Having gone through the condo buying process a couple of times, and serving on a condo association board, I cannot stress how important due diligence is when purchasing a condo. One of the most important aspects is to understand the condominium association’s reserves.
How much is a healthy condo association reserve?
As a professional financial statement analyst, I am amused when I hear a magic number, like $20,000, given by realtors as to what constitutes a healthy cash reserve for a condo association. 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.
Size of condominium building
For example, 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
Many condominium associations have their reserves broken out into a maintenance and repairs (operating) component and a capital reserve that is used for unexpected or planned large 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. In the least, the reserve should cover six months of recurring operating costs, and have something left over for unexpected emergencies and capital expenditures.
Condominium associations, like other homeowners associations are required to file income taxes, known as IRS Form 1120-H. Few others 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 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.
Many potential homeowners 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 help keep the regular monthly maintenance low. 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 special assessments are necessary to keep the condo association afloat. I would avoid such a condominium purchase, or risk higher maintenance payments down the line.