Inflation hurts many different people in society, particularly those on a fixed income. With core inflation surging past 8% in May, and a gallon of gas in California nearing $7, the talk on every news outlet is about it. But I have not heard any talk about the impact of inflation on homeowner associations, and every owner in an association, and particularly the board, needs to be aware of it.
Most boards increase the dues to keep pace with inflation, and that is wise. Of course, increasing monthly dues is largely unpopular, and some owners have trouble affording the increase. But if the board does not keep pace with the cost of services, in a few years they could be 20 to 30% below the necessary dues. Typically, 75% to 80% of the monthly goes to current operating expenses and the balances is put in reserves, so without an increase, 100% of the dues will pay for current expenses and no money will be allocated for future expenses to replace community capital improvement projects such as painting, re-roofing, repairs and the like.
If you own a property without an association, you can choose to defer necessary work and save that expense. The roof can be patched instead of replaced, or the house painted in a few years. Or an owner can choose to do the work themselves, or pick a less expensive alternative. Associations don’t have that option. One owner can’t pay lower dues and opt out of community improvements.
An association has reserve funds on hand that are dedicated to the repair or replacement of common area items. The required funds are determined by a reserve study conducted annually. There are three main variables to determine the proper reserve levels: (1) the useful life of the item (e.g., 10 years for a pool heater); (2) the cost of the item to be replaced (e.g., $9,000 for a pool heater): and lastly, the rate of inflation. A pool heater that costs $9,000 today, will cost more 10 years from now depending on the rate of inflation. At 3%, a $9,000 heater will cost $1,500 more in 10 years or $10,500, and that is the figure the association must have on hand when it needs to be replaced.
But what if inflation is 10% for 10 years? Now the association must have $18,000 on hand or 70% more. Almost every reserve study for the past 10 years has used 3% as the rate of inflation and estimated necessary reserves based on this low number. If reserve study incorporates a higher figure, such as 5%, immediately, even well-funded and financially conservative communities, will be underfunded. Why is a reserve balance lower than 50% a problem? Low reserves are a red flag to buyers, since they can expect much higher dues in the future or a special assessment that they have to pay. Lenders also avoid lending in communities with very low reserves for the same reason: the borrower they fund may not be able to pay a high monthly or one-time special assessment which triggers a foreclosure.
Boards and owners may be in for a financial shock when they receive their next reserve study. Responsible boards will increase their dues to keep pace with inflation, and once the inflation rate abates, reduce the dues increase. Boards that ignore their reserve studies and choose not to upset owners with an increase, may be just kicking a large financial rock down the road.
