Inflation, Interest & Reserve Levels
"Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair."
~ Sam Ewing ~
I like the above quote as it sums up a lot about inflation and how it affects us in our daily lives. Prices keep going up all around us and it feels as if we are getting less for more.History
Government reported inflation rates in the United States have been relatively stable at 3-4% for the past hundred years. There have been short periods, such as during the 1970's when inflation rates spiked well about these levels but it would be considered a safe bet to count on a 3-4% rise in costs of goods and services on an annual basis.
What does this mean for your Association?
It means common area component expenses will rise substantially over the expected life of each component. Association dues will need to be raised to stay in line with rising costs of materials, labor and services. Ideally, annual increases in the dues should offset the inflation rate. Interest on Reserve Accounts will also help to offset rising costs but it is important to remember that the interest earned is based only on the actual balance in the reserve account while inflation affects the costs of all the common area expenses. Below is an example of this over a 30 year period.
Lets assume you have a reserve account with a balance of $80,000 which is generating a 1.50%, after tax, annual interest rate. Lets also assume the current costs to replace common area components would total $1,000,000 as of today, and the inflation rate is 3.5%. For the purposes of this example no dues are collected and no expenses are incurred, we are just letting the balances and costs ride out over a thirty year period.
Year Reserve Account Balance Current Component Costs Percent Funded Reserve Level 1 $80,000 $1,000,000 80% Good 2 $81,200 $1,035,000 78% Good 3 $82,418 $1,071,225 77% Good 4 $83,654 $1,108,718 75% Good 5 $84,909 $1,147,523 74% Good 6 $86,183 $1,187,686 73% Good 7 $87,475 $1,229,255 71% Good 8 $88,788 $1,272,279 70% Good 9 $90,119 $1,316,809 68% Fair 10 $91,471 $1,362,897 67% Fair 11 $92,843 $1,410,599 66% Fair 12 $94,236 $1,459,970 65% Fair 13 $95,649 $1,511,069 63% Fair 14 $97,084 $1,563,956 62% Fair 15 $98,540 $1,618,695 61% Fair 16 $100,019 $1,675,349 60% Fair 17 $101,519 $1,733,986 59% Fair 18 $103,042 $1,794,676 57% Fair 19 $104,587 $1,857,489 56% Fair 20 $106,156 $1,922,501 55% Fair 21 $107,748 $1,989,789 54% Fair 22 $109,365 $2,059,431 53% Fair 23 $111,005 $2,131,512 52% Fair 24 $112,670 $2,206,114 51% Fair 25 $114,360 $2,283,328 50% Fair 26 $116,076 $2,363,245 49% Fair 27 $117,817 $2,445,959 48% Fair 28 $119,584 $2,531,567 47% Fair 29 $121,378 $2,620,172 46% Fair 30 $123,198 $2,711,878 45% Fair Total % Increase in Reserve Balance Total Increase in Component Costs 54% 171% Over the 30 Year period
The first year indicates this Association has a "Good" reserve level and is considered to be 80% funded. It is in a position to adequately pay for reserve expenses as they arise.
Over the years though this number falls and by nine years out the percent funded is now considered to be of a "Fair" level; the Association risks having to impose special assessments when high expense components fail.
By 30 years out the Association is approaching a "Poor" funding level; the Association will soon be in a position of relying on special assessments and loans to pay for component repair/replacement.
This Associations reserve account balance has increased 54% but the component expenses have risen 171% over the same thirty year period.
Solution
From Year 1, this Association should increase dues at a 2.5% annual rate (Appreciation Rate 3.5 - Interest Rate 1.5% = 2.5%) and just slightly more if the Association's goal is to have a 100% funded level within this 30 year period.The above example simplifies the actual financials of an Association but it provides a visual of how Inflation can have a dramatic affect on an Association's costs and funding level over the years.
The above Association benefits from starting with a "Good" percent funded reserve level and all it needs to do is sustain this level. It has been our experience that most Seattle area Associations feature a "Fair" and even more typical "Poor" percent funded level. This places most Associations in a position of having to increase dues to keep up with inflation rates and to improve the percent funded level, of the Association.
Our goal is to create a financial plan, laid out in our Reserve Study, which will increase an Associations reserve level to a "Good" percent funded level, over a 30 year period. Interest and inflation rates are taken into account and dues increases are spread out over a 30 year period so that even an Association with a "Poor" funding level will see substantial improvements in it reserve level with realistic increases in dues.
Joel Tax
Reserve Analyst
Crescent Reserve Studies
Ph: 866.574.5115 ext. 4
Seattle Reserve Studies, Bellevue Reserve Studies, Tacoma Reserve Studies, Everett Reserve Studies