Capital Reserve Fund Purpose, Limitations, and Components Capital Reserve Funds are tax-exempt savings that can only be used to preserve the value of capital investments. This is why they are often called Replacement Reserves--they are used to replace worn or broken parts of a capital investment. One test of whether an item may legally be included in the Capital Reserve Fund is whether it will have to be replaced in order to preserve the value of the investment. In addition, any expenditure that substantially extends the life of a Capital Reserve Fund component can be included in a Capital Reserve Fund. The purpose of the fund is to preserve assets. The asphalt in the parking lot, for example, is a Capital Reserve Fund component because it is an essential part of the property and contributes to its value. If we rejuvenate the asphalt every 5 or so years, we will, in theory, never have to replace it. Thus the cost of rejuvenation every 5 years can be included in our Capital Reserve Fund. Because interest earnings on capital reserve funds are tax exempt, it is beneficial to communities to include as many items as possible in order to avoid paying annual taxes on multi-year savings. Having healthy Capital Reserve Funds means current residents pay for the life of items they are using today that will be replaced by future residents. Healthy reserves also maintain affordability because they protect owners from unexpected assessments. Maintenance items cannot be included in a Capital Reserve Fund. The distinction between maintenance and capital reserve items is more of an art than a science and is ultimately determined by the IRS. In general, maintenance items are things that are done on a regular schedule like painting and are predictable, ongoing expenses. The IRS is particularly sensitive to any item called "painting," which it considers maintenance.

Cash Flow Projection Method vs Component Method The purpose of the Capital Reserve Study is to determine how much money a community needs to save to protect its capital investment, the property. There are two methods of doing this. One is to value each component of the property, measure the life of the component, and to mandate savings necessary to replace each component. As each component is fully funded, the reserve contributions are reduced. ASG does not recommend this method because it would require us to immediately bring the balance up to approximately $400,000 that would sit in the bank for 20-50 years. The Cash Flow Projection Method, on the other hand, uses the same measurements (cost and life) to determine how much money will be required in any given year and recommends an even savings rate that will be sure funds are available when they are needed and not before. These calculations begin with the original cost of each item, prorate the cost by expected life, adjust for inflation, and calculate the expected interest earned on savings. This allows regular deposits each year and provides a cushion in case of premature failure of major systems. With careful calculations, this method is reliable and prevents unnecessary and burdensome savings. ASG has used the Cash Flow Projection Method to make recommendations for our Reserve Contributions.

Inflation Rate vs. Construction Inflation Rate One key figure in our Reserve Study, is the inflation rate. This rate is not the general economic inflation rate that in recent years has been about 3%. This is the inflation rate of construction costs -- materials and labour. It is calculated by the Construction Specifications Institute (CSI) and for 2006 was 8.6%. It is expected to be slightly lower in 2007 but is not expected to drop significantly after that. Thus the rate of inflation that will be used in our study will be 7%, not the 3% that was used in the previous Reserve Fund Study done in 2002. This rate is adjusted regionally os it is specific to our geographic area.

Updates of the Capital Reserve Study ASG recommends review of the Capital Reserve Fund Study on a regular basis as an operating budget expense. An annual "paper" review updates components that have been replaced, added, or significantly improved and makes adjustments for changed interest or inflation rates and the balance remaining in the reserve fund. It does not involve a site visit and is based on figures supplied to them. This study costs $300. In three years, ASG recommends a full study, including a site visit. This study will cost only $1200 because it will be based on our original study and on the paper updates. (The current study cost $5000.)

Combining Capital Reserve Funds and Maintenance Reserve Funds In the study, ASG combined the Capital Reserve Fund and Maintenance Reserve Fund totals for the purposes of calculating what we need to save each year. This does not mean they can be combined in bank accounts or spent interchangeably. Combining the totals was only done because it allowed them to apply the various adjustments (interest rate, etc.) more easily and to project total required savings.

Correcting Under-Funding Our current funding levels will not be sufficient to meet future needs. There are several ways we can remedy this. ASG has recommended increases to the Reserve Fund every year for 20 years. This is a small increase now but compounded with a new increase each year will mean significantly higher contributions over time. We can avoid this by making more contributions now and allow the funds to earn interest. ASG will run new numbers using increases over 10 years. A second method would be to institute a transfer fee on sales to fund the Reserve Study deficit. This would put significant funds into the study now that would be earning interest over time and help avoid significant increases over time. The rationale is that current residents have been under paying reserve contributions.

Rationale for the Longer Period of Time Our current study covers all components in our commonly owned property -- all the common elements. The previous study covered only items that would expire in 30 years. Some companies use 50 years. The rationale for this is that most real estate projects will do major Capital Improvements in 30 to 50 years. They will not replace current assets. Hotels, for example, have to modernize, not replace. ASG and the Community Association Institute argues that condominiums do maintain their property and do not plan major capital improvement programs that make replacement reserves redundant. Thus they recommend that all components, regardless of projected life, be included in the study.

Rationale for Painting Every 5 Years The rationale for painting every 5 years is that the paint is only guaranteed for 5 years. Protected areas may not need painting that often but it is uneconomical to paint in sections. The set up costs are too high. We should check the paint to be sure it is adhering and that the caulk is holding. Typically the initial caulking is very poor so it had to be replaced. We may be able to repaint in 7 years. It will be a judgment call.

Two documents related to the presentation shows the hypothetical reserves and schedule, with year totals and cumulative balances. The Reserve Fund Study is basically my outline and notes.