Reserve Funds, Assessment or Loan? How to Pay for Capital Improvements
Sure, it’s what’s on the inside that counts. But it’s what’s on the outside that matters to residents and potential homeowners. A great-looking and well-functioning community is the difference between languishing and rising property values.
Whether a San Diego homeowners association decides to add a new spa or a San Francisco high-rise needs a new roof, these big capital improvements have a huge impact on residents and the HOA’s reputation in the community at large. (Don’t let maintenance neglect turn into a capital improvement. To learn how to prevent this, read our article, “HOA Maintenance, Capital Improvements and Useful Life: Are You Prepared?”)
The question is, how do you pay for capital improvements? And what are the pros and cons of using one option over another?
Pros: Reserve funds are designed to fund capital improvements. In the best case scenario, when a piece of equipment or part of your facilities reaches the end of its useful life (or you’re looking to make a valuable addition), you use your reserve fund to pay for it.
Option 1: Use your reserve fund
Cons: Reserve funds do have restrictions for what they are used for. In California, according to civil code 5510, reserve funds should not be used for anything other than the “repair, restoration, replacement, or maintenance of, major components.” Consult with your association attorney before tapping into your reserve fund to make sure you are using it for the right job.
“But, what if I don’t have enough to cover the costs?” You’re not alone. According to a 2013 study by Association Reserves, approximately 72 percent of associations have “under-funded reserves.” This means boards do not have the funds to pay for items when they reach the end of their useful life. Make sure your reserves are properly funded, or your association may not be able to take care of your community’s assets. Your HOA may even be sued for breach of contract, negligence or injuries caused by improper maintenance.
Even if you have fully funded reserves now, that might not always be the case. California’s rising minimum wage rate will undoubtedly affect your reserves. Click here to learn more.
Pros: Taking a special assessment on HOA members is a viable way to fund a capital improvement, especially if your reserves come up short. The biggest benefit from utilizing a special assessment is the fact that your HOA will not assume any debt. However, before you take this step, always consult with your HOA management company, association’s attorney and your governing documents.
Option 2: Take a special assessment
Cons: Mention the phrase “special assessment” and you will get groans from your residents (at a minimum). To help mitigate this, you’ll need to formally explain why the community will benefit from paying for this capital improvement to defend against backlash from homeowners. (Pro tip: partner with your property management company to create a strategic communication plan.) Aside from facing disgruntled homeowners, you’ll also need to prepare in case homeowners cannot afford to pay the assessment up-front and need to coordinate a payment plan.
You’ll need to formally explain why the community will benefit from paying for this capital improvement to defend against backlash from homeowners.
Pros: A loan may be your best bet to pay for a capital improvement, as there are many benefits. For starters, HOAs will generally not receive prepayment penalties for making additional principal payments or paying the loan off completely. Typically, the only time a prepayment penalty applies is if the loan is refinanced with another lender. Also, while most banks will lend up to 10 years, many banks extend amortization to 15 or 20 years. This reduces the monthly payment and makes financing more affordable for associations. Lastly, closing costs are minimal for association loans. Since there is no physical collateral, the title and attorney fees are often much lower.
Option 3: Get a loan
Most banks will lend up to 10 years, but many banks extend amortization to 15 or 20 years. This reduces the monthly payment and makes financing more affordable for associations.
Cons: There aren’t many drawbacks to using a loan to pay for your capital improvement. As with all of the options above, you will need to consult with your association attorney and governing documents to make sure you are abiding by association bylaws. Additionally, make sure you are working with your HOA management company’s financial partners to ensure that you are getting the best, most competitive interest rates.
In 2017, our affiliate FirstService Financial closed $185 million in loans, making a significant impact for FirstService Residential clients.
“What option is best for my association?”
Selecting the best way to pay for a capital improvement can be challenging. There are many factors to consider, and you want to ensure that you are protecting your HOA’s financial health and helping propel its vision. That’s why it’s critical to work with an experienced management company that has access to a team of seasoned financial experts and a network of experienced HOA professionals.
These experts provide guidance in making the right investment decisions that will benefit your community in the long run, from both a fiscal and lifestyle perspective. For example, one Palm Desert active adult community partnered with community manager Eric Angle and FirstService Residential to determine what capital improvements would be most cost-effective and beneficial to residents over the long haul. To focus on the right elements, Angle worked with FirstService Residential’s network of on-site managers in similar communities. He said, “We provided the board with guidance for capital improvements based on local and national trends and based on what had worked and failed in other communities.” Having this kind of support when making financial decisions is absolutely crucial.
“We provided the board with guidance for capital improvements based on local and national trends and based on what had worked and failed in other communities.”
If you’re not doing basic maintenance the right way, your options for capital improvements will be limited. Not sure where you stand? Complete the form to download our free guide, “11 Questions to Assess the Health of Your HOA Maintenance Plan.”