Thursday, December 27, 2007

Stealth Reserves: Tapping Unused Assessment Authority

We have written many times in this space about the consequences of underfunding the long term maintenance and repair accounts of common interest developments. The latest survey done by Berding & Weil and The Levy Company confirms that reserves required for long term repair obligations are shrinking industry-wide, and that the average community association reserves are only 53% funded. The result of this is that vital repairs—roof replacement, painting, repair of siding and trim, and similar work—may be either deferred or done in a substandard manner all because of lack of necessary funding.

The Genesis of a Financial Crisis

Community associations in this situation may not realize that they have a problem. The average person can look at a roof all day and not see anything wrong with it, so a plan to re-roof by a particular deadline may not seem critical—until the roof starts to leak. And if some knowledgeable expert is not available to explain the situation or to encourage necessary repairs, it is easy for the board to ignore the problem as long as there are no owner complaints. Delaying necessary repairs means that the cost to do them will be higher when they are done—deepening the funding quagmire. Once a problem has a repair price tag that exceeds the available cash in reserves, the board may not be able to easily solve the problem.

Borrowing to do necessary work is prevalent in the industry and can be an excellent solution as part of a well-thought out funding plan as long as repayment of the borrowed funds is part of the plan and does not deprive the association of contributions it must make for future reserve expenses. If the plan is that the loan for a new roof is to be repaid using contributions to the future re-roofing reserve, for example, your association is probably already, or soon will be in financial trouble.

Owner Resistance and Home Equity

All of this usually stems from failing to reserve sufficient cash on a regular basis to pay for future repair projects. And the reason most associations fail to do this is because raising the amount of the owner’s monthly assessments is guaranteed to draw criticism from members who often do not understand the economics of the situation. What they see is their monthly statement, and the check they write for perhaps three or four hundred dollars every month. While they are generally aware that a portion of those assessments are intended for long-term projects, they are not as well informed as the board on these matters and someone will surely object if the board raises assessments appreciably. Hence, boards are often deterred from doing this and assessments stay the same.

Sometimes, the plan is that if major repairs should be needed the board will propose a special assessment. But unless that special assessment is small (generally no more than 5% of the prior year’s budgeted gross expenses) a majority of the owners will have to vote to approve it. And if that means the owners must approve special assessments that are more than nominal, say several thousand dollars each, obtaining approval is uncertain. Projecting member approval of a special assessment as the primary method of funding a critical repair project is a risky business plan.

So given this double whammy—owner resistance to increasing monthly assessments and similar, if not greater, resistance to approving a substantial special assessment, many boards take an easier out—borrow the money. But if the idea is to repay the loan using cash that would otherwise be used for future reserve contributions, the board is following an ill-advised plan. Also, a bank loan may require that the members approve a special assessment to secure the loan which might still be difficult to achieve even though the payments are spread out over time. But an association may have more available resources than it realizes. Consider the following alternative.

Monthly Payments vs. Deferral

California real estate increases in value over time. Regardless of the cycles that influence the immediate prices of some homes in some areas, over time that fact has been reaffirmed year after year. If you can bridge short-term down cycles by holding the property for several years, there is almost no gamble on the outcome—your equity will increase. And often it increases in part because it is located in a well-maintained community. Most owners realize this and believe that regular investment in keeping the property in good condition will yield dividends at sale time. They just don’t want to have to increase their monthly payments to do it.

Many board members believe that if they assess an owner’s separate interest the assessment must be collected in the short term. There is nothing in the law that requires that—but it is a popular belief and associations also do not want to jeopardize their income stream with lax enforcement of their assessment rights. Also, the board must insure cash flow to pay for regular operating expenses—water, garbage, landscape maintenance, management, just to name a few. But reserves are a different story—reserves are used for projects that are often planned years in advance. And, except for emergencies, they can be funded on longer cycles, much longer than the monthly cycles used for operating expenses. The cash flow accounting method basically recognizes this and allocates the cash contributed by owners to coincide with the timing of various projects. But even this method does not deal with the question of when payments must be made by individual owners and assumes that they will be made monthly like all regular assessments.

Because reserve contributions are tied to the operating budget, and because operating expenses usually must take priority when funds are limited, natural owner resistance to increasing the amount of monthly assessments drastically limits the board’s ability to adequately fund reserves. However, if collection of the reserve contribution were handled separately and owners were provided an alternate, less painful means of funding reserves, it could prove to be a boon to community associations. As we said, owners usually recognize the connection between a well-funded reserve account and property values—they just don’t like, and many cannot afford, to make higher monthly payments.

Tapping the Unused Assessment Authority

One answer might be for an association to defer collection of part of that portion of the annual assessment that represents the reserve contribution to a later date—specifically to the date of sale of the unit, and collect it from escrow. Most owners would be less inclined to resist higher reserve contributions if they could pay it out of equity instead of from monthly cash flow. For one thing, equity is, in a sense, “found money” which accumulates due to the gradual rise in property values and the reduction in mortgage balances. It is not specifically earmarked or needed for anything other than perhaps the down payment on another home or emergency expenses. Also, even with many years of deferral, the accumulated total of assessments owed would not represent a very high percentage of the owner’s total equity, so the payment “pain” would be minimal.

This source of funding could reasonably be labeled “unused assessment authority” since common interest developments in California have the statutory right to increase monthly assessments up to 20% over the prior year’s assessment, but for the reasons stated above, rarely do it routinely. If an association had an annual assessment of, say, $4800.00 per unit, the board could, without a vote of the members, increase that assessment to $5760.00 the following year—an increase of $960.00 per unit. Now a board would not likely impose assessment increases of that magnitude on a regular basis, but it illustrates the point—that boards of directors of community associations have sufficient statutory authority, right now, to make meaningful contributions to reserves if they chose to exercise it. And there is nothing that requires that increase to be spread across the entire budget pro rata—it could all go to reserves, so long as provisions were made for operational emergencies. If the present reserve contribution were say, 20% of the total annual assessment, this increase alone would result in doubling the annual contributions to reserves! It wouldn’t take too many increases in reserve funding like that to make up most routine shortfalls.

But assessing and collecting are clearly two different things, and that’s why a policy which permitted an owner to defer payment of some or all of the reserve portion of their annual assessment until they sold the unit might be a powerful incentive to boards to increase the amount of those contributions and for owners to be right with it, thereby avoiding a potentially disastrous deferral of needed repairs. Various studies have placed average turnover of homes in California at right around seven years. With condominiums, that time is likely much shorter. But even a seven year cycle of turnover could provide a reserve cash flow sufficient to fund long term repair and maintenance if the projects were well-planned and the amount of deferral permitted was synchronized with the plan and the expected turnover rate for that association.

Of course, the CC&Rs would have to be reviewed for any constraining language and steps would have to be taken to obtain adequate security for the deferred amounts in the form of an assessment lien that stays current with the amounts owed. The board would also have to reserve for itself the option of ending the deferral if emergencies arose or if a unit remained unsold for too long, and that option would have to be carefully explained to the members. Also, the association’s accountant must review any plan to defer collection of assessments to be sure that planned deferrals do not interfere with the board’s ability to properly conduct the business of the association. Finally, legal counsel should be called upon to fashion an agreement or amendment to the governing documents which specifies the conditions and obligations attached to any deferment. These obligations would have to remain secured by appropriate liens on the owner’s interest, and associations would have to be diligent about putting payment demands into escrow, but those procedures do not represent anything very different than is now done in collecting regular assessments, and all of this could be accomplished most probably without any change in existing law.

Deferral Mandates Increases in Assessments

We are not suggesting deferring collection of a portion of the monthly assessment if it is presently at a level that already does not adequately cover the reserve contribution. Only if the board were willing to use its untapped assessment authority to increase the association’s contribution to reserves, does deferring collection make any sense. Using deferral when collections are already inadequate would just make matters worse. A decision to defer must be accompanied by a well researched plan which takes into account the association’s true future reserve needs, along with the political will to raise monthly assessments sufficiently to meet those needs. Deferral is just a collection tool which could assist boards in collecting more funds than monthly collection presently allows. Deferral as outlined here is in essence a loan by the board to an owner, secured by that owner’s equity. Like any loan the deferred amount should bear interest to at least keep up with inflation. The consideration for the board’s willingness to defer, however, has to be a greater contribution to the reserve account to justify extending this option to owners.

The shortfall in reserve funding is increasing annually and it has made itself known already in many associations that cannot afford to make essential repairs. Cutting the owners some slack through payment deferral could help a board realize the benefits of its substantial unused assessment authority and encourage it to adequately fund the association’s reserves.

Thanks to Jim Devereaux and Steve Weil of Berding & Weil for several suggestions and helpful editing.