3 Options for Funding Capital Improvements
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“Keeping up with the Joneses” and maintaining property values in your association starts with preventive maintenance – but it doesn’t end there. To enhance the resident experience and to attract future owners, you must invest in strategic capital improvements. From renovating your clubhouse or lobby to adding more electric vehicle (EV) charging spaces on the property, capital improvements play a key role in building your reputation in a highly competitive market.
What exactly IS a capital improvement? There’s a lot of confusion around the topic. Investopedia defines it this way: “A capital improvement is the addition of a permanent structural change or the restoration of some aspect of a property that will either enhance the property's overall value, increase its useful life or adapt it to a new use.” Capital improvements are meant to be long-lasting; tasks like painting that have to be done routinely don’t count.
“Capital improvement projects cover a broad spectrum, from lobby renovations and elevator modernization to replacement of mechanical systems, concrete restoration, clubhouse upgrades and even a new structure or amenity,” said Andrew Lester, president of FirstService Financial, the financial services arm of FirstService Residential. Some capital improvement projects may also be material alterations, which may be subject to certain restrictions in your association’s governing documents or state law. Consult your association’s attorney before undertaking a capital improvement project.
Because capital improvement projects are meant to last, they tend to be relatively expensive and require an investment in the future of your high-rise or community association. So how can you pay for them? Here are three options for funding capital improvements.
1. Look to your reserve fund.
Your reserve fund should be your association’s go-to for funding repair and replacement of your existing assets. That means it’s even more important to ensure that your reserve fund is adequately funded to pay for those projects. Unfortunately, that’s not the case for many associations. According to FirstService Financial, up to 72% of community associations in the United States have not properly funded their reserves and may run into financial trouble because of it.
The key is to update your reserve study on a regular basis, at least every few years, to avoid surprise budget overruns. This is especially important when planning for work that will be done 10 or 20 years in the future, or even longer. “I once worked with an association that funded their reserves fully in preparation for a roofing replacement,” said Richard Breske, director of client relations, client accounting, at FirstService Residential. “Unfortunately, they hadn’t updated their reserve study in a few years. Even though they had the original $900,000 for the project saved, they didn’t account for inflation or materials cost increases. The actual cost was $1.4 million and they had to look for another source of funding to bridge the gap.”
Work with your association attorney to determine if your state has any legal requirement that associations fund reserves to a degree. Keep in mind, there are also other requirements associations need to think about. The Federal Housing Administration requires that condominium associations fund their reserve in the amount of at least 10% of their annual operating budgets. If you anticipate that potential buyers into your association will want to take advantage of FHA programs, then it’s in your board’s best interest to fund your reserves appropriately. However, while 10% funding is the minimum required, that funding level will not meet the levels required for most major capital improvement projects.
What can occur if you don’t keep your reserves adequately funded? You may not be able to pay for important repairs, replacements and major projects, which can open your association up to liability or safety risks. Failure to maintain your community or high-rise is one of the most common causes of residents suing an association for breach of contract, for negligence and even for injuries caused by improper maintenance. Avoid lawsuit potential and keep your residents safe by funding your reserves properly and making repairs and replacements when needed.
Quick note: As an alternative to using reserve funds, there are some capital improvement projects associations may be able to fund by including the costs in their operating budget. However, this is typically the least recommended option, as it means those costs are passed onto the membership in their regular assessments. “We don’t often recommend funding capital improvements via operating funds,” said Hector Vargas, president at FirstService Residential. “This has a major impact on homeowner assessments, which can deter potential buyers. When assessments are high because capital improvements are included in the operating budget, it may adversely affect marketability and property values.” Boards should always consult their association attorney before funding a capital improvement project with their operating budget.
2. Impose a special assessment on the community.
If your reserve account does not include enough funds to cover your capital improvement project or if you have not reserved for the specific project you’re considering, you will need to look for other funding sources. The most obvious (but understandably the least popular) way to fund a capital improvement is by levying a special assessment on the membership. In some cases, a special assessment is unavoidable, due to an emergency or unexpected project. Even if your association has a robust preventive maintenance plan and well-funded reserves, surprise expenses do happen. Even so, special assessments aren’t generally received positively – they may even result in conflict or anger from residents.
The primary benefit to a special assessment is that the association isn’t assuming any debt, making it a viable option for some communities or high-rises. However, not all homeowners can easily afford the burden of a special assessment. If your board is considering levying a special assessment, think about the impact on your homeowners and offer payment plans if possible. The drawback to that is that you may not get all of the money in time to complete the necessary work and may need to consider other funding options if the situation is critical.
Your ability to special assess may be limited by your association’s governing documents or state law. Consult with your association’s attorney before levying a special assessment. Also, when planning a special assessment, remember to actively communicate about the need for the special assessment and explain how it will positively impact the association in the long term. Similar to regular assessment increases, the key to maintaining a harmonious environment and alleviating resident concerns is proactive and consistent communication with the membership.
3. Use a loan to pay for projects.
Thirdly, associations can use a loan to pay for capital improvements. Borrowing money for these types of projects is common among associations. Unlike a special assessment, a bank loan allows unit owners to pay for the construction project over a long period of time and to spread the cost of an improvement over generations of homeowners, so that work is paid for by all the people who enjoy the benefits of it. While loans do come with interest and fees, they may be the most feasible option to pay for a large project.
Your property management company and financial services partner should help guide you to the right loan for your association. By working with providers that have a large network and relationships with financial institutions, you’ll often be able to save money on interest and fees and get support with the application process. For example, because of its existing relationships with financial institutions, FirstService Financial is able to negotiate on behalf of FirstService Residential-managed communities to help them get better rates than they would typically on their own.
“One of our communities needed a loan for an unexpected project. Working with FirstService Financial’s recommendations, they were able to borrow $850,000 at a great interest rate and with only $500 in closing costs,” said Jorge Dominquez, regional director at FirstService Residential. “The process took less than 30 days, start to finish, and the board was pleased to have this option rather than depleting their reserves or levying an assessment.”
Your ability to borrow money may be limited by your governing documents or state law. Again, make sure you consult with your association attorney and governing documents before beginning the loan application process to ensure compliance.
What are the benefits of using a loan to fund capital improvements?
- There are typically no prepayment penalties for making additional principal payments or paying the loan off entirely. In most cases, the only time a prepayment penalty applies is if the loan is refinanced with another lender.
- Most banks will lend up to 10 years, but banks often extend amortization to 15 or 20 years. This reduces the monthly payment and makes financing more affordable for your homeowners.
- Closing costs are minimal for association loans. Since there is no physical collateral, the title and attorney fees are much lower than if real property were involved.
Watch the full video!
How will you fund your next capital project? Watch our video to learn the pros and cons of the most common capital improvement funding options.