Warning Signs: Not Paying Close Attention to Your Building's Reserve Fund
June 24, 2015 — Your treasurer has presented his latest report, and he has offset expected losses from operating expenses with money from the reserve fund. Your managing agent has sole control over your reserves. Your manager uses the reserves to pay for capital projects and does nothing to replenish them. If any of these scenarios are familiar to you, then watch out: they are warning signs that something is amiss.
Reserve funds are essential to the operating health of co-ops and condos and the peace of mind of their boards and owners. There are three issues that involve a reserve fund:
- What is the minimum amount needed?
- What should it be used to pay?
- Who should control it?
There are different schools of thought regarding the size of a reserve fund. Probably the most conservative approach is that regardless of the amount of money you have, you should always strive to make it larger. Fannie Mae, the federal agency designed to expand the secondary mortgage market by securitizing mortgages in the form of mortgage-backed securities, believes that condominiums should have a reserve for replacements built into every year's budget equal to 10 percent of the operating budget.
At annual meetings, accountants regularly state that buildings should have a reserve fund equal to three to six months' worth of operating expenses. That seems reasonable, although the operating expenses often bear no resemblance to the actual cost of replacing aging building systems. Local law requires that buildings undergoing conversion to condominium or cooperative ownership should have a reserve fund equal to three percent of the aggregate sales prices of the apartments. The American Institute of Certified Public Accountants requires every co-op or condo indicate whether it has not released an engineering report (which it may or may not have done) on the remaining useful lives of the building's equipment. Co-ops and condos must also indicate in their financial statements where the money to pay for repairs and replacements is coming from: the reserves, the operating fund, special assessments, or a refinancing.
The reserve fund should be used for repairs and replacements and not to subsidize a building's operating expenses. The reason for this is simple: the reserve contains a finite amount of money, but operating expenses are recurring. If a board tries to keep maintenance costs down by using its reserve to pay for operating expenses, when a capital need actually arises, it will have to raise maintenance twice as much and impose an assessment to pay for it.
I cannot count the number of times I have seen a dissident board get elected because they argued that the maintenance or common charges were too high, only to deplete the reserve fund to subsidize operations — leaving the co-op or condo without a reserve fund and with even higher maintenance and common charges. Then their replacements have to clean up the mess.
Anyone running for the board on a platform of reducing maintenance or common charges by using the building's reserves should not be elected. Moreover, every accountant will tell you that the building's fixed expenses are typically more than 85 percent of the budget, so they cannot be reduced without changing the building's quality of life and the value of the apartments. Never focus solely on the short term.
Assuming your building has a reserve fund that has not been used to offset operating expenses, no money should be removed from it without the signatures of two board members.
It is critically important for the board to be aware when its budget is wrong. In fact, if someone is tapping into the reserve fund to pay operating expenses, it is a warning sign that either the board made a mistake in the budget or that expenses are significantly higher than it anticipated. The board has to determine whether it was overly optimistic on revenue, whether it encountered an unanticipated event (and why it did not anticipate it), or whether it underestimated expenses.
Additionally, the board does not want one person — whether it is a managing agent or a treasurer — to have control over the reserve fund because there have been instances (fortunately rare) where either the agent or treasurer has utilized the reserve fund for his or her own purposes. Requiring multiple signatures for access to funds keeps theft in check. Furthermore, all discussions of the use of the reserve fund should be clearly described in the minutes of the board meeting so there is no confusion in the future as to whether the use was properly authorized.
Illustration by Jeff Moores
Stuart Saft is a partner at Holland & Knight.
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