Financial Fitness for Tomorrow, Part Two

By Kathy Danforth / Published March 2017

Editor’s Note: Part One was published in the February 2017 issue.

R

eserve Expenses

On the opposite side of income are the expenses. While operating costs require monitoring, obtaining competitive bids, etc., it is the major replacements and projects that can overwhelm community finances. “Reserves are by far the most effective way to pay for these major, predictable expenses,” says Will Simons, RS, with Association Reserves.

“If a community is waiving reserves and the money for future projects is not being accumulated over time, future owners—including some current owners—will have a special assessment or require a bank loan when the association needs a lump sum of cash all at once,” Simons relates. “Not funding reserves is always a bad idea because it’s a shock to the owners when the only way to pay is a special assessment or a bank loan, which causes the project to cost more than it should.”

Funding reserves is also a matter of fairness and responsibility. Matt Kuisle with Reserve Advisors states, “New boards should understand their responsibility to maintain and preserve their communities for the benefit of current and future owners. Reserves are not for “future” expenses. Instead, they are for the portion of wear and tear on the common elements that our communities experience each day. Providing adequate reserves will help secure the financial health of their community, fulfill the fiduciary duty of the board, and provide peace of mind for their homeowners.”

Simons reports, “We are seeing new buyers paying more attention to reserves—smart buyers are wanting to see reserve studies and financial information before buying because they don’t want to pay more than their fair share or be stuck with a special assessment. With adequate reserves there is a smaller chance of work not being done, from waiting to paint to using outdated equipment or having lackluster amenities and common areas that are not serving their purpose. There are so many variables in price that the value of reserves to a home’s selling price is hard to quantify, but accountants, realtors, and mortgage brokers are all asking more questions about reserves, especially since 2008.”

Kuisle concurs, and adds, “A board that does not make the pro-per disclosures or follow the statutory requirement for funding and spending reserves exposes themselves to claims of mismanagement and breach of fiduciary duty. Board members can be held persona-lly liable for these decisions, which aren’t always covered by Directors and Officers insurance.”

Kuisle explains that for Florida condominiums, “The budget must include reserve accounts for roof replacement, building painting, pavement resurfacing, and any other item for which the deferred maintenance or replacement cost exceeds $10,000. For homeowner association boards, a reserve fund must be maintained, and its use is restricted if it was originally established by the developer prior to turnover or by a majority vote of the homeowners. In other words, if an HOA board simply makes a motion to establish a reserve account, that account is considered voluntary and those funds may be used on other items.”

However, Simons points out that boards are only required to present a budget fully funding reserves; the homeowners can petition to request an alternative budget with reserves less than fully funded or waived entirely. “In our experience, the number of associations that waive fully funded reserves is not a majority of associations, but it is a significant, scary number. There is never a case where that’s a good idea, and it’s always a red flag when we’re working with associations that have waived reserves in the past.”

Kuisle advises, “It is the board’s responsibility to fully fund those reserves that are not waived or reduced by an owner vote, so if there is not a quorum or sufficient votes to waive, the full funding amounts go into effect.” He adds, “According to a national study done by the Foundation for Community Association Research, 18 percent of communities do not believe they are setting aside adequate reserve funds. In my experience, I would say the actual number is much higher, but I think a majority of communities actually don’t know if they are fully funding. They may promote ‘fully funded reserves,’ but the schedule they adopt is missing major components like concrete restoration or balcony railings. This is really a bad situation for the boards when the time comes for repairs or replacements and they don’t have enough money, despite their claim of passing a ‘fully funded’ reserve budget each year.”

“There are many different reasons why they get into this situation,” Kuisle observes, “but I think most boards simply do not fully understand the extent of their fiduciary duty to the association. They allow themselves to believe that the monthly fees will be ‘too high,’ or ‘We’re not going to be here when…’ to the detriment of future boards and owners. I’ve talked with many boards and managers who simply don’t want to know. I call this the ‘ostrich approach’ to reserve funding.”

Even for communities that are intending to fund reserves and avoid special assessments, there are common errors. Kuisle stresses, “Without question, concrete restoration, balcony railings, plaza decks, and other structural components are often overlooked in reserve planning. Plumbing and electrical systems are also often overlooked, as they are out of sight and often out of mind. In HOAs, we also see the ponds and drainage systems overlooked. There is a debate on whether reserves are required by statute for these items, but given the scope and cost of these projects, I highly recommend boards include reserves for the large, inevitable expenses. In addition, we are finding that many systems that rely on technology (security, fire alarm equipment, elevators, etc.) are experiencing sho-rter lives due to changes and more frequent upgrades to software and hardware.”

“Sometimes communities will miss interior renovations—painting, remodeling, or replacing carpeting in lobbies and amenity areas,” Simons observes. “A bigger issue can not be going into enough detail for a mechanical reserve, which can include everything from elevators to air conditioning to security cameras, each with a significant cost and a different life cycle. If you lump items without attention to detail, you run a higher risk that you won’t have enough money when you need it.”

To avoid unpleasant budget surprises, Simons says, “We usually set the bar a little lower, at projects costing $3,000–$5,000 and up, for all but the largest associations. If six $5,000 items need attention in a year, that $30,000 usually can’t be absorbed into the budget. To the extent that items are predictable, it’s better to fund them with reserves to eliminate the surprise and risk.”

Two commonly used methods of reserve funding are the component method, which was required until 2002, and the pooled method. With the component (or straight line) method, separate fund accounts are maintained that can only be spent for the specified individual purpose unless the majority of owners vote that the money can be used for another reserve item. “Many still use this method,” says Simons. “Some don’t know there’s a more efficient method, and some prefer the idea of increased accountability. I consider that a misunderstanding since pooled reserves can only go to expenses for listed components.”

According to Kuisle, “Because the statutes state that reserve funds can only be used for authorized purposes, the pooled method allows boards more flexibility to spend the reserves on any item in a group of assets instead of just one singular asset. The pooled met-hod typically results in lower funding requirements, while the component method usually results in having more savings on hand at any one point in time. Moving existing component reserve funds into a pooled reserve does require a majority vote of owners in advance at a duly called meeting.”

“We strongly recommend pooled reserves, which is the industry standard,” advises Simons. “It takes a vote of the owners, but once you do it you never have to do it again, and there is much less administrative hassle.”

Unless an insurance deductible has been included as a listed reserve item, Simons does not recommend tapping the reserve fund for that expense. “You risk not having the money for the specified projects when needed. If there is no emergency fund available, we recommend a special assessment. There is a time when a special assessment is the wisest choice for a one-time, infrequent expense. A fairly new option for condominium owners is individual insurance coverage for any special assessment for a hurricane deductible, which sounds like a good idea to check into!”

Simons advises, “It’s important to look at reserves every year and to look at the big picture. Reserves should be one of the biggest line items, but last year’s number is not necessarily good this year. Work may have been done without updating calculations. Industry trends may affect prices; building materials such as asphalt, paint, and roofing material are all tied to the price of oil. If the real estate and construction market are booming, contractors may be busy with new construction so the cost of renovation may go up. No one wants to pay more in association fees, but if the consequence of lower fees is lower property values, it may not be worth the short-term savings.”

Creditworthiness

For various reasons, an association may determine that a loan is the way to move forward in some situations, so it is important to know what criteria a bank may look at to determine if they are willing to loan money. And, since banks are assessing financial health, some of the factors can be considered as a general financial check-up even if they are not preparation for qualifying for a loan.

Janet Romano with Stonegate Bank notes, “Most of our loans are made to associations that are already customers, so associations know in advance what we are looking for to approve a loan. For example, I will tell them to clean up their delinquencies before they apply. In considering a community for a loan, the delinquency rate is an important factor. We do not want to see more than five percent of owners behind by more than 60 days.”

“We also look at the amount being borrowed,” says Romano. “The per-unit share of the loan should not exceed 10 percent of a home’s current selling price. Also, the monthly payment amount should not increase the current maintenance fee by more than 50 percent. If it does, then we would require a vote of the unit owners because we are looking at whether the people can support this loan.”

The association’s regular pattern of funding reserves is also up for review. “We want to know whether other capital items might require funding during repayment,” Romano notes, “and if they are funded by reserves. For any loan more than $1,000,000, we will want to see a reserve study to make sure everything is covered.

“Other factors are intangible—is there a stable board and management? Don’t call the bank two weeks after a board recall. For their protection and ours, we need a letter from an attorney that the board is allowed to borrow money for this purpose; or if an owner vote is required, that it was properly held. The letter will need to state that the parties are entitled to take out the loan, they are in good standing, and there are no substantial lawsuits against the association. Also, it should state that the project is not a material alteration requiring a vote of the unit owners.”

Most associations are not facing the rigorous financial pressures of five years ago, but there are still plenty of challenges in balancing needs of the residents, documents, laws, and budget constraints. Proper accounting controls, budget preparation, watching trends and changing regulations, managing funds in accounts without risk of losing principal, technology upgrades, and more will all affect a board’s financial governance. As guardian of the finances, a board has a wealth of work cut out for them.

 

Contributors:

Will Simons is with Association Reserves. For more information, call (800) 403-9011 or visit www.reservestudy.com.

Matt Kuisle is with Reserve Advisors. For more information, call (800) 980-9881 or visit www.reserveadvisors.com.

Brad Schneider is with CondoCPA. For more information call (877) 900-1040 or visit www.condocpa.com.

Janet Romano is with Stonegate Bank. For more information, call (866) 227-0441 or visit www.stonegatebank.com.