 Welcome to condo insider. I'm Richard Emory. I've been hosting the show for a couple of years now. We try to talk about condo or association living and, and all the things that are happening and try to educate board members and owners and answer questions we've done shows based on responses from our audience for we just did one recently on the delinquencies because of that inquiry from one of you out there in Hawaii land. But anyway, we've been doing these formats we've been interviewing guests at times and okay times, I've done a show where I talk about particular topic and more technical terms. So today we're going to do that we're going to talk about the infamous or famous reserve study thinking, you know, we all know that condo associations have to by law, do a reserve study. We have homeowner associations and co ops do one because it kind of makes good business sense to prepare to prepare for the future with regard to your future capital needs but technically speaking by condo law so we're going to kind of focus on condos today, and the current thinking of reserve studies because a little bit of history. In 1995, the Hawaii legislature passed the what we call the reserve law, basically requiring all associations to be 50% funded by January one 2000 kind of gave them a five year window to get figured out and fund the reserves. The law was amended in 1997 before the January one 2000 start date, because in the real world out there and and I hate to call it the mainland but the real world reserve studies is there are two funding methods is percent funded and cash flow funding which we've talked about before. And the law didn't provide for the cash flow method of funding in 1995 and in 1997 it was amended to allow for the cash flow ending the funding, because of the fact that's the most dominant method of doing reserve studies throughout the United States. Then in January one 2000, the law took effect. And what I have seen and I'm going to go through this little more detail later on, is that this is the future of lawsuits for condos. They've already started to happen there's been many lawsuits already with regard to reserve studies. And it's fairly simple to insulate yourself from lawsuits. If you do just a few simple things, but we're going to take you through kind of the reserve study. The first part of the show will kind of review the history and kind of what we have. And the second part of the show we'll talk about the modern thinking, because there's so many ways to look at this, you know, that that over the years is 2000 to 20 years later, it is morphed with all these different issues and opportunities and ways to address funding issues so hopefully your association saves for the capital expense but also doesn't break the bank of the homeowners that the plan has got some reasonable basis to it. I'm often like to quote Mark Twain, who actually he popularizes saying of Benjamin Israeli but I what he said was lies damn lies and statistics. So you take data from a reserve study, and depending how you put it in the, in the sausage grinder and how you turn the grinder, what comes out can be vastly different by the ways and assumptions and things you do but I'm going to try to add some clarity to this and give you some food for thought on modern reserve study thinking. And so let's just talk about a few of the very basic things before we begin. When you're done, your condo you don't have a choice. The wall says you will do a reserve study. And when do you do it, you have to do it every single year. Now that doesn't mean you hire a professional, and you pay money to have a reserve study done every year but think of it this way. You do a reserve study this year, and you projected the painting to be done next year for $100,000. And the board says well you know, I don't think we need to paint the building this year I think we can get a couple more years out of this paint the building in 2025. Well the reserve study should be adjusted. The forecast is new assumption. So every year you're kind of updating the reserve study and saying well a that we do we said we're going to do last year yes or no if not recycle when you are going to do it. Maybe if you did do it with the cost you had in the study accurate or what is the current accurate cost. So you'd be plugging in the new numbers based on new actual local current information. And then number three you might say you know there's something we never thought about that we want to do and that we should have included in the reserve study. So conceptually speaking, you have to amend your reserve study every year, you may hire a professional to do the initial base document, but you technically have to do the reserve study every single year as a part of your annual budgeting process. And I have some notes years I want to forget anything. But let me just give you the national definition of a reserve study. It is a budgeting tool, unquote. So what does that mean. It means it's not science. You know I have to predict as a reserve specialist, useful lives remaining life replacement cost inflation interest earnings on your money. If I could do all that like science and accurately, they probably would have made me the head of the Federal Reserve system. I can't do it as a tool, kind of take these assumptions and use them reasonably and forecasts, which are future capital needs are going to be. And what it also is not. It's not a quality inspection of the project. You're not going out there as a reserve specialist or if you're doing the reserve study yourself as a, as a board, which you can do you don't have to hire someone. They acquired you to do it in good faith. So the issue becomes. It's not a quality control inspection so you don't know you can look at all these tables and manuals we use. We don't know if that's going to be the actual circumstance. Whether that front door will last as long as the manual say it'll last or because of use of less less or longer. And you have to put in perspective that this is a budgeting tool designed to make sure that you save money to pay for these components when they come do in the future. And what you need to understand is all came about because there are lots of lawsuits and complaints back to the real estate commission, the Department of Commerce and Consumer Affairs. Back in the in the 80s that people would buy in a unit. All of a sudden get a special assessment for the roof. Well, they wanted to make it that if you bought into a brand new property, and the roof has a useful life of 20 years, and you live there for 10 years. You made your program to share contribution during the time you live there for your use of that roof or depreciation in someone's senses. So the idea behind the law was the force kind of association to look at all these capital components and then start a savings plan to give you the best chance that you have the money when that component needs to be repaired or replaced. There's kind of a concept behind it with regard to how this works. So, putting that into perspective. You have to do a reserve study. Now, if you hire a professional. There are three levels of reserve studies for it's called level one two and three. That's, that's, that's pretty simple. Level one is the highest level reserve study. That's when you usually hired a professional. And what he does is number one he comes out and takes your existing data and and develops his own data with all the components are. And then he applies useful life to it saying it's got a 10 year life 20 or life if you're existing building. What is the remaining life was a 10 year life but they've had it for five years so it's only got a five year remaining life. You've got to do a replacement costs under a level one, the reserve specialist doing the work actually goes and does a physical site inspection, helps develop the components along with your board and our resident manager. And talks to vendors and air conditioning people and painters and roofers to get what they expect the estimated budget cost is to replace those items. So it's the highest levels there's been the most work done with respect to developing the data is that perfect of course not. I mean you can say the rules for the last 20 years we have a lot of hurricanes and wind and rain and it'll last 15 years or 18 years, or there's no wind and rains in the last 25 years. So it's why it's important to update it every single year. Level two study is the same thing as a level one, except we're not contacting the vendors and and we're using our own database so we're not doing any independent verification of the cost. We are coming out to the property and looking at it again to see if we see anything. And we are taking the data to develop the components and information you need to calculate the research study. For me, which is the lowest levels we're just taking the data and regurgitating it. That is at the end of the year to be fixed that last year did we replace it how much of the costs us. We're not doing a site inspection, and we're not doing independent cost verification. Now what are the differences between level one two and three, the price. You know it can be rather expensive depending on the size of the building to do a level one reserve study if you want to do it accurately. Level two is going to be significantly less because the most complex part of it and time consuming part is verification of cost information. Then level three, you're basically taking the basic data and, and updating it for the next year's budget, and that's going to be the least expensive of all. So that's just how level one twos and threes work and I'm always asked how often should you do a level one and I've never seen it writing anywhere but everybody seems to say, well every five years you should do a level one. I don't know if that's true or not, but, but certainly having a level one to start the process would be very telling to a board of directors on what they should include or not include in that. A level one reserve study. Well, you have very basically a few things common elements, normally limited common elements are not included although sometimes you have an open parking lot with asphalt. That might be included. There's nothing to prohibit it from being included. You might have when I is often railings on the nice maybe a limited common element, but they have to be replaced at some point in time as the building ages so you might include that. Number two is going to be if you own a resident management apartment or one exists because it's in your declaration. All the upkeep of that resident management apartment the appliances the carpet the painting have to be in the reserve study. There's going to be what we call fixtures. Well the fixtures are going to be your ceiling fans in the community room. The doorknobs the lights on the wall those types of things that is personal property if you're a big association, you may have pools chairs and furniture, you may have equipment in the gymnasium and if you have a fitness center, or any other type of personal property that you have that the residents enjoy while they live there. And then lastly but not least is some people include loans or in their in their reserve study, in the sense that that's kind of the components so that's what you got to put in the study as I said earlier, you've got to estimate the find the components, estimate their useful life, estimate their remaining life, estimate their replacement costs, and then factor in by inflation and that's just turning on your money. And I'm not making that up that's in the law and administrative rules and support the law so it can be quite a complex project for a bigger association. So something you got to pay attention to. And in that note, I've kind of given you the background. We're going to take a short one minute break then we're going to come back and talk about the modern thinking, and about wall suit so what's happened in the real world will be right back in one minute. So I'm back. Anyway, I talked about the kind of the background and history of reserve studies. I did want to mention that there's certain things you typically don't put reserve study. And that is contingency, for example, you don't want to put another item is like, I don't know what it is, you know, I'm just going to throw in an extra amount of money. And the demand puts a demand on the contribution amounts and is not normally included as well as your insurance deductibles or if you're going to do a future improvement and put something brand new with the project that wasn't a part of the decoration. Normally that stuff's not included. If I could give a test and say to somebody I'll bet you $10. I don't know the two types of reserve studies. I would have made a fortune by now because nobody ever gets a right. They always say percent funded and cash flow funding on the two types of reserve studies. That's not the right answer. Those are the two types of funding methods, but it's not the right answer on the two types of studies. The two types of studies are the component method, and the pooling method, and the component method does is funding as percent funded, and the pooling method doesn't as cash flow. And it's very, very different what the results can be and I'm going to try to give you a visual example of this and keep it simple. There are two components. A paint job you got to do in three years for $30,000. And a roof job you got to do in 10 years for $70,000. In my example, you can see you need 30,000 for the paint job and 70,000 for the roof and the next 10 years or $100,000. So let's look at component versus pooling method calculations. Let's do the component method, percent funded method. What the rules are for a reserve study preparer is you must calculate each component separately. So back to the 30,000 for the paint job I need one third of that that's 10,000, and my roof job of 70,000 10 years I need one tenth of that or 7,000. So I need $17,000 under the component method, and to be 100% funded I need to collect 17,000. That's about 50% funded we collect $8,500. So in three years when the $30,000 paint job is due, you have 25,500 in the bank, and nothing for the roof. And what the administrative rules say is you must immediately assess the owners $4500, and then you must assess the missing amount of money or the 50% of the missing money for the roof. So $7,000 a year so 50% would be $3,500 a year. So you'd assess the owners 10,500 to catch up on the 50% funding for the painting, and you'd have to assess the $4,500 for the, for the, have the money to do the painting. Well, I've said to people, many times, hardly anybody in the United States uses component method percent funding funding. It's a single year number people who project these percentages every year for the evermore are just doing it for their own exercise of utility, because under component method it's a single year study what's your percent funded, and you have to calculate each component separately. Now how does that compare with the pooling method remember I said 30,000 of the paint in three years, 70,000 for the roof in 10 years, and you know $100,000 in 10 years. It's like 10,000 a year, use 100% of it for the paint job, and I use 100% for the roof job for the subsequent seven years. I'm, I did fully I mean I've got all the money I need I've done everything, and under cash flow I only need $10,000 for the reserve study. Now, that being said, everybody uses the pooling method, because if you look at all the studies I've seen I've seen hundreds of thousands of studies. Cash flow gets very erratic results and it's not worth the energy. And think about this way from evaluating your building you better off saying I'm, I'm 50% funded you better off saying I'm funded fully. You know your your reserve study gives it the full amount of money you need. So that's kind of the difference between the two. The most reserved study preparers today, because we have very sophisticated software will do the cash flow pooling method, and it'll give you the percentages but I always delete them I can do that by clicking a little box on my software say don't show the creek confuses the heck out of people. You know it doesn't make any sense to do that so you need to know that the component method is not used anymore. The pooling method cash flow is the is the basic standard of the industry today. Now let's talk about what we've seen in litigation on this. Remember you have an obligation to fund this fully litigation has come about from three or four events by associations. The first event is they didn't do reserve study, and the statute says you have to do reserve study, and an owner could follow a lawsuit against you saying you didn't do reserve study, forced you to comply with it, and be reimbursed for their cost to sue you, because you had a statutory obligation that's in law. In fact, it was a breach of fiduciary duty. A judge or an arbitrator can make the board of directors personally pay for the costs to do reserve study because you have a statutory obligation to do it. So the number one reserves, number one lawsuit is someone not having done an adequate reserve study. And through that process typically they're not maintaining the common elements and the owners are upset. And common lawsuit is and I had this happen. Well as an expert and a witness I knew a lot of expert witness work on reserves is that the board said you know our reserves are in great shape. If we just pretended the central air conditioning system didn't exist. If we just pretended it doesn't exist. Yeah, can we take out that $3 million component to replace in 20 years. We have more than enough money based on our contributions, and we'll just figure that out 20 years from now. And so the lawsuits we're seeing is where reserve studies, either intentionally or, I'm going to say it should have been obvious, left out major components to intentionally and willfully try to reduce the reserve study and so the law is very clear you can't do that. It's a violation of the statute to manipulate the reserve studies to get around funding your reserves properly. But the number two case I see is the ones that it's intentional because I go to meetings all the time and board site. What if we just did it this way and took this out of the out of the study and I say you can't do that. You know, I noticed recently a board overthrow of our waking key project. And after the new board took over they said well our business judgment is to take $9 million and expenses out of the reserves. I've got this anecdotally so I'm not involved in this but the lawyer was talking to me about it over nice class of red wine and we're saying. Are they nuts. I mean it's obviously fraud, it's willful intent. They're not going to be covered by the director and also liability insurance so you can't try to manipulate the data to say, I don't have a central air conditioning system is my example. You know, so the next one I find really interesting, mostly on new developer projects. They come and they say okay well we are going to put the developers public report out and we're going to put in an estimate of maintenance fees and the fee dispersions they call it. They say well, what we're going to do is say that we're going to use 10% of maintenance fees as the number because allegedly not so not true but allegedly. The FHA says that 10% reserve funding is adequate. The problem with that thinking is Hawaii law doesn't say you can use the FHA 10% underwriting requirement as a measurement standard for reserves. It's not within the law. And frankly if you read the FHA and of course you get into hot FHA Fannie Mae all these other ones have little quirks on this but they're all about the same. And after that, that's not what it says. It says not less than 10%, but otherwise prescribed by a reserve study. So you can't argue that you can just take 10% and use that number, because it's not a legal number to use. So we're seeing lawsuits against developers and managing agents where the reserves are inadequate and what happens is new buyers get in there. And all of a sudden the first one or two years after they bought, they get a 20 or 30, 40 in some cases 50% increase in maintenance fees to properly fund the reserves. And these people who may have been under a reserved housing, their ACDA or something like that, can't afford it. And so what do you mean you, you use the number that you can't validate or document. I mean, it's fairly easy in today's world to look at like size buildings and see what their funding for reserves and the status but I see many lawsuits right now where they're starting to attack developers because they fact they use a number that's not provided for in the statute. And so that's where the lawsuits are coming. Let me see if I missed anything on my list here. The last one is that they'll put in a contribution, let's say 100,000 this year, and 110,000 next year, 120,000 next year and they do in this 20 year forecast. And I'm looking at one working on right now as a consultant where their current contributions are 750,000 a year in 2021. And they're 4 million in 2041. So they go up every year by 3, 5, 10% some number. And so the question is, if you're supposed to be paying for your fair share while you live there, and you're really kicking the can down the road and putting on someone else down the road. And these annual increases, you can't call it inflation because the software itself already considers inflation in the analysis. So, if they put 3% in every year it's not inflation because the software is already got if they put in 3% in the number. I'm going to summarize now and we're going to let you go back to whatever you were doing that the key word and all this right now all the people avoid litigation is disclosure. Whatever you did make sure that your reserve study has adequate disclosures, exactly what your assumptions were, why you made those assumptions, and what you did, and then even if you're wrong you're protected. So the magic word is always disclosure, and people need to put more time in their reserve study and make sure it represents what the building is, what they expect in the future. And at the same time disclose what they did and why, and that way they'll avoid litigation because anybody who buys in there, you told them what your assumptions were and allow the law allows you to be wrong. And on that note, thank you for watching condo insider. It's a complicated to somehow do this over the internet, but I hope you learned something about it. And if you have questions feel free to through think tech a wide send me an email or write me a question. Aloha and have a good day.