with predicting down the road future needs and costs. “The mistakes that are made have to do with understanding the models that are used to predict what the costs will be as well as how much should be set aside on an ongoing basis to offset the future costs. The most typical way to predict these costs is to have a reserve study prepared. The most critical part of the study is to meet with the professional that prepared the study in order to develop a funding plan to meet the association’s specific needs.” However, he says, in many instances, this meeting never takes place.

Boards have a fiduciary duty, says Russ Fernandes, a principal at New Jersey-based Becht Engineering. “Boards need to remember that they have a fiduciary duty to all unit owners and the responsibility of maintaining the common elements,” Fernandes says. “

“While it may be possible to put off repaving a parking lot for a year or two, for example, other issues like replacing a leaking roof may need to be done regardless of the economy,” he says.”At the risk of appearing insensitive to the plight of their fellow owners and neighbors, especially in this tough economy, it is important that, at a minimum, boards increase their contributions to reserves each year to at least keep pace with inflation and price increases. If unit owners cannot meet their obligations to the association, then the board has to work with their attorney and decide how they pursue the delinquencies. Needed projects that cannot be put off may require that the association obtain outside financing to cover any shortfalls.”

Nik Clark, director of client services for the Milwaukee-based Reserve Advisors agrees with his colleagues that “failure to plan” is probably the most common mistake he sees on a regular basis. “Historically, many associations just didn’t plan/budget for major capital expenditures and took a ‘wait until it breaks’ mentality,” says Clark. “Other common mistakes are trying to do-it-yourself (DIY) without the expertise and knowledge to compile a comprehensive forecast.”

Gene Ferrara, a professional engineer and consultant with Englewood Cliffs, New Jersey-based JMA Consultants & Engineers P.C., said the key is to understand the goal of the reserve study.

“The first reason for a study is not to find out how much things will cost but rather what is wrong and what needs a closer look at,” Ferrara says. “I suggest prior to a proposal being made, that a clear understanding of all systems be obtained. That would mean walking the site with both elevator, mechanical and exterior consultants. The reserve study is best handled by those professionals/consultants that you already have servicing the building—that is, of course, if you feel they are best handling your needs. We strongly recommend against a one-stop shop because with all of the different systems, codes and variables it is impossible to have a firm that can best cover all items.”

Ferrara notes that sometimes specialists are needed. If you have a pool or specialty co-generation plant or some fancy grounds applications, such as an advanced parking garage or tennis courts, other specialty consultants may have to be brought in.

Frumkin and others have been preaching the mantra of proper planning for many years in the industry.

“Very often we see that associations have not adequately put funds aside for future capital improvements,” Clark explains. “There are various reasons for this some of which include ‘we will worry about it when the time comes for replacement,’ or ‘we will not be living here when the improvements will be needed, so we will let the next owner handle the expense,’" says Clark. “Additionally, associations may not have properly prepared for future expenses because they have either not had a reserve study prepared or the reserve study they have does not adequately account for the future costs of improvements.”

One professional engineer interviewed believes that as many as 90% of the associations he sees and deals with on a regular basis are either unfunded or seriously underfunded.

Understanding Capital Needs

Regardless of the state or location, a board of directors or board of managers should take the wise approach to assuring there is enough money in the association’s reserve fund. This isn’t a rainy day fund because there is no question certain big ticket projects will come to pass. While management companies are usually excellent information resources for boards looking for budgeting answers, often times it is prudent to seek the advice of experts in this niche field as they can better prepare timelines.

“In a reserve study,” notes Frumkin, “not only are the replacement costs of the components as well as the remaining useful lives calculated but also the components that are included are determined. In an update, the components are not selected since the purpose of the study is to update the replacement costs and the useful lives using the original reserve study as the basis.”

He adds, that with that said, a reserve study is generally performed soon after a community is constructed to reflect the actual “as-built” construction and to determine what all the components are. The only time a new reserve study is performed is if the association lost confidence in the components included as well as their quantities.

“In regards to the reserve study update,” Frumkin says, “these are typically updated for a community up to about 10 years old every three years and as the association ages on a more frequent basis, such as every other year. This also can vary based on what type of funding plan the association uses and how much risk is taken. Again, this shows the importance of a meeting to discuss the plan prior to implementation.”

Timing and Costs

While fees for reserve studies vary, most experts offered ball park figures. In Frumkin’s estimation, the cost greatly depends on the size, age, complexity and the number of amenities offered by the association.

Ferrara says to think of a survey like a doctor’s physical for the building plant. “It should be extensive the first time and updated every year. The cost for a major 15-20-story building is around $15,000 to $20,000 depending on all systems and areas to be covered. Then on an annual or every two years, the update could only cost around $3,000,” he says. He adds that as a caveat, that if the elevators were recently replaced or updated, if the façade went through a major restoration or if the roof was replaced in the past five years or the boilers were replaced, the survey costs will be much less.”

When asked how long a reserve study assessment takes to complete, experts note that time frames vary. Studies, Ferrara noted, can take up to six months to award, prepare and review with boards. The first version is a draft so that budgeting and goals of the board or owner are figured in. The final draft will be the plan for moving forward based on all factors. Remember, he adds, that plans do change and when that happens, the final draft of the plan will need to be updated so that is remains current.

Reserve study services are often performed by persons with varied backgrounds including architecture, civil engineering, structural engineering, mechanical and electrical engineering.

Wilkinson explained that reserve studies should be prepared by professionals trained and certified in the field. One such certification is Reserve Specialist (RS), which he holds and is available through the Community Associations Institute (CAI). “To obtain this certification, candidates must have prepared at least 30 reserve studies within the past three calendar years, hold a bachelor’s degree in construction management, architecture, or engineering, or something equivalent based on experience and education, and comply with industry standards and codes of conduct.”

Ferrara says to pick the best person for the job and not just be content with those who have “reserve specialist” after their name. An engineer or consultant that actually understands and works with real-life building systems and knows the building codes and current specifications can be a valuable expert to have on hand.

Look Out for Red Flags

When a professional is hired to conduct a reserve assessment, they are looking for both the obvious red flags as well as problems that are hidden to the untrained eye. “In many cases it’s the obvious. Signs of deterioration, staining, cracks or an apparent lack of maintenance are in some cases overlooked by those who may see a property day in and day out,” says Wilkinson. “A lack of ongoing and preventative maintenance generally raises concerns that the condition of a community’s capital assets is well beyond its physical age and may fail prematurely.”

The scope of review is solely dependent on the building and its operating systems, Ferrara says. “Red flags for me are bad answers given by the board or management when asked. Such as when was the roof replaced and is there a warranty in place? If they answer ‘I do not know,’ that is the first sign of poor management or record keeping. I suggest that a review of all systems be performed with dates of major maintenance and/or replacement, as well as any warranties that may be in place.”

Frumkin acknowledges that an assessment can take anywhere from a day or so to a few weeks and is highly dependent on the size and type of community being surveyed. “The critical thing that the preparer is focused on when doing the inspection is the condition of the components, since this relates directly to the estimated remaining lives. Red flags that come up are the condition of the components which indicate that underlying problems may exist that should be recognized when preparing the pricing. In addition, when doing an update, a red flag could be seeing additional components that will require replacement but are not on the study being updated.”

Avoiding Pitfalls

Most, if not all, management companies have experienced boards that were not prepared for a capital improvement project. While they might have had monies in respective reserve funds, it simply wasn’t enough to underwrite the project. This results in major headaches and troubles for boards and resides alike. Studies, says Frumkin, should be used as a planning tool for future capital improvements. Generally projections look from 5 to 30 years down the road, he says.

“The worst case scenario is that associations can, and have been condemned if assets are not properly maintained. This is a worst case scenario which results in huge financial burden for unit owners and sometimes loss of investment. More common are substantial special assessments that can be almost equally difficult for associations,” says Clark. The special assessment is a double-edged sword. While monies can be obtained, it doesn’t adequately prepare for the future. It is deemed a stopgap approach to project funding and doesn’t always end well. “If a roof begins to fail and water damage is occurring, an association may have no choice but to special assess to the tune of thousands upon thousands of dollars. Unpaid assessments can result in liens and foreclosure,” says Clark.

Fernandes acknowledges that even the best-made plans can fall by the wayside. “There is no way for a board to budget for every hypothetical emergency. The best approach is first to have a reserve study done by a competent reserve specialist which will identify items to be included in the reserve fund. Many ‘hypothetical emergencies’ can be avoided by carefully inspecting and evaluating a property during the preparation of the reserve study. Most future repairs and replacements can be identified and planned for, reducing the likelihood of unanticipated occurrences.” he says.

Frumkin agrees. “The most common ramification of being underfunded is the need for either a special assessment of the unit owners or the need for bank financing. Keep in mind that if you do not collect the funds needed, the roof is still going to age and require replacement.”

There are some traditional methods of funding. Independent of methodology used—there is baseline funding; full funding; statutory funding; and threshold funding:

Baseline funding means to establish a capital reserve funding goal of keeping the reserve cash balance above zero.

Full funding means setting a reserve funding goal of attaining and maintaining reserves at or near 100% funded.

Statutory funding means establishing a reserve funding goal of setting aside the specific minimum amount of reserves as required by local statutes.

Threshold funding means establishing a reserve funding goal of keeping the reserve fund balance above a specified dollar or percent funded amount. Depending on the threshold, this may be more or less conservative than “fully funded.”

As an example, a community association roof has a 20-year life span. The roof is 10 years old with an estimated $50,000 replacement cost. If the reserve fund has $25,000, the board or association must collect $2,500 over the following 10 years.

Boards must also differentiate between short, medium and long-term goals. This approach allows for proper funding practices. “The industry standard for a reserve study is 30 years. This is an appropriate time-frame because it encompasses the cycle of major replacement items that need to be considered,” says Clark. “Studies of five or 10 years might likely misrepresent—to the low side—proper reserve funding levels because major expenditures, which have useful lives of 15 to 25 years, may not make the radar screen.”

Ferrara suggests that reserves be allocated for normal repairs, replacements and maintenance, and another fund be set aside to account for new codes, laws and disaster spending or emergencies. However, they choose, boards should do whatever works best for their building community, he says.

With board members often in flux, it can prove difficult to budget for a capital improvement project that is 20 years down the road when many residents and board members will have moved on. This is why it is important for boards to take a collective long view with the assistance of industry professionals so boards don’t fall behind.

Managing Editor Debra A. Estock contributed to this article.