Has your Board, especially if it has a financial professional on it, ever looked with dismay at the low interest that a Capital Reserve Fund is earning? They may think that if they could get a better return on that Reserve Fund, then they could do more projects. Or they could reduce assessments.
This is when they ask about investing the Reserve Funds. Some of the questions that I get the most are:
- How can an Association invest their capital reserve funds?
- Does the Association need to keep its money in CDs?
- Can it invest in the market to get a better return?
Here's my answer: When an Association invests its Capital Reserve Funds, the priorities need to be in this order:
- Safety - The investment needs to minimize the risk of losing money.
- Liquidity - The investment needs to be available when the Association needs it.
- Return on investment - This is a distant third priority behind safety and liquidity.
Where to Put Capital Reserve Funds
I believe that Associations should only invest in very secure places. By "secure" I mean:
- Savings Accounts
- Money Market Accounts
- Treasury Bills and Bonds
And that is about it for my list. In Reserve Funds: How & Why Community Associations Invest Assets, published by Community Associations Institute, the writers give "Generally Accepted Guidelines for Investing Reserves." They suggest a model for investing reserves based on the need for the funds. They recommend:
- Funds that may be needed in one to three months should be placed in federally-insured money market accounts.
- Funds that will be needed in three months to one year should be invested in short-term CDs or Treasury bills. These should be purchased in a staggered or "laddered" timing so that they do not all mature at the same time.
- Funds that will not be needed for a year or more should be invested in staggered or laddered CDs or Treasury notes.
Here is what the Pennsylvania Uniform Condominium Act and Uniform Planned Communities Act has to say about investments:
In managing the association's reserve funds, the officers and members of the executive board shall have the power to invest the association's reserve funds in investments permissible by law for the investment of trust funds and shall be governed in the management of the association's reserve funds by 20 Pa.C.S. § 7203 (relating to prudent investor rule).
The "Prudent Investor Rule" makes the Board "consider the purposes, terms and other circumstances of the [Reserve Fund], and pursue an overall investment strategy reasonably suited to the [Reserve Fund]." This Rule has all of those fuzzy terms - "other circumstances" "overall" and "reasonably" - that drive clients crazy.
Plus, these are going to mean different things for different Associations, depending on their financial health and looming capital projects. But we can try to figure out how a Board should think about investing Capital Reserve Funds.
Questions a Board Needs to Ask
These are the questions that a Board needs to ask before coming up with an investment strategy. They are:
1. What is the expectation of the Unit Owners?
This is the most important question. If a Unit Owner has been paying into the Capital Reserve for years, what do they expect? They expect that the money that they paid is sitting there, available to the Association to use when necessary. It is not an investment that the Unit Owner hopes will appreciate in value. Rather, it is a part of the value of their home.
If your Association is FHA approved, you may have additional requirements regarding your capital reserve fund as well.
2. How liquid does the investment need to be?
All Unit Owners expect that their Capital Reserve will be available to fund the capital projects when they are needed. Imagine needing to repave a parking lot. Hopefully, the Unit Owners have been paying into a Capital Reserve Fund for years so that all of the money for the project is there. It would be awful if that money was tied up in an investment that could not be liquidated to pay for the project.
3. How good is your Reserve Study and Capital Plan?
This is very closely related to liquidity. If the Association has a good Reserve Study, then it has a good idea when it will need to dip into the Reserve Fund. If the Association plans on replacing the roof on the clubhouse in 10 years, then it can make an investment that ties up that amount of money for 10 years. If there is not a Reserve Study, then the Association needs to have greater access to its Reserve Fund in case it needs to make emergency repairs.
4. What are the income tax considerations?
Generally, Associations do not pay tax on what the IRS calls "exempt functions." This includes assessments but usually does not include interest income or capital gains on the sale of stock. If the Association makes money on its investments, that income could be taxed at a rate of 30%.
This is not a full picture of the income tax considerations, and it is not meant to be tax advice. (For example, the tax rates vary based on the form used to report any income. And there are rules that affect funds that are earmarked for a specific capital project. The bottom line is that it is complicated.) But the Board should consider that the return on investment might not be as great as it looks initially.
5. How much risk is the Board willing to take?
Again, I am talking about legal risk, not financial risk. If the Board invests the Capital Reserve Fund and it loses money, the Association could be liable. This is called a "surcharge" - basically all of the money that the Reserve Fund lost. If the Board puts the Capital Reserve Fund in a series of CDs, they will not get in trouble because the Reserve Fund did not make enough income.
This article is NOT financial advice. I am only looking at the question from a legal and practical perspective. There is not a lot of guidance from the law when it comes to Capital Reserve Funds. Unfortunately, there is nothing that says that an Association has to do something or is not allowed to do something else. The Board has to figure out what investment strategy is best suited to the Community.
I feel that investing the Capital Reserve Fund in guaranteed, safe investments is always a good answer. Even if it is unlikely, if the Capital Reserve Fund loses money, it could cause lots of problems in the Community.
Originally published 27, May 2021
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.