Cash Flow Analysis
The Cash Flow Analysis has become the most accepted method in the industry today. With the exception of the State of Florida which has some restrictions on the use of this method; it is the most widely used across United States.
The cash flow method is essentially a snapshot in time, typically 30 years, where all the costs are added up and then evenly divided annually to the membership of a community over that 30 year period. This method is more flexible and typically requires a lower reserve allocation rate. Components are not segregated and funded for, so this method requires less time and accounting then the component method. Most communities and organizations have found that this method is more in line with their long-term budgeting goals and requires less time to accurately and reliably follow.
The downside to the cash flow method is that it is not as conservative as the component method and there is a slightly higher risk for reliance on special assessments particularly in years when there are a high number of component failures (Peak / Threshold Years). This risk can be minimized as long as a community or organization remains in a good funding level which would typically be 70% Percent Funded or higher.
The Component Method
The component method has become less utilized in recent years as it is more conservative and usually requires higher reserve allocation rates and correspondingly higher homeowner’s association dues. With the goal of most communities and organizations to keep their dues as low as possible this method has fallen out of favor.
The component method also requires significantly more time and understanding of the concepts to accurately and reliably follow. This method is not a snapshot in time but requires the board to save for each component separately. An example is that funds for a roof could not be utilized for replacement of the siding. In this case if the community did not have enough reserve funds to pay for the siding replacement they would need to utilize a special assessment or loan even if there were ample funds in the reserve account. This does not make much sense in a community or organization that has many components that all have different useful lives, associated costs and a large reserve account balance. This method is very conservative so when it is implemented accurately it has an extremely low risk for reliance on special assessments or loans. However in a real world situation this has proved to be extremely difficult specifically as time progresses and there are different boards with different opinions and changing goals for a community.
Some reserve study professionals will provide both of these methods in the final report however we typically do not suggest communities or organizations choose this option as I can be difficult to follow correctly and very time-consuming.
Written by Joel L Tax - Professional Reserve Analyst - 03/15/2016