For many years the focus of new residential development has been in planned communities, homeowner associations, and condominiums that offer safer, more attractive neighborhoods, recreational amenities and “maintenance free” infrastructure. However, buyers are not always aware of the simple fact that they are actually buying all of these elements in addition to their own home or unit. More importantly, when these improvements wear out or fail, the owners, through their association, have to replace them. Where does the money come from to do that?
In a perfect world, all capital projects, large, small, or unexpected, would be funded through association reserve accounts. The reality, though, has a way of intruding into perfect scenarios and many association boards and managers find themselves scrambling to find palatable funding options for large or unexpected capital projects. Below is a summary of the three primary funding alternatives available to associations.
The primary source for funding of all capital replacement projects is a capital replacement reserve fund. This usually is and should be; a separate savings account from the normal association operating account. It is a cost-effective and fair option as typically the reserve fund has been built over a series of many years by residents who have paid their fair share while living in the community. The key to adequately funding this account usually depends on the community obtaining a professionally prepared Capital Replacement Reserve Study and updating it regularly. Reserve studies estimate the likely cost of replacing these capital components, and also the expected remaining life of the components so that an adequate funding plan can be developed. Communities that have consistently updated reserve studies and followed recommended funding levels can usually fund upcoming projects in this manner. However, even the best communities may fall short due to unexpected events (e.g., early pipe failure, etc.) and will need to find a way to supplement available funds.
Special assessments are a quick way to raise additional funds without raising underlying assessments. While typically cost effective for the association, large special assessments can have a substantial negative impact on the community. Not all owners will be able to absorb large, unplanned assessments. This, in turn, may drive up delinquencies. In addition, a history of special assessments can have a negative impact on resale values as potential buyers may view the community as not planning well. Special assessments are an option to address specific projects, but they are not a replacement for adequate reserve funding. When considering a special assessment, it would be wise to include your reserve study analyst in this planning to ensure that it will accomplish its goal and see if other long-term funding adjustments need to be made to the reserve account. Finally, special assessments penalize the unlucky owners who happen to own when the special assessment is put in place, thus limiting the fairness factor addressed by funding over a longer time period. Be aware that special assessments may also require a vote by the community.
As associations age and face very large and/or unanticipated infrastructure projects, more and more communities are considering at least partial funding through a loan. A loan will allow costs to be spread out over the useful life of a capital item (some up to 15 years), thus permitting costs to be absorbed into ongoing assessments over a much longer period. This helps address the fairness issue as a loan will be paid back by both current and future owners who benefit from the capital item being financed. Be aware that acquiring a loan requires substantial work from both board members and management as authorization to borrow frequently requires a vote by the membership as well as the time and effort needed to complete the loan process.
Key questions to ask if you are considering a loan are:
- Does your community need a vote by membership in order to borrow?
- Who will administer the process as any loan will require additional administrative time and effort? If management, have you budgeted to compensate for the necessary effort to facilitate the process?
- Is there community buy-in? Are owners aware of what is needed?
- Is your community financially prepared for a loan? Are delinquencies under control? Are you budgeting appropriately to meet operating needs and future capital improvements not covered by the loan?
While each bank will have slightly different requirements, all lenders will want to see a community willing to make sound and realistic business decisions. If you are considering a loan, contact a lender who is familiar with community association loans and get their feedback. Most are happy to help and will give helpful input into the decision-making process.
Combination of All
Many communities need to get creative when faced with funding needs and implement a combination of the options listed above. For example, some projects may include using reserves, a special assessment, and a loan, thus spreading at least some of the cost out over a longer period.
Any shortfall in funding will likely cause at least some heartburn and handwringing among community members and require boards of directors and management to navigate a delicate political environment. Open communication is essential to successfully resolving and addressing funding shortfalls. Many communities have navigated this road, and there are definite solutions to funding capital projects. Reach out to experienced professionals such as management, attorneys, reserve specialists, lenders or auditors for advice, communicate effectively with owners and recommend sound business decisions. Doing so will help put your community on the path to making sound funding decisions for both immediate and future capital projects.
By Don Plank, CMCA, AMS, PCAM and Douglas Greene, RS
Don Plank holds a PCAM designation from CAI and managed community associations for 9 years before assuming his current position as Vice President of Association Banking Services at National Cooperative Bank.
Douglas Greene is an architect and holds a Reserve Specialist (RS) designation from CAI. He is a senior partner at DMA Reserves.