By: Carson M. Horton, RS

What’s All the Fuss About?

As the economic fallout from the subprime fiasco continues to spread, mortgage lenders are facing increasing scrutiny from regulators and politicians eager to find a solution to the problem.

With all of the recent news about the problems facing the Federal National Mortgage (FNMA) Association and the Federal Home Mortgage Corporation (FHMC); the Congressional bailout in the form of HR 3221; it should come as no surprise that new lending guidelines have been put in place at both of these mortgage institutions.

Of concern for all condominium buyers and sellers, is the new underwriting rule requiring mortgage lenders to verify the association in which the condominium is located has a line item in their annual operating budget providing for a reserve fund contribution totaling at least 10% of the association’s annual revenues. According to an article by Nena Groskind, in the July 2008 edition of Condo Media magazine, this new lending requirement was adopted January 1st of this year by both FNMA and FHMC.

New Rules for Everyone

Considering the influence exerted over the mortgage lending industry by these two secondary mortgage market giants, it is reasonable to suggest virtually all mortgage loans for condominium properties will now be subjected to this reserve funding requirement.

Although FNMA and FHMC underwriting requirements technically apply only to loans which will be sold in the secondary mortgage market (known as conforming loans); given the recent collapse of the subprime lending sector and the rapid disappearance of non-conforming lenders, mortgages on condominium properties are going to be hard to come by if the association in which the property is located cannot meet the new reserve funding requirements mandated for conforming loans.

While these underwriting guidelines will obviously have wide-ranging implications, what do they actually mean for the average condominium buyer or seller? To best answer this question we must consider a number of issues relating to community associations; their reserve funding policies and the long range planning process for managing common interest assets within any association.

Do the New Rules Go Far Enough?

Let’s begin by acknowledging the importance of reserves for all community associations. Recognizing the importance of the reserve planning and funding process is the first step in building a sound, long range financial plan for all communities. That this fact has now been embedded in the credit analysis process for mortgage lenders making loans on condominiums, must be viewed as a positive development.

With that said, is it safe to assume the new FNMA/FHMC guidelines are an adequate measure of the financial health of the community in which you live or are considering the purchase of a condominium in?

Unfortunately the answer is a resounding NO!

While there is no argument this is a major step in the right direction, a one size fits all approach is very much in error when analyzing the reserve fund requirements among different associations. To further cloud the issue is the longstanding lack of any meaningful industry or regulatory standards for the reserve study/funding process.

Although in recent years there has been an undeniable trend toward regulatory oversight at the state level; it is safe to say even today, the majority of states throughout the U.S. have little or no statutes requiring condominium associations to prepare a reserve study or fund a reserve account. In the handful of states with some sort of reserve fund regulations in place, the standards can vary substantially from state to state. Even in a state such as California, which arguably has some of the strictest statutes in the country, there is no statutory requirement that any association must actually fund their reserve account!

Change is Good

Before reviewing the inadequacies of the current thinking on the subject of association reserves, let’s consider the positive aspects of the underwriting guidelines adopted by Fannie Mae and Freddie Mac at the beginning of 2008. The new guidelines will result in the following beneficial results for virtually all community associations;

• Will ensure all associations address the subject of reserves and funding of a reserve account; with very little ability to maneuver around the new 10% funding requirement;
• Will ensure a certain level of reserve funds are accumulated by all associations; even if the 10% requirement proves to be inadequate for a particular association, it is still far better than having no reserves;
• Will result in most associations obtaining a reserve study from a professional provider; although as far as we know the new lending guidelines do not dictate any standards for establishing the reserve funding needs of the community, other than the 10% rule; the reality is most associations are likely to end up with a professionally prepared reserve study;
• Will no doubt increase the overall awareness and understanding of the concept of reserves and reserve planning for community associations;
• Will increase the level of accountability of builders & developers who create new associations in the process of developing new housing;
• Will increase the level of accountability of community management companies, association Boards, reserve study professionals and the real estate sales industry as a whole.

Caveat Emptor!

Individually and in their entirety any of the developments mentioned above represent a positive step in the right direction for the community management industry in general, and specifically buyers and sellers of condominiums. As with all types of change there are certain risks and limitations to be considered before declaring any such set of rules or regulations an unqualified success. Among the more pressing concerns which all buyers, sellers, lenders and management professionals should consider are the following:

• Of the utmost importance is that the required 10% reserve contribution is simply not enough; not for a new association, old association; large one or small one. The correct reserve funding requirement for a community association is not a by-product of the operating budget. Therefore, requiring the reserve fund contribution to be a fixed percentage of the annual budget or association revenues is simply an erroneous supposition. The correct amount of money which should be contributed to the reserve fund is, in every case, the outcome of an analysis of the common area components within the community. This analysis is known formally as a reserve study. Performing such an analysis properly takes a great deal of expertise; and typically for the best results, the expertise of more than one individual with differing areas of specialization, working in collaboration with one another. To simply assume a reserve contribution equal to some arbitrary fixed percentage of the annual budget will be adequate is, in the long term, a recipe for failure.

• Almost equally important is the likelihood under the new guidelines, that many associations will begin funding their reserve account with an amount equal to 10% of their annual revenues and call it good. While this may technically mean they are in compliance with the new FNMA/FHMC funding requirements; it is not the correct way to establish the appropriate amount for the association’s reserve contribution. Prospective buyers in particular, should be wary of this potentially hazardous situation because even if the current funding requirement were to be adequate based on the 10% rule; there is no guarantee the association’s reserves haven’t been under-funded in the past to a point where if they begin funding at the required 10% level, it may be far too little; far too late. Again, the only way to determine what the correct level of funding should be and whether an association’s reserves are adequate to meet future funding needs is to perform a reserve study. A well prepare reserve study will include an analysis of the long term funding needs (in most cases thirty years) of the association. Part of this analysis will be a statement regarding the adequacy of the current reserve fund balance being able to meet the near term funding needs, in addition to the sufficiency of the reserve fund for the long term.

• The tendency for an association’s members, Board of Directors, community managers and others concerned to simply assume; if the reserve fund is being funded at the required 10% rate it is sufficient merely because it satisfies the FNMA/FHMC lending requirements. After all, “if it’s good enough for the bank, shouldn’t it be satisfactory for everyone else?”  The answer to that question is no; plain and simple! We’ll keep saying it until everyone gets the message; the only way to know is to perform a reserve study. In the absence of a current, credible reserve study, buyers, sellers and lenders alike simply have no assurance whatsoever the association’s reserve fund is adequate at the present time or will be adequate in the future. 

• Due to the rapid increase in demand for reserve studies from community associations, there is a strong likelihood that any number of un-qualified, opportunistic vendors will emerge in every region of the country; offering to prepare reserve studies for anxious associations concerned about the need to be in compliance with the FNMA/FHMC guidelines. Since it is a virtual certainty this is going to occur we will conclude this article with an overview of what to look for in a reserve study provider and how to spot a charlatan. Suffice it to say the number of highly qualified firms in the reserve study field is limited throughout the nation. A recent review of the Community Associations Institute (CAI) vendor directory indicates the total number of individuals who possess the Reserve Specialist (RS) certification is less than 150, throughout the United States. With the number of community associations affected by the new lending rules numbering well into six figures nationwide it is easy to see that qualified reserve study providers are likely to be in short supply and high demand well into the future.

Now that we are at least somewhat aware of the benefits and pitfalls likely to result from the new lending requirements let’s consider what to look for in a quality reserve study and a competent reserve study provider.

What to Avoid

Perhaps most important of all is for anyone new to the subject to understand a bit of background. Historically the reserve study process has been considered largely an esoteric function often performed by accountants or engineering firms; or perhaps a combination of the two. More recently the field has evolved into more of a multi-disciplinary process involving individuals with a variety of professional backgrounds, some of which are decidedly more appropriate for the work of a reserve study provider than others.

One way to gain an immediate understanding of who may or may not be well suited to prepare reserve studies is to consider what type of individuals or companies are particularly ill-suited for the work. Due to the somewhat insular nature of the community management and service industry there has been a strong tendency over the years for many vendors who already serve the community association market to “double-dip”. That is to say, when new business opportunities arise from within the market niche’ already being served, the temptation on the part of established vendors to provide these newly demanded services is often times too great to pass up.

The problem with this is, in many cases, the vendor may or may not be qualified to provide the new service. Because of the established relationship with their client base, they possess a marketing advantage when moving laterally from one market to another. Good examples of this phenomenon are those of community management companies and accounting firms. With an established client base of community associations many management companies have dabbled in the reserve study field; typically with disastrous results.

The same has often been true for accounting firms who cater to the association market offering more traditional accounting services such as tax preparation, financial reviews and other financial related services. With their high degree of credibility, in the eyes of most clients, they often find it relatively easy to convince many unsuspecting clients they are also an appropriate candidate to perform the association’s reserve study; regardless of their actual qualifications for the job.

Another consideration when evaluating the suitability of a potential reserve study provider is what the implications might be if the vendor has any other involvement with the association; either on a professional or personal level. Strictly speaking the reserve study provider should operate independently and have no other involvement with the clients for whom they perform reserve studies.

The reason for this is the reserve analyst must remain fair and impartial when performing the analysis. If there is any other professional relationship, such as also being the association’s community manager or accountant then there is always the possibility of a conflict of interest. Whether an actual conflict ever arises the mere appearance of a potential conflict is enough to cross the ethical lines of professional conduct.

What Should You Look For in a Reserve Analyst?

So what are the qualities you should look for in a reserve study provider? Among the most important, in our view, is for your prospective reserve provider to be a true specialist. Preparing a reserve study that is well thought out; logical; equitable and accurate is a lot more work than most people realize. While it may not be rocket science; it is a highly specialized field and one well suited to specialization.

In understanding why specialization is important let’s consider the case of an accountant or a community manager and apply a little reverse logic; suppose your association were to luck out and find the best reserve study provider in the entire world. They complete your reserve study in a timely manner, for the appropriate fee and everyone is tickled pink. Does that mean this individual should be considered to perform your next financial review? Or prepare next years’ tax return? Or be hired as your new community manager?

Of course not; which is exactly the point we are trying to make regarding the need for specialization. Just as you want a specialist to prepare your tax return; you want a specialist to prepare your reserve study. Just as you want the best community manager available for the money you spend; you want the best reserve study for what you pay to have one prepared. You do not hire your reserve analyst because they are a whiz-bang community manager, or because they have been doing your tax return for years. You hire them because they are a specialist who is an expert at what they do.

Similarly important is for your reserve specialist to have the appropriate background, experience and training. With virtually no formal training of any kind available for aspiring reserve study specialists, the industry is comprised entirely of individuals with a wide array of backgrounds and experience qualifications. From this matrix it has become more and more apparent, over the last ten years or so, what makes for a good reserve specialist in the way of education, experience and training.

Ideally the reserve specialist should have recent experience in a field directly related to preparation of reserve studies or at least in the field of life cycle costing, construction estimating and project management; or other similar professional disciplines which have afforded them the opportunity to obtain significant amounts of estimating and scheduling experience with the kind of construction and repair projects typical for most associations.

What is a Condition Assessment?

Quality reserve studies are based on a comprehensive assessment of the association’s common elements generally referred to as a property condition assessment; condition statement or something similar. Such a study, known as a Level 1 reserve study is really the only way to establish a sound reserve funding program with reliable replacement schedules and cost data.

The matter of who is chosen to perform this assessment is of critical importance in obtaining a reliable reserve study. Many firms maintain an in-house staff of engineers and or architects who will perform an inspection or field survey of the property and prepare the condition assessment from which the reserve analyst then develops the reserve study.

This is not an entirely bad way to go and is certainly preferable to having a study prepared by your accountant, community manager or a stay-at-home board member with nothing better to do. However, there is a legitimate question to be raised with the overall integrity of the analytical process if the technical consultant and the reserve analyst are either the same person, or are two separate individuals working for the same firm. Conflict of interest issues similar to those previously discussed could result from such an arrangement, although it is certainly not the worst it could be.

HOA Services Group utilizes independent third-party architects in developing reserve studies for the majority of its clients. In cases where the client may not be able to justify the expense of an independent consultant, we perform the condition assessment using staff personnel with extensive construction and property inspection backgrounds.

Regardless of which approach is chosen for any specific project, the decision is always that of the client; based on their individual need and financial limitations.

Architects who perform property assessments are generally specialists themselves with many such firms not working as design practitioners at all. This again speaks to the highly specialized nature of reserve study work.

In Conclusion

To summarize; any association in need of a reserve study should look for the most highly qualified vendor they can find. In the case of large communities it is generally not cost prohibitive to recruit a provider from a geographically remote location. For small associations this approach simply does not make economic sense, in most cases. Anyone under serious consideration should have at least one member of their staff who has been awarded the RS designation granted by CAI.

Although not an absolute guarantee of an individual’s expertise, it is the only nationally recognized certification available and credit should be given for the experience level required to obtain the RS designation. The choice of an architectural consultant of the client’s choosing should be offered by any reserve provider under serious consideration. If the provider cannot provide you with a list of suitable firms who will prepare a condition assessment; or if they discourage you from hiring an independent consultant they should be avoided.

Only full time reserve specialists who actually specialize in performing reserve studies should be considered for the job. Your accountant, community manager, maintenance person, insurance agent, banker, lawyer, out of work sister-in-law or stay-at-home board member are not suitable candidates for the job!

With virtually all community associations now required to fund a reserve account on an annual basis, it is fair to say, all associations should have a reserve study prepared. Beware of the fly-by-nights, charlatans and even long-standing providers who have a reputation for sloppy or inadequate work, because a poorly prepared reserve study will end up costing your association many times what a well prepared study would have cost in the first place.

Considering the emerging understanding of the importance of the reserve study process throughout the real estate industry; it should be considered extremely foolish to accept anything less than the very best reserve study services available to your community.

Carson M. Horton, RS is a principal in the Oregon based reserve study firm HOA Services group, LLC.