Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac) purchase most of the residential mortgage loans lenders make and set the standards those loans must meet. New rules were enacted in 2007 that require lenders to verify every condominium loan made that the HOA contributes at least 10% of its annual budget to reserves.

In HOAs that don’t comply, owners may have trouble refinancing or selling their unit. To ensure that this doesn’t happen, boards that have avoided the reserve fund question in the past will now have to address it. The elephant in the room is about to take a seat at the table.

Here are some best practices:

You Need a Plan. Homeowner associations need a plan for funding and managing their reserves, and the first step is to commission a reserve study. A reserve study will identify all the major common element components, estimate their useful life, and project the cost of repairing or replacing those components when the time comes. The goal is to make sure that when it’s time to replace the roof or the HVAC system, you will be able to pay for it out of reserves rather than obtaining a bank loan or levying a special assessment on owners.

But keep in mind that even the best reserve study has its limitations. While it predicts likely useful life spans and replacement costs, it can’t guarantee either one. A reserve study is based on assumptions that change over time. The climate, weather, soil conditions, maintenance, design and construction quality play a role in the aging process, causing some components to age differently than expected. The financial climate is also variable. Investment earnings and the inflation changes from day to day. To keep the reserve study accurate, industry experts recommend (and state statutes often require) that the reserve study be updated annually.

How Much Do You Need? The reserve study will estimate how much money is needed for future projects and when the funds will be needed. Fannie Mae and Freddie Mac want to see a minimum of 10% designated for reserves in the budget. But that formula will produce different results in different homeowner associations since common elements vary. For the typical garden style condominium, it is necessary to reserve at least 25-35% of the annual budget to meet future needs. So, while 10% is better than nothing, you should follow the funding recommendations of the reserve study which will likely be much higher.

Communicate with Owners. For HOAs that are not currently contributing enough to reserves, the solution is to start contributing more by increasing the monthly fees. The board can easily justify the increase by pointing out the new mortgage lending requirements. In other words, there is no choice. Owners must fund the reserves because it will be difficult to buy, sell, or refinance a unit if they don’t. Once the reserve study is completed, provide owners with a copy and encourage them to read it. Hold a special meeting and invite the reserve study provider to explain it. Make sure owners understand the reserve funding schedule and emphasize the relationship between the reserve level and property values. It is not just lenders that will be scrutinizing the HOA’s finances. Increasingly savvy buyers will be scrutinizing them as well.

Don’t Commingle Funds. Reserves should not be used to pay for ongoing preventive maintenance and repairs. Those should be paid out of the operating budget. Reserve funds should be segregated in a special bank account apart from operating funds. Typically, the portion of HOA fees earmarked for reserves is swept into this separate account monthly. Only reserve related expenses should be paid for out of this special account.

Borrow Reserves Funds Carefully. Only borrow from reserves in an emergency or because of seasonal high expenses (like the insurance premium comes due early in the year and not enough fees have accumulated yet to pay it). If you must borrow, document the board vote approving that decision, establish a reasonable repayment plan and stick to the plan.

Develop a Reserve Investment Plan. Reserve funds are typically placed in FDIC insured savings accounts, money market accounts and Certificates of Deposit. Most state laws don’t have specific reserve investment standards for homeowner associations. The governing documents usually give the board investment discretion. Boards should develop a written investment policy that defines the investment goals, establishes the objectives against which the investment performance will be measured, and identifies the boundaries within which investment selections will be made.

The investment policy should include: 

• Keep the reserves safe (don’t risk the principal).  
• Preserving earning power (choosing investments that at least match the inflation rate).
• Ensure that the funds are available when they are needed.

Other issues to consider include: 

• Consider working with an investment professional. This is particularly important when the reserve fund is large.
• Remember that this is OPM (Other Peoples’ Money). Tread carefully.
•  Document the investment decisions in meeting minutes.
• Diversify the investments (savings, CDs, etc.)
• Focus on liquidity. Industry experts recommend holding 5% of reserves in cash for emergencies, another 10-15% in short term (six months or less) securities and the rest spread among varied investments with varied maturities.
• Don’t overlook the earnings potential of your operating funds. If they aren’t in an interest-earning checking account, they should be.  
• Review your investment strategies annually to make sure they still match near and long term goals. Don’t let cyclical changes in the market alter the investment strategy which should remain long term. Some boards may perceive the new Fannie Mae and Freddie Mac requirements as an unwelcome burden. But maintaining adequate reserves has always been part of the board’s fiduciary duty to preserve the investment owners have made. The new rules haven’t created that obligation, but they force boards that haven’t done so to make reserve funding a priority.

This article contains excerpts from an article by Nena Groskind of CondoMedia. For more innovative homeowner association management strategies, see Regenesis.net.