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My real estate practice is focused in Hoboken and Jersey City, NJ, where a large majority of properties are in condominium form. As such, one of the most common questions in buyers' minds is “How Much Cash Reserve Should a Condominium Association Have?” This number is important, since it indicates if the condominium association is in good financial health to make all necessary repairs to the common areas, which are crucial in preserving and increasing the value of the individual unit. Moreover, it can predict whether monthly homeowners' association fees are likely to go up in the future, and therefore increase the cost of owning the condominium.
How much is a healthy condo association reserve?
Before I practiced real estate, I was a professional financial statement analyst, and I still maintain my CFA charter. I make it a point to deep dive into a condominium association's “numbers” with my buyers, so they can direct more educated questions to their attorneys to ask the seller. Oftentimes, a magic number, like $20,000, is given by real estate agents or real estate forums as to what constitutes a healthy cash reserve for a condo association. However, I believe like all numbers, a reserve must be put in context. A high seeming reserve might not be high enough, while a lower reserve may be intentional given the low interest rate environment, and the intention of the board to raise money through special assessments as required.
In addition to working as a Realtor ®, I have been serving on my condo association board for several years as a Treasurer, so I actually manage and forecast a real condominium associations reserves. And I have found that several factors determine what a healthy condo association reserve should be.
Size of condominium building
First and foremost, the size of the building determines its reserves. Suppose the condominium building in question is a 100 unit high rise with average monthly maintenance of $500. This comes out to annual maintenance income of $600,000. So, clearly in this instance $20,000 will not be a healthy condominium reserve amount. However, it might be more than enough for a 5 unit building that has less than $10,000 in annual expenses.
Amount of annual expenses
Condominium buildings incur expenses that fall into two large buckets: recurring or operating expenses that can be budgeted, and unexpected or planned large repairs. Many condominium associations have their reserves broken out into a maintenance and repairs (operating) component and a capital reserve that is used for financing repairs. Operating reserve covers ongoing expenses such as water and trash, landscaping, utilities, insurance, sprinkler and alarm monitoring, cleaning, etc. The capital reserve is often kept in an interest bearing account.
I believe that in the least, the reserve should cover six months of recurring operating costs, and have something left over for unexpected emergencies and capital expenditures.
How do you find out what the annual operating expenses are? Most well-run condominium associations have an annual budget that shows past years' expenses and estimates expenses for the current year. In addition, condominium associations are required to file income taxes, known as IRS Form 1120-H. Some larger associations that do not qualify for the short form file the longer corporate tax return, Form 1120, which lists assets (including the cash reserve) as well as the expenses and income. The simple one page 1120-H tax return provides only the expenses and income of the condo association.
In my opinion, barring any unusually large repair expenses, the reserves should be greater than half the average of these operating expenses in the past three years. I think of it as covering six months of expenses to keep the building running smoothly.
Potential for unexpected repairs
The master deed of condo associations has a section called engineering study that details the potential useful life of the structural components of the building, like the roof, HVAC system, elevator, furnace, plumbing, electrical etc. It also lists the estimated cost to repair or replace these. Of course, estimates can't always be accurate, but a review of meeting minutes can reveal if any impending repairs were made, or any assessments to allow repairs have been announced. For example, if a 10 year HVAC system costing $5000 is scheduled to be repaired in the upcoming year, the reserve should have that amount built in.
Although not stated expressly, potential buyers should check with the condominium board if any owners are delinquent in paying their HOA fees. This is important because if cash does not come in in the form of maintenance revenues, the reserves will be depleted sooner than estimated. Oftentimes, mortgagee (banks) ask this question on the condo questionnaire form. Buyer can also find out if any units in the building are foreclosed or pre-foreclosure, which could indicate short-term pain (for example in the form of legal fees) for the remaining unit owners. Eventually though, condominium associations are able to recover outstanding maintenance fees.
Many potential homeowners and real estate agents are spooked by special assessments. However, I actually think that as long as they don't occur every year (which would indicate incompetency of the board or management company), special assessments may help keep the regular monthly maintenance low. This sometimes happens unexpectedly in smaller luxury or boutique condominium buildings. I think of it as higher reserves in the individual owners' bank accounts, rather than that of the condo association. One way to check if special assessments are the norm is to look at cash reserves for the last three years and note if they are showing a decreasing trend. This means the reserves are not adequate and higher maintenance payments down the road are inevitable.
Note: This article was previously published on Yahoo Finance. Author owns copyright to this material. All rights reserved.
Dalia Tole, CFA