 Ladies and gentlemen, appreciate you tuning in today. This week's Condo Insider on Think Tank Hawaii. Appreciate your time that you are dedicating to this session today. Considering that we are going to be entering, or we are entering rather, the budget season for the association world, the condominiums out there, the homeowner associations out there, you guys are now getting into the initial stages of your budgeting and reserve process. It is a busy time and it's an important process for your association to make sure that your association remains fiscally sound. That being said, today's show, we are going to focus on the ABCs of reserve studies in your preparation time for your budget season. That being said, I have prepared a PowerPoint for you for our episode today, just with some basics for your reserve studies that we're going to chime in today. So on your first side, basically what is a reserve study? Well, a reserve study is a financial forecast or a financial projection on what your association will need to collect over a period of time to fund all of your capital components or capital expenditures. And when I say capital components or capital expenditures, I am meaning your large ticket items. For example, like your rooftop replacement or painting and spalling, your elevator modernizations, your asphalt seal coding or asphalt reconstruction. So it is basically components that have a long useful life. A reserve study is meant for components that are not considered regular operational expenditures. They're items that have a useful life and once that useful life is reached, you will have to replace that component right around that timeframe. That being said, a reserve study is a planning tool. It is supposed to be done on an annual basis when you're preparing your operating budget for your reserve study. There are three different levels to a reserve study. A level one is essentially the most thorough reserve study where the reserve specialist or whoever's performing your reserve study is performing a sidewalk of your property. In addition, they are quantifying the different components of your association. When I say quantify, I mean they're looking at the number of light fixtures. They're looking at the square footage of your asphalt or your coding system for your parking structure. They're looking at your different square footage of your rooftops, linear feet of your railing. So essentially there's a quantification or they're giving a quantification to those different components in your reserve study. And that is essential in the level one. That kind of holds that's what makes the level one reserve study different than the others. A level two reserve study essentially is an update with a site visit but you're not quantifying the different components that you see on that site visit. You're using the information that was already prepared during the level one reserve study. And then there's a level three reserve study which is essentially done on an annual basis and most associations are performing a level three reserve study. It is a simple update. You are looking at your beginning balances. You are looking at your reserve contribution. You're looking at your interest income, your inflation rate. So it's just updating numbers. So it was completed what was not completed. And again, a reserve study needs to be updated on an annual basis because things change. Pricing changes, building codes change, cost of labor changes and cost of material changes. So there's a main change that occur over the life of a reserve study and that's why it's required to update on an annual basis. Moving on to the next slide. When we're doing a reserve study we're essentially looking at or we're answering three questions at the bottom of that sign. You can see it. What belongs to the association? What is the estimated use of life of that component that is in your reserve study? And what is the estimated replacement cost for that component? That being said, those are essentially the three questions that we're answering in a reserve study. That being said, when a level one reserve study is being performed there are a number of things that you will do. You will do a site visit where the reserve specialist will go and visit your property basically from rooftop down to the lowest level possible of your structure or go through the different building, excuse me, the different clauses, mechanical rooms, electrical rooms, basically identifying all the different common elements that belong to the association that should be included in a reserve study. And when you're doing that site visit essentially you're building a component inventory list for your components of your association. In addition, you look at governing documents. We'll get into governing documents a little bit later in our presentation. So I'm not gonna touch on that too much but a reserve study you are creating a component list that should include all of the different aspects of your association. Oftentimes I see when I go and do a reserve study the previous reserve study were missing many components. It's not uncommon for me to double or triple the amount of components that your previous reserve study had just because there are multiple components that are just not generally thought of when you're doing a simple level three reserve study without a site visit. So I would recommend and see why you recommends that you do a level one reserve study every four to five years you do a level two every three, two to three years and a level three on an annual basis until you or until you do a different level reserve study. Keeping in mind a reserve study is not a crystal ball. It's, we're using estimations, we're using variables that we're making assumptions such as inflation rate, inflation changes goes up and down, interest in changes it goes up and down. So there are some variables that we're utilizing that are making assumptions for your project cost in the future. So it's not a crystal ball. A reserve study is not a forensic inspection or a destructive investigation of different components in your building. It is a financial planning tool. The site visit basically is observation only. There's no destructive testing whatsoever. It's basically quantifying and giving those components a replacement cost and an estimated useful cost. So please keep that in mind that it is an estimate. It is not a crystal ball. There are other factors that may come into play when those projects come due. And that's where you're gonna wanna make sure that you're decently funded in case you do have unanticipated expenditure when you go into these projects. Moving on to the next slide. Why is it important to perform a reserve study? Well, number one is required by law. I-14B-148 I believe is what it is requires a reserve study to be done. Also Hawaii administrative rules subsection or sub chapter 16-107, which interestingly enough was actually drafted prior to allowing the cash flow method. So in the state of Hawaii, there are two methods that are permissible cash flow and percent funded. And we'll get into that here in a little bit, but that statute and the section in Hawaii administrative rules basically give some guidance on how to formulate your reserve study for your associations. Other reasons why a reserve study is important, obviously for a resale of your units or your homes at your association, reserve studies can have an impact on FHA lending specifically. They can have impacts on conventional loans and interest rates, but more specifically, they can have an impact on FHA lending. Many associations out there with the cost of homes need FHA lending in order to qualify for some of these homeowners. If you're not putting away a minimum of 10% of your revenues to a reserve account for funding future reserve projects, you're technically not meeting the FHA requirement and your association may not be eligible for FHA lending. So it's very important that you keep it a close eye on what your reserve contribution is and if it's meeting that 10% minimum requirement required by FHA. Moving on and also adding to the sales aspect of it and why is a reserve study important is because potential buyers are looking at it. They're asking questions about the reserve study. They're becoming very knowledgeable about reserve studies because you hear on a regular basis about these different associations that had an unanticipated special assessment or a huge increase in maintenance fees because of a project that they weren't planning for number one or they're underfunding for or they did not have a realistic estimation for the replacement of that component. So potential buyers, they're becoming more educated. They're becoming more and more educated about the larger projects like your waste stacks, replacement or your fire alarm systems or your elevator modernizations. Those are becoming more prevalent questions for potential buyers because people are hearing about the special assessments and the loans that are involved with these large projects. An unrealistic reserve study on the next slide, obviously there are definitely adverse effects to not perform a level, excuse me, a reserve study number one, you are just likely not funding at levels that you should. Therefore, you're not gonna have funds available to you to maintain your curb appeal. You're gonna have incomplete capital projects where you may just paint a portion of your building at a time because that's all you can afford or you might perform spawning without painting it afterwards and your association might present itself in a poor fashion to potential buyers. You can see the deferred maintenance in the different associations when you visit them, whether or not they're well funded or not, just based on the overall approach experience or the ambient that it produces when you're going through these different buildings. There are unforeseen and unplanned expenditures that do happen. There are many components in these high rises that are hidden behind walls. You can't really properly tell what the useful life is or remaining useful life is for some of these components unless you do some destructive inspections. So you may want to consider funding some funds putting some funds in your reserve study or professional consultants to further investigate some of these components that are hidden within walls like waste stacks or lagging or pipe insulation or all chilled water lines. These are some items that are very costly but oftentimes overlooked in a reserve study. What are other adverse effects from a poorly funded reserve? Obviously a weak or low reserve balance is that produce a high risk of loans or special assessments. And obviously that when you have your low reserve contributions or your low reserve balances, you're gonna have to increase your reserve contribution substantially which will result in a high maintenance fee increase. That is why it's important to make sure you're funding your reserve study and you're looking at an annual basis so you can gradually increase your reserve contribution maybe over a longer period of time where it's a little bit more palatable for people rather than in a short burst maybe over one or two years. But again, you know your association much better than myself or a reserve specialist producing or creating your reserve study. So make sure you're involved in the funding, the funding plans. Again, moving on to the next slide. Statute, there's two different funding options in the state of Hawaii. One is percent funding and one is cash flow. We'll go on to the next slide. We can jump into a little bit of the cap, excuse me, the percent funding method that is permissible with Hawaii statute. So the percent funding method basically is a component funding method where you are saving a specific dollar amount for each individual component in your reserve study. So all those funds are segregated for that specific component. That being said in the state of Hawaii utilizing the percent funded method or threshold funding method, you have to maintain a minimum fund of 50% funding of your current cost basically depreciate over a different amount of time. So that being said, you're only required to maintain a minimum of 50% funding. Again, that's just a minimum requirement. I oftentimes see boards, they make the goal to achieve the 50% funding level and then exceed that and get up to a fully funded level. And that's really up to a board. That's really up to a possible resolution or policy that the board implements for your different associations regarding your funding levels and your reserve study. That being said, moving on to the next slide, essentially you got a few different components here. Let's just take your painting and your roofing, for example, you need to collect $30,000 for your paint, $70,000 for your roofing over the next 10 years. It's about a hundred grand total. That being said, your roofing is due, excuse me, your paint is due in the very near future. Let's just say three years from now in 2024. So you really have to collect $10,000 per year to make sure you have that $30,000 available to you. However, using the percent-funded method, you only need to collect 50% of the $30,000 for the roofing and 50% of the $70,000 for the painting. So that being said, when those components come due, you're actually gonna be short funds utilizing the component-funded method or the percent-funded method because again, you're pulling those funds. So if you're utilizing it, you're probably gonna short yourself when those components come due. And then at that time, you either have to take from other funds and repay those funds over a period of time or you're either gonna have to special assess the homes or get a loan out. However, just keep in mind if you do take funds from other kitties or other components, you need to pay that money back to fund those components properly. That being said, we're gonna take a short commercial break here and we will return and continue our discussion regarding ABCs of Reserve Studies. Talk to you soon. And welcome back to Condo Insider and hosted by Think Tank Hawaii. Today we are discussing the ABCs of Reserve Studies. Again, this is we're in the initial stages of budget season for associations. We've touched on the basics of Reserve Studies at different levels of Reserve Studies and we've now started discussing the two allowed funding methods in the state of Hawaii. We have briefly discussed percent-funded method and now we are gonna move on to the cash flow method which is the next slide on your screen now. So we've touched on the percent-funded method. Again, that's a component-funding method where you're putting funds away per component. You're not pooling funds, you're designing a amount of money for that specific component. You guys in the cash flow method however, you pool those funds together into essentially one kitty or one reserve fund that's broken up to multiple CDs, multiple wanting markets, things like that. But you're pooling those funds and you disperse those funds as when components come due or have reached their useful life. So that being said, utilizing the same chart that we looked at with some funding, you have your painting in 2024 for $30,000 and you have your roofing in 2031 for $70,000. So you have a total of $100,000 that you need to collect over the next 10 years. At year three, you're gonna need $30,000 of that. So essentially you have to collect $10,000 over the next three years. And then from that third year all the way to the 10th, you'll have an additional 70 years to collect the remaining $70,000 that you need for the roofing project. However, keeping in mind utilizing the cash flow method, you need to look at your ending balances in your bank account versus the percent funded level like you do in the percent funding method. However, with cash flow, as long as you maintain positive balances for the next 20 years, you are meeting statute. However, the cash flow method can be a less conservative method if you are not basically funding properly or you're not keeping a healthy level of reserve funds. Oftentimes I see reserve studies that produce ending balances that are around $100,000, $200,000 for depending on the size of your association that is very, probably very minimal. And one unforeseen expenditure is going to basically deplete that $100,000, $200,000 kitty that you have. So having a reasonable funding level or when you create a policy for your association that, excuse me, association, why is making a policy that they will not reduce their reserve fund below $750,000 or $500,000 because that association and that board of directors, they have a risk tolerance that may be a little bit higher than other associations or other board of directors. So be mindful of the funding or the ending balances and make sure you maintain healthy ending balances so you can cover unforeseen expenditures or expenditures that may arise when you're doing these large projects. So don't create a reserve study that basically keeps you right at the bare minimums of what's required for you to comply with statute because there is some risk exposure involved here. So moving on to the next slide, comparing the different results, percent funded method to be 100% funded, we have like 17 grand on an annual basis, 50% funded, you need to collect the $8,500. But again, however, once that component comes due, you really only have 50% of the funds that you need for that specific component because it is a component funding method. So you're saving specific funds for that component you can't take from other components. Utilizing the cash flow method, you need to collect $10,000 at a bare minimum to minimum to collect that $100,000 over that 10 year period. But again, you don't wanna ride the minimum requirements. You want to make sure you have balances that are healthy and that can cover unanticipated expenditures that may arise. Moving on. So essentially if you have a weak or low reserve balance on the next slide, there are a few things that you can do to remedy that. Number one, obviously you can increase a reserve contributions. And again, more times than not when I perform a level one reserve study, I am seen on a regular basis that associations need to increase the reserve contribution in order to meet their financial obligations. There are huge projects that are coming to life, white waste act replacements that cost associations millions of dollars that have not been really planned for until just recently. An association needs to start planning financially for that and that does have a drastic effect on the reserve contribution. Some possible other methods to fund those projects do a special assessment or a loan. However, always keeping in mind that a reserve study is meant to avoid special assessments or loans. So if you know that you have not replaced your waste stacks and you are built in the 80s or the 90s, you know that you should start adding that component to your reserve study. Is it going to have an effect on your maintenance fees? Yes it is. But based on other properties in our area that have a failure between 40, 50, 60 years for these waste stacks. So if you're getting within the last 20 years of that component's life, you need to start funding for that component. Again, moving back to potential buyers, a reserve study is a valuable tool. It shows potential buyer that an association is funded for these large projects that they've given us some thought that they're saving sufficient funds to cover these future expenditures. One question that I get on a regular basis, is there any upcoming special assessments? As you can see the question on the next slide, that is the most common question that I and realtors get from potential buyers is are there any special assessments? You know, are there any unforeseen expenditures that have come to light that we need to start funding for? We need to be aware prior to making this purchase. That being said, moving on to the next section here, the reserve study also helps clarify ownership. Or in other words, what are the limits of the unit or homeowner? What belongs to you? What is your financial responsibility in versus the association's financial responsibility? What are considered common elements that the association covers through maintenance fees and what is the association's financial obligation to make sure that these are maintained? So let's look at that a little bit closer on your next slide. Understanding ownership continued. We really look at your governing documents, specifically your declaration and sometimes your bylaws under the maintenance and repairs section of your bylaws. But in your declaration, generally speaking, it'll clearly define what are considered common elements. It will generally clearly define as well what are limited common elements of the association. And one of the sections that I find most useful in unperforming our reserve study are the limits of apartments or the section to which determines essentially where the boundary line is located, number one or number two. It identifies which components are included as an expense to the homeowner or it's included with the unit and not considered a common element. So some frequent components that have question marks just due to the fact that governing documents are not always clear are windows, unit frames or window frames and windows, doors and door frames, Lenai railings, governing documents are not always clear. However, oftentimes though, when you look at the limits of apartment, it'll specifically say that the unit shall include doors, door frames, windows, window frames. So it clearly defines if those components are included in your excuse me, including in the unit and your personal financial obligation as a homeowner. But again, oftentimes it does not specifically show whether or not those doors and those windows belong to a unit. So a resolution may be required adopted by the board of directors which is permissible under Hawaii administrative rules. A board can basically adopt a resolution to clarify documents that are unclear with regards to who is or who is the owner to specific different components of your association. Why is that important? Because Lenai railings, for example, or window replacement or door replacement, those are very costly components to an association, potentially millions of dollars. So an association needs to have a clearer understanding of on who owns those windows, who owns those doors, who owns those Lenai railings because that will have a drastic effect on how much you need to collect for your reserve contribution when you're performing a reserve study. Moving on to our last slide, again, just to kind of summarize what we went through today, really spend some time on your reserve study. Oftentimes the associations spend hours and hours on a budget and very little time on a reserve study. Keep in mind a reserve study has the project cost you millions of dollars. Add notes to your reserve study for future board members, future property managers to write down who was the vendor that did the work, how much of the work was done, what was the basic scope of work that was performed to add notes to your reserve study. Excuse me. Clearly understand the ownership and financial responsibility of you, the homeowner versus the association. Again, understand that property dividing line. What is your responsibility as a homeowner versus the association? So try to understand what is your financial obligation so you can properly save accordingly if those windows do belong to you or if those doors do belong to you. Board members, when you're performing a reserve study, review multiple funding plans. Look at different possible increase laddering schedules or maybe a one-time increase with a small inflationary increase in future years just to keep up with an inflationary effect. Look at multiple funding plans that you feel could be utilized for your association. Again, one size does not fit all. So one funding plan might be the ideal situation and it may not be for the other association. So we'll look at multiple funding plans. If you're governing documents are not clear about ownership of specific components, draft resolutions to clarify the ownership of those components. Create standard guidelines if you don't own your windows or you don't own your doors. So when people replace those, there's a standard guideline in place to keep the uniformity of a building. Consider contingencies. These large high rises, they have multiple valves that are huge that are large in diameter that costs thousands and thousands of dollars. And there are so many valves that it is hard to quantify. So you may wanna consider contingency funds in your reserve study to cover these larger expenditures. Also you may want to consider an insurance deductible if your association's insurance policy has a deductible of $25,000 or $50,000, you may want to consider putting the insurance deductible in your reserve study for that current fiscal year in case the association has to pay $25,000 or $50,000 for an insurance loss. So that may be a consideration. That being said, statute allows for exempt property if a component does have a useful life longer than 20 years, you can actually exempt then until it reaches the last 20 years of its useful life but you have to disclose. So that's the last recommendation is make sure you have many disclosures in your reserve study. Spend some time on your reserve study guys. Thank you for spending some time with me today to discuss reserve studies and we will see you next week on our thank, excuse me, our condo insider episode next week. Thank you, aloha.