Question:     What are reserve expenses? 
Answer:       
Reserve expenses are those that are related to capital expenditures, and not annual operating expenses.  For example, regular maintenance of fences is not a reserve expense, but complete replacement of a fence would be.

Question:     What requirements are there for an association to maintain reserve funds and/or to have a reserve study done?
Answer:

• Colorado law does not require associations to maintain a reserve fund, but the governing documents for the association may.  Check your governing documents.
• Fannie Mae and Freddie Mac guidelines suggest associations’ reserve funds are supposed to be adequately funded.  Some guidelines require 10% of the annual budget be allocated to reserves.
• There is a lot of momentum from different directions leading associations to maintain adequate reserve funds.
• Given the economy and the level of foreclosures in recent years, many experts expect to see increased scrutiny from lenders.  Such scrutiny correlates to the operation of associations.  If associations’ reserve funds don’t meet the guidelines, then we could see an increase in loans for individual units being declined because of that.

Question:     What are the types of reserve studies an association can have done?
Answer:

• Full/on-site inventory
• Identifies all components
• Identifies the life expectancy of each component
• Identifies where in the life expectancy each component lies
• Includes a site inspection
• Update existing reserve study without a site visit or with a limited site visit
• Review of the reserve study in relation to funding only

Question:     How far out into the future should a reserve study project?
Answer:
Most reserves studies project out 20 years, but that’s really too short.  Reserves studies should project out further than 20 years and should not include an arbitrary inflation number.

Question:     Who should prepare an association’s reserve study and how often should it be updated?
Answer:
The reserve study should be prepared by professional/technical experts depending on the type of community.  Reserve studies should be updated at least every three years.

Question:     What does the new reserve statute in Colorado require?
Answer:

• Every association must adopt a policy which addresses the reserve study and when it is to be done.
  § Note: The statute doesn’t outright require a reserve study, but implies associations will have a reserve study.
• The policy must indicate whether the reserve study will address physical and/or financial aspects.
• The reserve study policy must indicate the funding sources for the reserves.

Question:     Does the reserve account have to be a separate account?
Answer:
Not necessarily, but it is good practice to have the reserve fund be separate from the operating account.

Similarly, if an association has a capital improvement account for new improvements (as opposed to replacement), that should be in a separate account as well.

Question:     What does it mean for an association’s reserve fund to be 100% funded?
Answer:
100% funded means the association has 100% of the money the reserve study requires at a particular point in time.

For example, if the reserve study indicates a component will cost $100,000, and it has a 20 year life, at the end of year 1 of that life, the association does not have to have $100,000, but only has to have $5,000 to be 100% that year.

If an association over-funds its reserve account, the association could be faced with tax issues as the excess funds could be non-exempt income.  Check with your CPA for such tax issues.

Question:     What considerations should an association take into account when investing its reserve fund?
Answer:

• Associations should ladder its CDs, corporate bonds, municipal bonds, etc.
• The board should follow its investment of reserves policy in deciding on investments and should follow the “prudent investor rule.”
  §  The prudent investor rule provides that in deciding where to invest, the board should exercise ordinary care and look at the facts and circumstances at the time of the investment.
  §  If the board makes intelligent and reasonable decisions, the board won’t be liable if the investment ends up losing money.
  §  To further protect itself, the board should use experts to assist it in making investment decisions.

Question:     Can an association borrow from its reserve fund for operating expenses?
Answer:
For example, if there is a big snow storm and the association is over-budget on snow removal, the association may have to take money out of its reserve fund to pay for snow removal.  In doing so, associations need to consider:

• Do the governing documents allow this?
• When is the reserve fund going to be paid back?
• There could be potential issues related to interest on the money to be paid back to the reserve fund.
• The transaction needs to be clearly structured as a loan from the reserve fund, with an obligation to repay.  This should be done via a resolution of the board of directors, or at least noted in the minutes.  Otherwise, the association could face tax issues.  Any association contemplating borrowing from its reserves for operating expenses should consult its CPA if the repayment period is going to be fairly long.

Question:     As an alternative to funding reserves, some associations borrow necessary capital from a bank.  How is that done?
Answer:

• The bank will usually require the following paperwork:
  § A small set of financial information
  § Cost estimate of the project for which the loan is to be used
  § Adequate budget
• In analyzing whether an association is creditworthy, banks will look at the delinquency levels because it is the assessments that are collected that will enable the association to service the debt. 
• If an association is considering taking out a loan, the association should consult its attorney to put together a plan to reduce the delinquency rate, if necessary.
• Some banks will use the association’s reserve fund as collateral for the loan.  However, the loan agreement usually prevents the association from compromising the collateral, which would stop the association from using the funds in the reserve fund. 
• Because of the problem described above, banks will more often take an assignment of the right to future income (i.e., assessments) as collateral instead of using the reserve fund as collateral. 

From a legal perspective, before an association obtains a loan, it needs to review its governing documents to see what restrictions are placed on the association’s ability to borrow.