Capital Reserves and Dues Analysis

Dynasys Technical Services

(Last Mod: 05 March 2014 13:23:45 )

Bottom line it: What is a CRADA?

The Capital Reserves and Dues Analysis (CRADA) is a tool to help the governing board of a Homeowners Association (HOA) make informed and defensible decisions regarding the HOA dues and reserves levels. In addition to providing guidance for the board, it also serves as a valuable tool when presenting the board's decisions and recommendations to the homeowners and in educating the homeowners regarding the status and stability of their financial investment.

How are my HOA Dues set?

The strict answer is that they are set in accordance with your HOA's governing documents. Having said that, the governing documents for most HOA's give the responsibility of setting dues to the HOA Board and provide guidelines and limitations on how they are to do so. While the details of those guidelines and limitations vary from HOA to HOA, the Board is typically directed to review and adjust the dues each year to a level that is expected to adequately fund the HOA for the upcoming year. Most boards have a limit on how much they may increase the dues in a given year; frequently, the limit is simply given as 'inflation' or 'CPI' (Consumer Price Index) while other HOA's may have a specific cap, such as 8%, on the amount of the increase. In nearly all situations in which a cap exists, the Board has the option to go to the homeowners, usually at the Annual Meeting, and request a larger increase. If a sufficient number of homeowners vote in favor of the larger increase, then the larger increase goes into effect; if there is not enough support for an increase that exceeds the cap, the Board still has the authority to increase the dues up to the limit imposed by the governing documents. Some Boards do not have a limit on dues increases and have the authority to set the dues level at whatever rate they determine is necessary, regardless of how much of an increase it might represent.

How is the HOA Board's obligation with respect to setting the HOA Dues?

The HOA Board has the fiduciary responsibility to protect and preserve the homeowners’ investment in their property and their community. Part of this responsibility is to set the annual HOA dues at the lowest level consistent with placing the community in a position to meet its financial obligations now and in the future. This condition is met when the present financial reserves, coupled with consistent yearly dues increases at (or near) CPI, result in barely adequate resources to fund all planned and reasonably predictable community expenses while maintaining an adequate minimum reserves level to meet most major unexpected expenses while avoiding special assessments.

What is a “fiduciary responsibility”?

A fiduciary is someone expected to act on behalf and in the best interests of another and, in particular, place the other person’s interests ahead of their own. In this case, the HOA members have elected a small number of their own to serve on the HOA Board and empowered them to make decisions on behalf of all the homeowners (as outlined in the HOA’s governing documents). Since, in nearly all cases, the HOA Board members are, themselves, HOA members the issue of a conflict of interest seldom arises because the interests of the Board members and the interests of the bulk of the homeowners are very similar.

Why should present homeowners pay now for work to be done well into the future?

Besides a moral component that directs people to pay for the resources they consume, the short answer is to protect and preserve your investment. A “renter’s mentality” would involve not caring that the HOA is putting away adequate funds to meet major, long-term expenses – such as a roof that is not expected to need replacement for another twenty years – if they do not plan to live in the community that long. But an owner is not a renter – they have made an investment in their property and expect to maximize the return on that investment when they sell it. So consider the following – a potential buyer is considering two nearly identical properties. Both have roofs that are nearing their end of life and will need to be replaced in the next five years. The first association has monthly dues that are a few dollars higher but also has sufficient money in the bank to replace the roofs on schedule and even ahead of schedule if the condition of the roofs deteriorate faster than anticipated. The second association has slightly lower dues, but also has very little money in its accounts and therefore plans to delay the roof replacement as long as possible (probably until secondary damage from leaks leaves it no alternative but to perform the work) and they will likely have to assess each homeowner several thousand dollars at that time. If you were the buyer, which property would you rather purchase, even at a higher price? If you were the seller, which property would you rather be selling? Is it worth a few dollars a month to ensure that you will be selling the first property and not the second?

What is “CPI”?

This is the Consumer Price Index, which is the most common metric of “inflation,” or the rate at which prices change. The Bureau of Labor Statistics tracks the prices of several different “baskets of goods” corresponding to broad categories of consumers and publishes the results monthly. While it is a very useful indicator over long periods of time and for large groups of people, it is usually a poor predictor for the actual change in costs seen by any particular individual or organization over a short time frame. Unfortunately, it is pretty much the best indicator we have. The hope is that basing decisions on it, and making frequent (i.e., annual) adjustments will place the HOA close to where it should be so that the adjustments can be kept reasonable and manageable.

Why don’t I want my HOA dues to stay the same from year to year?

The cost of most things trend upwards over time, therefore it is unreasonable to expect HOA dues to remain fixed indefinitely. The goal of the HOA Board is to match the dues level to the expenses of the Association. If the dues are held constant for an extended period of time, then one of two things is almost certainly happening – the HOA is falling behind in generating the income necessary to keep functioning or the dues have previously been too high and the HOA could have operated with lower dues while still meeting its obligations. Either case is an indicator that the Board has failed, at least partly, in its fiduciary responsibility to the homeowners – namely to set the dues rate at the lowest level consistent with meeting the financial obligations of the community.

Why should the HOA retain a minimum reserves level that it has no plan to use?

To avoid assessments. Major and unexpected expenses, such as a sewer line break, will occur from time to time. If the HOA is not in a position to fund these expenses, they will have to assess the homeowners who will have to come up with the funds almost immediately. Therefore the HOA should establish a minimum reserves level that it believes is adequate to cover the most likely types of occurrences and strive to maintain its reserves level above that minimum at all times. 

Why should the dues be set so as to be “barely adequate” to meet all expenses?

Because any higher level would mean that the homeowners are not being charged the minimum dues consistent with meeting the HOA’s obligations. The Board has the responsibility both to charge the homeowners a level that is sufficient to meet the association's costs but also to avoid overcharging the homeowners.

Why should special assessments be avoided?

Not only do they place an unpleasant burden on the homeowners, but some may not be able to afford them and end up in foreclosure as a result. A history of special assessments that could have been avoided is a sign of poor planning and is seen as a risk factor by mortgage lenders. As such, the property value can be negatively affected. Recall that the HOA Board is charged with preserving the homeowner’s investment.

How does the HOA Board determine the proper level at which to set next year’s dues?

Although most HOA Boards make a good faith effort to set the dues at reasonable levels, many Boards lack the knowledge and information needed to do so properly. In many cases the dues are based solely on the prior year's actual expenses or by simply holding the dues constant until the dues fail to meet the HOA's needs. The result is generally that little to no funds are being saved to meet the major scheduled expenses, such as painting or asphalt replacement, that may only happen every five years or perhaps even only every fifty years. The consequence is that many HOA's find themselves in serious financial hardship from time to time and from which only a significant assessment can remedy the situation.

HOA Boards that are more proactive about anticipating and planning for long-term recurring expenses are usually able to place the HOA in a position to meet those expenses on schedule using funds that have been accumulated specifically for that purpose and to do so without large dues increases or special assessments. One very effective way to accomplish this is through the use of an annual Capital Reserves Analysis (CRA). A CRA examines annual income (primarily from dues), annual expenses (water, trash, etc), and the major non-annual expenses (roofs, asphalt, etc) and plots the expected reserves level at the beginning of each year over a time of typically several decades – long enough to ensure that each non-annual expense occurs at least once. This plot is called the “reserves trajectory.” The goal is to set the dues at a level such that the trajectory will never drop below the minimum reserves level but will come close to it at least once. This is very analogous to how a mortgage company sets the monthly escrow charge each year.

Why does a CRA need to be done every year?

It doesn’t. But the expenses incurred by an HOA seldom change exactly at CPI and minor changes in annual expenses can have major long-term impacts. Just as a mortgage company revisits the question of how much money to charge for escrow each year, an HOA that re-analyzes its reserves situation each year is in the best position to make small adjustments early enough so as to minimize the impact on dues. This is particularly true for HOA’s operating well away from their optimal trajectory or that have major near-term expenses that are driving their decisions.