Beg, Borrow or Assess
The solution de jour for the funding of major projects and required reserve maintenance items seems to be to have the Association borrow the money and include the principle and interest payments as part of the maintenance fees.
Is this the best solution? What are the alternatives?
We can and do continue to beg associations to fully fund reserves so special assessments and the resulting trauma do not fractionalize the membership. Most of our clients do fully fund reserves, but some hear the song of the siren and do not want to raise the maintenance fees to a level felt might be uncompetitive in the resale marketplace. Alternatively, they assume many of the residents will no longer live there or even be alive when something needs replacing. Let's look at the real cost of this alternative.
Even the best planning can result in a shortage of funds and if this occurs Board members often, erroneously, take on a personal feeling of responsibility for those shortages. As if they should have known oil prices would double the cost of roofing materials, or workers comp rates would go up precipitously, or insurance rates would quadruple and cause a budget shortfall. However, more often than not the reason for shortage of funds is budget and maintenance fees being determined politically and not realistically. Therefore, with this guilt the Board feels a responsibility to rescue the membership from the insult of a special assessment and looks for alternative funding. We will look at the different forms of borrowing.
Maintenance fees are, according to Chapter 718 Florida Statutes, the Condominium Act (Act) are assessments. The "S" word we now run into is "Special" Assessment. Special assessment means any assessment levied against a unit owner other than the assessment required by a budget adopted annually. Special assessments are levied to meet budget shortfalls, under funding of reserves, funding for special projects, material alterations, improvements, modernizations and unexpected expenses. This is the most common and easiest form of raising the necessary money for the needs of the association. Traditional waiver or under funding of reserves is the precursor of special assessments.
For the sake of this discussion, we will suppose the needed funds are for replacement of a reserve item (painting, paving, roofing, etc.). For whatever reason, the association is short $100,000 for an item that had a ten-year life and was not covered by any reserve funding.
Before we cover the costs associated with paying for this item it must be mentioned that the Division of Florida Land Sales, Condominiums and Mobile Homes (the Division) amended the Administrative Code (the rules of the game) last year to allow pooling of reserves. See https://www.flrules.org/Default.asp and look in Chapter 61B 22.005. Many modern associations have been using this tremendous tool for years. It allows full funding of reserves at a contribution rate well below that required for straight-line reserve contribution. Ergo, fully funded reserves may be possible when previously only partially funded. It may be possible to pay for that huge insurance increase and still fully fund the reserves without a maintenance fee increase.
Now we can look at the costs involved in the raising of the $100,000 needed.
If we were reserving $10,000 per year for 10 years, we would have $100,000. We will assume the interest rate earned is equal to the inflation factor and the amount of interest earned was less than would be required to pay income tax. For a 100-unit association it is $100 per year or $8.33 per unit per month.
If we borrow the $100,000 for a ten-year period at the current commercial rate of around 7%, we will be paying $1,161.08 per month for a total of $139,330. On top of that, there will be closing costs, attorney fees, UCC filing fees and Doc stamps for about another $3000. Now we are at $142.33 per year or $11.86 per unit per month. Then the item will need replacing; again we will not have any money to do it and will have just finished paying for the old one.
If we special assess the membership, the cost to the association is zero and it has $100,000 available to do the job now. It can then institute good business practices, adopt pooling of reserves and probably end up having the $100,000 available in ten years without increasing the maintenance fees.
What about the association's presumed responsibility to minimize the trauma to the membership with having to come up with $1,000 each on short notice? Let us look at the availability of funds from the membership.
If they use savings, they are currently probably only getting 1% on their money. It does not make sense to have the association pay 7% and have money in the bank only earning 1%. They are 6% ahead by paying from savings.
If they have stock the cost of margin funds should also be much less than 7%.
However, there is an even easier way to borrow money, a Home Equity line of credit. This is where the association can be of immeasurable assistance.
The interest rate for a Home Equity line is currently around 4% and that interest is supposed to be deductible on federal income tax. This could (in the 30% bracket) result in a real rate of less than 3% on the money borrowed or based on the 10 year term we are at $114.77 per year or $9.56 per unit per month. There is also no prepayment penalty and no up-front cost. Additionally Home Equity lines of credit usually are for a larger amount than the $1,000 used in this example. However, there is no requirement to use the money on any set schedule or to make principle payments on a fixed schedule.
The relationship the association has with the bank should facilitate the conclusion of whatever scenario you want to attempt. The bankers we talked to were more anxious to get 100 new equity line customers than in loaning the association the money. Your manager should be able to set up the whole program for the association. The bank will provide all the paperwork and the association will disburse it with the explanation as to the benefits to the members and to the association. No one is obligated to set up the equity line and has the option of paying the special assessment any way they want as long as it meets the schedule required by the association. The association does not even have to know or care who is taking out the line of credit with the bank.
These examples are reflective of today's interest rates and can be extrapolated for any set of circumstances.
In conclusion where do we stand?
Full Funding of reserves as soon as possible is the least expensive and now with pooling available provides flexibility and insurance for unexpected requirements. ($100 per year)
The Association borrowing the money is the most expensive and provides no tax benefit to the members ($142 per year). Additionally if an individual owner doesn't pay his share the Association members have to pick it up and pay it as part of the common expense.
A Home Equity line of credit provides the membership the flexibility of paying the assessment as needed could provide tax benefits and allows individual determination and privacy concerning personal business ($115 per year).
It may now be possible to hire that professional you always wanted, but didn't think you could afford, to provide the higher level of services the association members deserve.
Mark Benson, CMCA®, AMS®, PCAM®, CFPM®, Association Times, February 2007