After more than two decades of review and re-calculating numbers in reserve studies, it is conclusive that there is a range of different financial results being produced by reserve study companies.
At the end of the recent CAI National Conference, the Reserve Shop Talk session was attended by some of the largest reserve study company principals. The subject of setting industry standards on calculations and reporting was introduced. It was stated that many reserve study companies produce much differing report presentations while also producing different calculation results (using a variety of different undisclosed formulas for calculations).
While one attendee disagreed, others agreed. This may display a lack of and need for standardization of calculations and reporting. Different reserve study company reports should have the same resulting numbers if using identical data. This may be a logical approach for the reserve study industry, but there was no interest in pursuing this direction. This raises questions (and is the basis of confusion for property managers and HOA Board of Directors) when changing reserve study companies? How did our reserve position change so much? Whether it be positively or negatively.
For the purposes of illustrating this point, let’s review the various formulas and calculation results of one area of reserve reporting, 100% Funded. It probably it is not generally known, but there are currently four different methods for calculating 100% Funded:
- Current Cost – Straight Line
- Future Cost – Straight Line
- Current Cost – Future Cost – Straight Line
- Future Cost – Time Valued
The following shows how these methods are calculated (assumes a current cost of $10,000, estimated useful life of 4 years, 3.00% inflation and the reserve item has been in service for one year):
Current Cost-Straight Line:
The current cost-straight line method is the easiest and the most straight forward to understand of all the methods. This method does not take into consideration inflation. It is a simple calculation that if a reserve item has a current cost of $10,000 and a four year estimated useful life, then at the end of each year the 100% Funded amounts would be by year: 1) $2,500, 2) $5,000, 3) $7,500 and 4) $10,000. Calculated as: $10,000 / 4 = $2,500 per year.
Future Cost-Straight Line:
This calculation is the same as Current Cost-Straight Line except instead of using the current cost the future cost is calculated and divided by four years. The future cost is calculated with the following formula (this formula takes into account the reserve item has been in place for one year and will be replaced or maintained in three years):
(Cost * ((1 + Inflation Rate) ^ 3)) / Useful Life = $10,927.27
The future cost is divided by the estimated useful life of four years ($10,927.27 / 4 = $2,731.82) calculating the 100% Funded amounts would be by year: 1) $2,731.82, 2) $5,463.64, 3) $8,195.45 and 4) $10,927.
Current Cost-Future Cost-Straight Line:
Some States Civil Codes have been interpreted that the existing cycle of a reserve item should be calculated on a current cost-straight line calculation and the future recurring cycles on a future cost-straight line calculation. The 100% Funded amounts would be presented as above for the existing cycle (current cost-straight line) and the recurring cycles (future cost-straight line).
Future Cost-Time Value:
The future cost-time value calculates each year’s 100% Funded as a progression from year to year which more fairly represents the compounding of the inflation rate. The current cost of $10,000 compounded for one year at 3.00% equals $10,300. This future cost is divided by the estimated useful life of four years and multiplied times two years to calculate $5,150 as 100% Funded at the end of year two. The following year calculation is then repeated using the previous year future cost of $10,300 which is compounded for one year, $10,609. This is divided by the estimated useful life of four years and multiplied times three years to calculate $10,609 as 100% Funded at the end of year three. This calculation would continue for the ongoing existence into the future of the reserve item.
This method most accurately calculates the 100% Funded amount of a reserve item taking into account inflation compounded annually as opposed to any straight-line calculation.
Note: the above methods utilize the current cost considering that the reserve item has been in service for one year.
The matrix below presents the different balances of the 100% Funded calculation methods:
The variances of the straight-line methods exist on their own and are materially different when compared based on the percentage differences with the future cost-time valued method.
It is obvious why the 100% Funded calculation can vary from reserve study to reserve study due to different methods. Usually it is not disclosed in the reserve study what method was used which adds additional confusion to property managers and HOA Board of Directors for first understanding their current reserve study and then when comparing results to a previous reserve study.
There is currently no documentation or guidance on these calculations from CAI (Community Association Institute), APRA (Association of Professional Reserve Analysts, AICPA (American Institute of Certified Public Accountants), FHA (Federal Housing Administration, or any individual state Civil Codes or regulations.
This examines just one area of reserve study calculations. Other calculations need to be addressed in the same manner while addressing reserve study formulas and calculations. Reserve study reports also need to be addressed in the same manner as the above in order to set standards for consistency and understanding for the benefit of all property managers and HOA Board of Directors.