BUY03 - The Reserve Fund is Underfunded: What Does That Mean?
So let’s say you’re reading the reserve fund documents to your condo for the 1st time – either you’ve just put in an offer on a new place and just received them, or you’re finally tacking that mountain of mail from the Property Manager that’s been piling up over the last few years on a desk somewhere. You skim the documents and horror of horrors – they use the words “underfunded”! That’s bad right?
A bit of background first before you can really appreciate this article. You should read up the basics around reserve fund studies in our “What to look for: Reserve Fund Basics” article or much of this article won’t make sense. Actually this article will make no sense if you don’t!
OK, so with the basics down, you’ll understand the basic principle that the Reserve Fund report will state the amount that should be in the Reserve Fund’s bank account at the end of the fiscal year. Compare this to what’s in the account right now, adjusted for planned major repairs that draw on the fund in the current year and you get a sense of how well funded the Reserve Fund is. In theory it’s pretty simple – have more than what the reserve fund states is needed in your bank account at the end of the year and you should be fine. Easy peasey.
Of course the reality is that it’s never that easy. Reserve Funds fall behind recommended funding levels for a variety of reasons
1) The Inflation rate used is not enough; or
2) Annual Reserve Fund Contribution increases (typically through increased monthly condo fees) are not equal or greater than the amount specified in the Reserve Fund report.
3) Rate of Interest assumed to be earned on savings is not met in reality.
4) And now for the real reason behind most underfunding situations
An unexpected major expenditure to fix common property was made, and paid for (or about to be paid for) by the reserve fund.
Should Reserve Funds be Fully Funded? The Debate
It’s quite common to hear people say “Let’s cut back on our Reserve Fund Contributions – Why pay for tomorrow’s expenditures today?” Typically these same people want to hold the line on any condo fee increases and deliberately run the Reserve Fund underfunded.
To use an analogy, Reserve Fund are much like saving for your retirement. You can spend more money in your 30’s rather than save it and have a ton of fun – but when you hit age 67 and need the money to retire – your savings are not going to be enough when you need it. Only condos don’t get the option of working longer than 67 to make up for their free wheeling 30’s – typically they are left with one thing – the dreaded Special Assessment.
But CondoSensei you say – that’s totally fine by me. I don’t plan on being in the condo for more than 5 years. Technically you’re right – you might be able to dodge the bullet for a few years and not get caught – kind of like parking at a meter without buying time. However there are several reasons as to why reserve fund should be fully funded at all times
1) First and foremost there’s the issue of resale. Anyone who knows anything about condos (and that means you my dear informed StrataSense reader) should stay away from buying condos that are severely underfunded. Smart buyers will run. It is my honest opinion that condos will face increasing legislation and Reserve Fund requirements in the future to avert masssive losses, both to owners and ultimately government. Condos with underfunded reserves will have this deficiency displayed to the buying public in big bold letters and ultimately have a more difficult time in selling.
2) Long Term Owners – Anyone looking to stay longer than five years in a condo should really push for a fully funded Reserve Fund. Seeing as how condos are increasingly bought and held by people as a “rental property” for the long term (10-25 years), this should be an item of particular concern to those. The previously mentioned resale issues are the primary reason for long term owners to care.
No Legal Requirements for Funding
Here’s the surprising thing to me – most Provincial Condo / Strata Acts stay away from defining the legal definition of being underfunded. Vague statements like “sufficient funds that can reasonably be expected to provide for major repairs and replacement” are made – which absolutely amazes me!
In my humble opinion the government should absolutely legislate the lowest common denominator here – they should spell out the exact percentage of underfunding that is not permitted. Leaving this up to boards is crazy – in plain English it effectively says “We’re going to make you do this elaborate financial plan that says you need to save ‘X’ amount. However, if you save an amount less than ‘X’ – well we’re fine with that too….as long as you think it’s reasonable. So with your tax dollars returning that sage advice…. It’s up to you to make the call as to whether the underfunding is too much.
OK how much underfunding is too much?
This is a difficult question to answer, and short of a crystal ball there is no 100% accurate way of answering this. With this said, reserve funds are all about two things 1) Money coming into the Reserve Fund, and 2) Money spent on future expenditures. Lets start off with the easier of the two – money coming in.
First, if you take the amount between currently what’s in the bank, and what was supposed to be in the bank and divide that by the number of units in the building, you will get a very rough sense of how much the Board would have to special assess you to at least get back to even with respect to funding. Note that for an even more accurate calculation, you should divide by the underfunded amount by total number of unit factors for the building and then multiply by the number of unit factors for your unit. Whatever this amount is – ask yourself – “If I had to pay this amount now could I?” Or how about this one - “If the next buyer asks to lower the price of the condo by an amount equivalent to the underfunding – would I be OK with that?
Here’s the problem with this – a condo Reserve Fund getting back to just even isn’t enough. It’s the unexpected expenditures that weren’t expected to be spent this year (or ever to be spent sometimes) that really clobber people. You can’t save for what you don’t know about. Take some of the “leaky condo” situations that have appeared – in Calgary some units have been hit for 10% of the current market price for various exterior envelope reports and mould remediation work. What if there is an unexpected expense, or a planned expense is higher than expected?
So just how can you quantify these unexpected expenses if indeed they are truly unpredictable? 100% certain is not possible, but here are a few basic things you can do:
- Refer to our Minute Review Article (click link here). Focus on repairs or “problems” that have surfaced in the last few years that have been mentioned but their resolution has not been documented in the minutes. Follow up with the management company as to how the problem has been corrected, if at all.
- Refer to our many articles on Reserve Funds (click link here) to learn all the basics and how a reserve fund works - Specifically assess whether the items of common property are complete, and whether the amounts they are listed for are realistic.
- Do your own walk around the building and common areas – is stuff clean and well maintained? You’d be surprised at what you can pick up on simply by walking around the condo complex. On a recent walkaround of one condo I could see the 4th floor common area deck was clearly under repair. Paving stones and the water feature were ominiously ripped up, and I could see the waterproofing material underneath. Planters were empty and the irrigation for them was disconnected. Clearly a sign of a major repair. Sure enough – the place had a membrane issue with water intrusion an issue. Channel your inner Mike Holmes here, looking for problems. Are there signs of half done repairs? In general if you see major work being done beyond painting and minor repairs (ie if you see the sidewalk being dug up) that means it cost some dollars and you should ask as to how the Board is funding that repair.
Create your own Rainy Day Fund – Prepare for the worst.
I usually recommend this last bit for anyone in a condo, but I especially recommend it in an underfunded reserve fund scenario. This last bit of advice is somewhat of the nuclear option – which is to assume that you *will* be special assessed and ensuring that you at least have the means to pay the required amounts. As painful as it would be to do this, at least you wouldn’t lose you condo for not paying your special assessment (which yes, would happen). Sure…you’re probably saying. Easier said than done – how exactly do I do save for this, considering I just made the most expensive purchase of my life?
I’m not going to get into all the usual financial planner type talk about the acceptable amount of debt to get into, but if you’re in the spot where you’re exhausting 100% of your savings and the bank won’t give you a dime more – perhaps reconsider you decision to buy a condo. Losing your job, special assessments – these are all things you can’t control and the chances of these things happening are not remote.
How much should I prepare for? As a rough guide, I like to suggest 10% of the value of your condo as a baseline for how much you should prepare for in this worst case scenario. There’s no official formula for this kind of thing – it’s largely based on the experiences I’ve seen and had with large scale special assessments I’ve had in the Calgary area, primarily due to water penetration. I have seen assessments larger and smaller than this due depending on the underlying causes. However, Boards are typically aware of the fact that assessing more than this 10% amount would cause extreme hardship for the major of its residents at a given time. That’s not to say they wouldn’t do another round of assessments if the amount was large though….
So how do you fund your “rainy day fund”? Cash in in the bank is always an option, as is earmarking investments such as stocks / bonds to be “sold in case of emergency” (non registered I hope).
The more realistic option I recommend is to ensure that you have a home equity line of credit (HELOC) in place in case it’s ever needed equal to this 10% value. Note that banks have their requirements for these, and how much they will lend you is limited by several factors including amount borrowed as a % of the condo’s value, and your current level of debts. There will also be some costs in place to get this line of credit in place, typically an appraisal fee and legal costs.
While this all seems a bit extreme, having a HELOC is a prudent thing to have in place to deal with all of life’s little crises – not just special assessments. However, it also requires a lot of financial discipline – you must be the type that can resist spending it on things you wouldn’t have bought otherwise. Just because you have a HELOC doesn’t mean you have to spend it! Call it your emergency fund…
That said, my preference is for HELOC’s as it’s there if you need it, without tying down a large sum of money that is essentially idle.
But CondoSensei, you say…. I just can’t get that HELOC or save up that amount…. Isn’t there a pretty small chance of a special assessment happening?
Absolutely - like lotteries and casinos – there is a good chance you’ll never need this. But if it does happen, you’ll be quite happy that you’ll have a plan ‘ready to go’ and for some that peace of mind is worth a lot to them. For others, they’ll roll the dice, and deal with it if the have to. Life’s all about choices…