Question: I own a condominium unit in a fairly large association. I bought it two years ago. Apparently, over the years, with good management, we have amassed a sizable reserve account. Recently, the Board announced that since we are only earning a very small amount of interest on this account, they want to start investing these funds in the stock market. The announcement stated that with interest rates starting to increase, the Board believes that the stock market will be a good place to earn more money for our association.

Can the Board do this?
Answer: If absolutely every owner in your association agrees to go to Las Vegas and gamble with your reserve account, I would reluctantly have to say this would be legal (although clearly inappropriate).

Notice that I said that every owner must affirmatively agree. Your Board of Directors has a fiduciary duty to all of the owners who elected them to their positions on the Board. If they want to spend their own money on the stock market -- or in Las Vegas -- that of course is their business. They certainly have the right to spend their own money as they see fit.

But your reserve account does not belong to the Board; it belongs to every owner in your association. The clear obligation of the Board of Directors is to invest your money in secure, insured investments -- even if that means that your money may not be earning as much as everyone would like.

Reserve accounts are very important to the well-being of any community association. If, for example, your elevator or your roof needs replacement, and if the Association does not have enough money in reserve to pay for these matters, each owner -- including you -- may be faced with a special assessment. This may cost you a lot of money.

A reserve simply means that the association should have money set aside "in reserve" to cover the cost of future emergency or major repairs. Reserves are -- or should be -- an essential part of every community association.

The Community Association Institute (CAI), a national nonprofit association created to provide education and resources to our nation's residential community associations, has issued a publication entitled "A Complete Guide to Reserve Funding & Reserve Investment Strategies" (GAP Report 24). This publication should be on the bookshelf of every community association Board member and property manager. (It can be obtained from CAI, 225 Reinekers Lane, Suite 300, Alexandria, VA 22314, 703-548-8600, or on the web at www.caionline.org.)

According to CAI, "adequate reserve funding means more than just providing funds for roof replacements. In the long run it can contribute to the rise and fall of property values. For instance, if an association is in debt or has no reserve fund, educated home buyers may not want to invest in the community."

It is clear that you are an "educated" homeowner. I wish more people would be concerned enough to carefully review all of the material which their association sends them on a periodic basis. And I wonder how many people in your association are questioning the potential actions of your Board.

The CAI publication contains an analysis of State laws impacting on reserve requirements. In the District of Columbia, for example, there are no laws regarding reserves. In Maryland, the Condominium Act requires that the annual budget shall provide for reserves -- but does not require any level of funding. Virginia law also does not contain any mandatory requirement as to the amount of reserves which an Association must carry on its books.

Although many community association property owners may not realize it, a community association is a business, and must be run just like any other business. Indeed, many associations are very big businesses, with large incomes and equally large expenses.

Every year, the Board of Directors -- working through its management company (if there is one) -- must project its income and expenses for the next year. Often, this projection is speculative, based on previous years' experiences. However, there are on-going operating expenses which must be paid, such as water bills, trash collection, insurance premiums, and payroll taxes. In order to project the next year's expenses, the Board has to know approximately how much money will be available during the coming year. It should be obvious that the Board cannot plan to spend more money than it will receive.

In addition to general operating expenses, Boards understand that at some future point in time, they will have to make major repairs, alterations and even improvements to the common areas within the Association. The elevator must be refurbished, the driveway must be paved, and the roof must be repaired or replaced. All this costs money, and these additional expenses must come from somewhere. And all of these projected expenses must be incorporated into an annual budget.

How does the Board project reserves? Over the years, the concept of a "reserve analysis study" has been developed, whereby qualified engineers perform an "A&E (Architectural and Engineering) Study" of the entire complex. These professionals will report to the Board something that looks like this:

Item Projected Useful Life Cost to Repair Annualization
Boiler 30 $55,000 $1,833
Elevator 9 75,000 8,333
Roof 12 90,000 7,500
Total: $17,666
In our example, at the very least the Board must include this $17,666 number into the calculations for the next years' budget. That means that every owner would pay his/her percentage share of the entire budget -- and a portion of the condominium fee would be earmarked for reserves.

Obviously, every Association has different needs and different concerns. But the bottom line is that in order to properly plan ahead, the Association must include moneys for reserves in their operating budget. This money should then be deposited in a separate, secure, interest-bearing investment -- such as a Treasury bill or other government insured fund. It cannot be commingled with the association's operating account, nor can it be invested in high-risk stocks (or even "blue chips") where there is even a remote chance of risk.

There is no magic formula to determine how much is adequate. However, a reserve analysis study -- performed at least once every five years -- will guide the Board as to the level of reserves which are required.

If reserve funds are not available if and when money is needed, what can the Board of Directors do? Oversimplified, there are three other ways to raise money in a community association:

Increase Monthly Assessments: The Board could increase the assessments. However, if the Association needs the money immediately -- and it is not there -- the regular assessments will not come in fast enough to raise the needed money.
Special Assessments: In most associations, the governing legal documents authorize the Board of Directors to impose a special assessment on all owners. In our example, if the Board immediately needed $90,000 to replace a defective roof, and if there are 150 owners in the complex, this would require each owner to pay $600 immediately. Keep in mind that assessments are usually calculated based on the percentage interest that each owner has in the association. Thus, while the amount of the special assessment will vary, the fact remains that each owner may be required to pay up immediately. Wouldn't you rather pay a few dollars toward reserves each month instead?
Get a Loan: Many associations are taking advantage of this approach, and banks have started making loans to Associations. However, there are a lot of legal and financial hurdles that the Association has to overcome, and it takes time for a bank to commit to a loan.
A well managed community association must have a long range plan for major repairs and replacements. Dollar figures will be included in these plans, and these dollars will (or should be) added as "reserves" to the budget adopted each year by the Board.

There are two additional reasons why adequate reserves are important. First, if you want to sell your unit -- or refinance it -- most lenders will want to review your Association's reserve situation. If they are inadequate, the lender may reject the loan application. Second, as has been discussed earlier, if you ever go to sell your unit, potential purchasers (if they care enough to carefully review the association's budget), may be turned off if the level of reserves in the Association does not appear adequate.

According to the CAI Report:

Owners are often reluctant to contribute to reserve funds because they think the funds are costing them extra money. To convince these owners of the need for reserves, the Association must make them understand that a reserve fund is not an extra expense -- it just spreads out association expenses more evenly. Equipment and major components must be replaced, whether the expense is planned or not.

Boards of Directors have a fiduciary obligation to the owners who elected them to make sure that the budget they prepare is adequate -- which must also include appropriate reserves. This also means that your Board must make sure that these funds are available when needed -- and investing in the stock market is completely inappropriate.

Published: August 2, 2004