OVERVIEW
HOAs in California are largely governed by the Davis-Stirling Act, a series of statutes located in the Civil Code. In other words, all HOAs in California must abide by the Davis-Stirling Act, as well as other applicable California laws.
One of an HOA’s most important obligations is to maintain and repair (and where necessary, replace) the association’s common areas. In many HOAs, the common areas consist of several individual components (e.g., swimming pools, tennis courts, landscaping, condo roofs, plumbing, streets, etc.). As you can imagine some of those components are intended to last a long time before they have to be replaced, while others require only periodic maintenance.
To help ensure that HOAs will have sufficient funds to abide by their obligations to maintain, repair, and replace their common area components, the Davis-Stirling Act requires HOAs to establish and maintain reserve accounts to ensure that HOAs have adequate resources to address major repairs and replacements that will be necessary in the future. These reserve funds are typically funded through regular assessments paid by members of the association, and the use of the funds is subject to certain requirements and restrictions outlined in the Davis-Stirling Act.
This article is intended to provide you with a broad understanding of an HOA’s obligations regarding reserve funds, how HOAs are supposed to use that money, and how you can make an educated guess regarding an HOA’s financial health by looking at a single figure.
RESERVE STUDY REQUIREMENT
Determining how much to set aside (i.e., “reserve”) each year for each component can be complicated, which is why HOA’s are obligated to conduct reserve studies. While the Davis-Stirling Act requires HOAs to conduct reserve studies at least once every three years (Civ. Code, § 5550(a)), it requires HOAs to annually distribute an assessment and reserve funding disclosure summary containing, among other things, a “percent funded” figure (discussed in detail below). (Civ. Code, § 5570.)
A reserve study is a comprehensive evaluation of the physical and financial condition of the common areas and facilities within an HOA. The study includes a physical inspection of the property, a review of past maintenance and repair records, an analysis of the expected useful life of various components, and an estimate of future repair and replacement costs. Reserve studies also take more intangible items into account, such as the costs of inflation or other factors that might impact the costs of performing the work in the future—e.g., the costs of materials, like lumber.
Based on the findings of the reserve study, the HOA can determine how much money should be set aside each year for each component so that when a component needs to be replaced or maintained, the money will be there to do it. For example, let’s say that you live in a condominium complex with a number of multi-story buildings. Each of those buildings has a roof, and it’s almost certain that under your CC&Rs, the roofs are common areas—meaning that the HOA is responsible for their maintenance and replacement. Now, as it turns out, roofs are one of the most expensive components of a building to repair or replace. Over time, roofs will deteriorate and become damaged by weather or other factors. And if your HOA’s roofs were built at around the same time, it’s quite possible that they will experience similar wear and tear, thus requiring maintenance and replacement at or near the same time. Without adequate reserve funds, the cost of replacing a roof (never mind more than one of them) could be a significant financial burden on individual members of the association.
In fact, massive roof repair projects (as well as repairs/replacement of balconies and decks) constitutes one of the most common causes of massive special assessments we’ve seen imposed by HOAs in California. And when I say massive special assessment, I’m talking about $30,000, $40,000, or even $50,000 per household in a given HOA. Needless to say, when we see those kinds of special assessments, and we’re seeing them more frequently than ever before, they almost always stem directly from extremely poor reserve planning and financial mismanagement by the HOA.
[Interestingly, while the Davis-Stirling Act doesn’t actually require HOAs to adequately fund their reserve accounts—i.e., there’s no requirement to set aside sufficient funds to accomplish the work in the future—that obligation is strongly implied by an HOA’s obligation to “levy regular and special assessments sufficient to perform its obligations. . . .” (Civ. Code § 5600(a).) That issue is beyond the scope of this article, but may be explored in the near future.]
RESTRICTIONS ON USING RESERVE FUNDS
All expenditures from an HOA’s reserve account requires board approval. This shouldn’t be a big revelation because technically speaking, all expenditures of HOA money requires, at some level, the approval of the board.
The Davis-Stirling Act places restrictions on the use of reserve funds to ensure that they are used only for a specific purpose—i.e., the repair, replacement, or maintenance of the HOA’s major components. (Civ. Code, § 5510.) As indicated above, these components commonly include things like swimming pools, streets, roofs, exterior walls, plumbing systems, and HOA’s other common area elements. Reserve funds may also be used to cover the costs of litigation that involves the maintenance, repair, or replacement of major common area components. (Ibid.)
In addition to the foregoing, a board may borrow from reserves to fund other items (i.e., items generally paid for from the HOA’s operating accounts) so long as the board: (i) provides notice to the HOA’s members of its intent to borrow the money by including it on the agenda of an open board meeting; (ii) the notice includes the reasons for the transfer, some options for repayment, and whether the board might consider a special assessment to repay the money; and (iii) once the transfer is authorized by the board, it specifies in the meeting minutes the reasons why the transfer is necessary, as well as when and how it will be repaid. (Civ. Code, § 5515(a)-(c).) While money borrowed from reserves must generally be repaid to the reserve account within one year, if the board provides notice to the members and documents why additional time is in the HOA’s best interest, a board may “temporarily delay the restoration.” (Civ. Code, § 5515(d).)
The purpose of these borrowing requirements is to ensure transparency and accountability in the use of the association’s reserve funds. By providing notice to the membership, the board is giving members an opportunity to review and comment on the proposed transfer, and to raise any concerns or objections that they may have.
MANDATORY ANNUAL REVIEW
The Davis-Stirling Act requires the board to review the reserve account and the reserve study at least once a year. This review must include an evaluation of the reserve funding plan and an analysis of whether the level of assessments is sufficient to maintain the reserve account at the required level. A well managed board will make a determination as to whether any adjustment are necessary, and if so, that board will take appropriate action to ensure that the reserve account is adequately funded. That may include increasing assessments, passing a special assessment (or, where required, putting a special assessment on the ballot for a member vote), reducing expenditures, or adjusting the funding plan to reflect changing circumstances or conditions.
HOAs are obligated to provide all of the members with various documents each year, including an annual budget report and policy statement. One of the documents included in that annual budget report is a summary of the reserve funding plan adopted by the HOA (the Davis-Stirling Act calls this document the reserve funding disclosure summary). (Civ. Code §§ 5300 and 5570.)
THE PERCENTAGE FUNDED FIGURE (what that little number means and how a homeowner can use it)
The most important part of the reserve funding disclosure summary, at least in my opinion, happens to be a single figure—the percent funded. That percentage figure constitutes a calculation by your HOA’s reserve study specialist of the recommended funding level for the reserve account. More importantly, that percentage provides a snapshot of the adequacy of your HOA’s reserve funding at a particular point in time, and can be used by members and prospective purchasers to evaluate the financial health of the HOA.
For example, say that your HOA has only one major component (just to make things easy). Let’s also say that your HOA’s reserve study estimates that the “useful life” of the component is 10 years. And finally, let’s say that the reserve study estimates that the total cost of future replacement for that components is $1 million. To be fully funded—i.e., your HOA’s percent funded figure would be 100%—your HOA would need to set aside $10,000 per year for the full 10-year “useful life” so that at the end of that 10 years, your HOA would have the full $1 million in the reserve account to replace the component.
Now, I’ve never seen an HOA with anything near a 100% reserve percentage. It would be great, but it’s not realistic. You may be asking, therefore, what percentage should your HOA have to be considered financially healthy? Financial experts generally agree that a percentage funded of 70% or higher is indicative of a financially healthy HOA. There are, of course, a variety of factors that go into an association’s overall financial health, but the percent funded figure is generally a good shorthand indicator.
If your HOA were at the 70% figure, therefore, it would mean (at least in our example from above) that at the end of the 10 years, the HOA would have $700,000 of the necessary $1 million in the reserve account. To make up the difference, the HOA could pass a special assessment (or if the number is over 5% of that year’s budget, put a special assessment up for a member vote), borrow money from a bank, or pull from the HOA’s operating accounts.
Keep in mind that the usefulness of the reserve funding percentage is not diminished by the fact that the reserve funding disclosure summary is inadmissible in court “to show improper financial management” (Civ. Code, § 5300(d)). A reserve funding percentage above 70% is a good sign that your HOA is in okay financial condition, while a figure below 70% may indicate that the HOA has not adequately planned for future repairs and replacements of major components, which could result in special assessments or loans being levied on homeowners in the future. Just remember that the funding percentage is but one factor. It’s a good one, but it doesn’t tell the entire story.
CONCLUDING THOUGHT
The Davis-Stirling Act places significant requirements on the use of reserve funds. In addition to dictating how reserve funds may be used, the Davis-Stirling Act also helps ensure that HOAs adequately fund their reserve accounts by requiring HOAs to prepare and send all the members a reserve funding disclosure summary (as part of the annual budget) every year.
A well managed HOA will set aside sufficient funds each year to ensure that it’s able to fund any major repairs and replacements of its major components when it’s time to do so. Doing so helps to protect the financial stability and integrity of the HOA and helps ensure that members are not burdened with unexpected costs or liabilities.
While there is not set minimum requirement regarding the amounts that must be deposited into HOA reserve accounts, experts generally believe that a percentage funded figure of at least 70% indicates a financially healthy HOA. Homeowners or prospective buyers looking for a quick way to gauge the overall financial health of their HOAs can, therefore, look to that percentage to help them make that determination.
It is important for board members and association managers to be familiar with the requirements of the act and to take appropriate steps to comply with its provisions. Failure to do so can result in legal liability for the association and its members, as well as financial consequences that can impact the entire HOA.