Understanding HOA Budgets and Reserves

The single most important question to ask about a California HOA is whether it is financially honest with itself. Beautiful pools and tidy landscaping are easy. A funded reserve account that actually matches the cost of replacing the roof is hard. The buildings that look good and have full reserves are run well. The buildings that look good and have empty reserves are about to look bad.

This page walks through how to read a California HOA's financials in 10 minutes.

The two budgets

Every California HOA runs two parallel budgets.

The Operating Budget funds the things that recur every year. Insurance, utilities, landscaping, pool service, the management contract, accounting, legal, minor repairs, and administrative expenses. Owners pay into this through regular monthly assessments.

The Reserve Budget funds the things that wear out and have to be replaced eventually. Roofs, paint, asphalt, plumbing, elevators, decks, balconies, pool plaster, fences, signage. Owners pay into this through a separate line item in their monthly dues.

When an HOA runs out of reserves and a major component fails, the only options are a special assessment or a loan. Both are expensive and both make units harder to sell.

How to read a reserve study

California requires associations to commission a reserve study and update it at least every three years, with annual review. A useful reserve study has four pieces of information.

1. The component list. Every major asset the association owns and is responsible for replacing.
2. The remaining useful life of each component. How many years until it has to be replaced.
3. The current replacement cost. What it would cost today.
4. The funded percentage. How much money is in the reserve account compared to the ideal balance the study calculates.

The funded percentage is the headline number. Industry rules of thumb:

• Above 70 percent funded. Strong. The association is not gambling.
• 30 to 70 percent funded. Okay, but watch the trajectory. Is it improving or sliding?
• Below 30 percent funded. A special assessment is likely in the next few years. Buyers should price that in.

Reading the operating budget

I look for four things in an operating budget.

Year-over-year increases. If insurance jumped 40 percent and dues did not, the association is absorbing the loss into reserves. That is a problem.

Legal and bad debt line items. Big legal numbers usually mean the board is fighting an owner, fighting a contractor, or being sued. Bad debt usually means owners are not paying.

Concentration risk. If one or two vendors represent the bulk of the spend, the association is exposed if those contracts get renegotiated or terminated.

Reserve contribution as a percentage of the budget. If the operating budget puts less than 15 to 20 percent into reserves, the association is underfunding the future.

Special assessments

A special assessment is a one-time charge over and above regular dues. California limits how much a board can assess without a member vote (5 percent of the gross expenses for the fiscal year, with exceptions for emergencies and court orders), so when you see a large special assessment that was passed, it usually means the membership voted yes because the alternative was worse.

A history of special assessments is not automatically bad. It can mean the association is owning up to deferred maintenance. But ask why, and ask what is coming next.

Audit versus review versus compilation

California ties the level of required financial scrutiny to the size of the association's budget. The thresholds change, so check the current Civil Code, but the general idea:

• Compilation is the lowest level. The CPA puts management's numbers into financial statement format. No verification.
• Review is a middle level. Limited analytical procedures, but no audit-level testing.
• Audit is the highest level. The CPA tests transactions, confirms balances, and issues an opinion.

If you are buying into a large association and the most recent financials are a compilation rather than an audit, ask why.

Worth listening to

CACM's HOA Life Podcast covers HOA finance directly in Episode 4: Don't Fake Your HOA Budget. It is short, plain-spoken, and worth 30 minutes for any buyer or board member.