Friday, March 4, 2011

Operating Expenses vs. Reserve Expenses vs. Capital Improvements

Many residents and even Board Members do not know the difference between operating expenses, reserve expenses and capital improvements. Once people grasp the difference between the three, many don't know when homeowner votes are required for funding and/or expenditures. I'll be explaining the fundamentals of each.

Operating Expenses

These are the Association's day-to-day expenses. People should think of this as "repair" not "replace." Operating expenses include contracted services (i.e. landscaper, pool contractor, gate maintenance, management), insurance, utilities, taxes, administrative expenses (i.e. accounting fees, office expenses), and maintenance expenses (building repairs, plumbing repairs, lighting supplies). Association's use the pro forma budget to help create a map for the upcoming year's operating expenses.

The Association is required to distribute the budget package to the members every year. In California, the Board of Directors has the authority to increase the dues by 20% each fiscal year to cover operating expenses. Any increase beyond 20% will require the vote of the membership. The Board also has the authority to special assessment the members 5% of the gross annual income without the membership's vote. Anything beyond that would require the approval of the members. The Association would maintain a bank account as the designated operating account. The Board has the authority to enter into agreements and maintain the day to day operations...operating expenses.

Reserve Expenses

Reserve expenses are the replacement of existing building components; not the repairs. So, we can compare a component and demonstrate whether it is an operating or a reserve expense. If a homeowner relays they have a roof leak and the roof is repaired, that would be considered an operating expense. If the Association replaces the roofs, the roof replacement is a reserve expense. Associations use the reserve study as a guide on how much the components would cost to replace, and what the useful remaining life on each component would be. Associations must also maintain a separate bank account that is deemed the reserve account. The best way of distinguishing the operating and reserve accounts is to think of the operating account as a checking account while thinking of the reserve account as a savings...or even almost a CD account. There are many restrictions on the Association's ability to use the reserve funds, as the reserve funds should be used for reserve expenses. If the funds are used for non-reserve items, there are a set of Association requirements that will not be explained in this article. The Board has the authority to cause the replacement of existing components as needed, assuming that the funds are available.

Capital Improvements

Capital improvements are projects where a new component is introduced to the community. It is a project that, once installed, will then create operating expenses and future reserve expenses. An example would be a community's desire to install a spa when that ammenity does not already exist. The rule of thumb for a capital improvement project is that the Association should obtain membership approval before undertaking a capital improvement project. Because this component does not already exist within your community, the Board will have to re-allocate existing funds to pay for this component, or the Board may need to special assess members to obtain the funds to undertake the project. This new component will have to be added to future reserve studies, and additional reserve funding will be required to maintain the component.

If you have questions on these topics, please feel free to email me at

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