It is a little known fact that the preparation of a common-interest-development reserve study is not required to be done by a third party, section 1365.5 (e) – “At least once every three years, the board of directors shall cause to be conducted…a study of the reserve account requirements…”. No reference to third parties, so a study can be prepared internally by an association. Also, California Civil Code Article 1365 (Article 1365) makes no reference to requirements of updating the study in the second or third years.
Does this mean that associations (HOAs/POAs) should be preparing their own reserve studies? Probably not. Most associations do not possess the professional expertise or experience required to prepare “a reasonably competent and diligent visual inspection…as part of a study”. But the overbearing reason for the board of directors to engage a third party to prepare a HOA reserve study or plan is to provide liability relief. There are many competent Reserve Specialists that are capable of “competent and diligent visual inspection”, but are they capable of interpreting Article 1365 reporting requirements?
The interpretation and controversy of deciphering Article 1365 has been going on for more than two decades. Based on history, the debates will probably go on for another couple of decades due to the many layered amendments incurred which provide confusion and redundancies.
Deciphering the Reserve Requirements of Article 1365:
Reserve requirements are not the only subject that Article 1365 addresses. The reserve requirements are intertwined with operations, reporting, distribution, disclosure, assessments, foreclosures, meetings, and the subject matter goes on and on. It is the board of directors that are ultimately responsible to abide by Article 1365 which is extremely difficult to accomplish without the help of competent management and third-party professionals. The challenge for the board of directors is determining how and who will ultimately prepare the reserve information that will be disseminated to the owners. It is probably just as hard for a board of directors, management or the Reserve Specialists to determine who is taking what responsibilities of the reserve reporting requirements of Article 1365.
Section 1365.2.5 (a) states: “The disclosures required by this article with regard to an association or a property shall be summarized on the following form: Assessment and Reserve Funding Disclosure Summary”
When reading Section 1365.2.5 (a), “The disclosures required by this article…”, the article is Article 1365 in its entirety. The form “Assessment and Reserve Funding Disclosure Summary” (summary form) outlines certain defined or selected reserve reporting requirements of Article 1365 but not all of them. The preparation and distribution of this summary form appears to be an annual requirement in which Section 1365.2.5 (a)(3) and (6) refer to “the most recent reserve study”. Section 1365.5 (e) which requires a reserve study, “At least once every three years…”, makes no reference to prepare or include this summary form. This would leave the association to prepare this summary form unless the board of directors engaged a third party to do so. Are the summary form and the reserve study separate requirements (one being annual and the other every third year)? Should a Reserve Specialist be engaged to prepare this summary form? Welcome to the confusion and redundancies of Article 1365. What are the other reserve requirements of Section 1365 (e)?
“The study required by this subdivision shall at a minimum include:
- Identification of the major components that the association is obligated to repair, replace, restore, or maintain that, as of the date of the study, have a remaining useful life of less than 30 years.
- Identification of the probable remaining useful life of the components identified in paragraph (1) as of the date of the study.
- An estimate of the cost of repair, replacement, restoration, or maintenance of the components identified in paragraph (1).
- An estimate of the total annual contribution necessary to defray the cost to repair, replace, restore, or maintain the components identified in paragraph (1) during and at the end of their useful life, after subtracting total reserve funds as of the date of the study.
- A reserve funding plan that indicates how the association plans to fund the contribution identified in paragraph (4) to meet the association’s obligation for the repair and replacement of all major components with and expected remaining life of 30 years or less…”
The summary form is primarily focused on current and future reserve fund balances, requirements and percent funded (Section 1365.2.5 (b)(4), “…the amount of reserves needed to be accumulated for a component at a given time…”). While the reporting requirements of a reserve study are different from the summary form, the elements of the reserve study are necessary in preparing a summary form. It is not the question of what comes first the chicken or the egg. A reserve study must be prepared before a summary form can be produced. The question then becomes when should a reserve study be prepared?
Considering the following: Section 1365 (a), “A pro forma operating budget, which shall include all of the following:” Section 1365 (a)(2) A summary of the association’s reserves based upon the most recent review or study conducted pursuant to Section 1365.5…”. Section 1365 (a)(2)(B), “As of the end of the fiscal year which the study is prepared:”. Section 1365 (a) (4), “…a copy of the operating budget shall be annually distributed not less than 30 days nor more than 90 days prior to the beginning of the association’s fiscal year.”
Based on Article 1365 requirements, a reserve study would have to be prepared before the annual distribution requirements (30 to 90 days prior to the beginning of the association’s next fiscal year) if it’s conclusions were to be utilized in a timely annual distribution. For example, if the association’s beginning of fiscal year is January 1, 2010, the annual distribution of documents should be accomplished by December 1, 2009 requiring the reserve study preparation to be prior. As with other disclosures, the summary form would also appear to be required in this time frame.
Even though a reserve study is only required every third year, Section 1365 (a)(2) still requires annual reserve reporting requirements separate from the summary form as follows:
(A) The current estimated replacement cost, estimated remaining life, and estimated useful life of each major component.
(B) As of the end of the fiscal year for which the study is prepared:
(i) The current estimate of the amount of cash reserves necessary to repair, replace, restore, or maintain the major components.
(ii) The current amount of accumulated cash reserves actually set aside to repair…
(C) The percentage that the amount determined for purposes of clause (ii) of subparagraph (B) equals the amount determined for purposes of clause (i) of subparagraph (B).
(D) The current deficiency in reserve funding expressed on a per unit basis. The figure shall be calculated by subtracting the amount determined for purposes of clause (ii) of subparagraph (B) from the amount determined for purposes of clause (i) of subparagraph (B) and then dividing the result by the number of separate interests within the association…
- A statement as to all of the following:
(A) Whether the board of directors of the association has determined to defer or not undertake repairs or replacement of any major component…
(B) Whether the board of directors of the association, consistent with the reserve funding plan adopted pursuant to subdivision (e) of Section 1365.5…
(C) The mechanism or mechanisms by which the board of directors will fund reserves to repair or replace major components…
(D)Whether the association has any outstanding loans…
- A general statement addressing the procedures used for the calculation and establishment of those reserves…”
The annual reserve reporting requirements in Section 1365 (a) (2) appear to have most of the ingredients of a reserve study. Does this mean that a reserve study needs to be done every year so the information in the reserve study can be extracted to fulfill the annual reserve reporting requirements of Section 1365 (a)(2)? A complete reserve study would include “a reasonably competent and diligent visual inspection” which is not required annually. An update of the previous year reserve study or the previous reserve study update per Section 1365 (e) would be necessary in producing the annual reserve reporting requirements of Section 1365 (a)(2).
Annual reserve reporting requirements (Section 1365 (a)(2)), the summary form (Section 1365.2.5 (a)) and reserve studies (Section 1365.5 (e)) makes for confusion and redundancies. If the confusion and the redundancies could be removed and proper grammar injected, we might find the original Article 1365 or something everybody could understand and agree on.
For the complete Article 1365 go to: http://www.leginfo.ca.gov.