Four ways to fund an HOA capital improvement project
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Living in a residential community means around-the-clock routine maintenance to preserve the community and its assets. But there comes a time when one of your assets will reach the end of its useful life and require a replacement or significant repairs. And as the association, it’s your fiduciary responsibility to determine how to pay for it. These substantial repairs and replacements, as well as new construction – are considered capital improvements.
According to Investopedia, “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.” According to the Internal Revenue Service (IRS), “this type of improvement must be any addition or improvement to a piece of property that is expected to last for longer than one year.”
To learn more about capital improvement projects and how they differ from routine maintenance, visit our article Maintenance and Repairs vs. Capital Improvements – What’s the Difference?
So, from constructing a playground or spa to replacing your boiler or swimming pool filtration system, these are all examples of a capital improvement project. Because these projects must last longer than one year, they can be expensive undertakings, but funding options are available.
Operating AccountThe association’s operating account is the funding source for all the daily routine maintenance and upkeep that goes into your community. This is funded through the owners’ HOA fees.
Suppose your association happens to have a surplus in the account or just sufficient funding for repairs. In that case, using the available funds to pay for the project upfront and avoid additional costs to owners is recommended.
Reserve FundIf your association does not have sufficient funds to pay for the capital project upfront, your community’s reserve fund should be your first line of defense to fund the repair and replacement of your existing assets. Reserve funds may be used for new construction projects in some states. In contrast, others limit their use to what is outlined in your reserve study, so always consult your association attorney before tapping into your reserve fund.
Are reserve funds limited to capital projects, or can they be used for other projects throughout the property?
According to John Lee, vice president of FirstService Financial, the answer is yes, with some conditions. “If the project you’re undertaking is outlined in your reserve study, you can absolutely spend your reserve funds on those items. However, if you’re undertaking a project and have not reserved for it, then you will need to find another source of funds, whether special assessments or a loan.”
Can an association use an emergency line of credit to pay for a capital project instead of dipping into its reserves?
“An emergency line of credit is for just that – emergencies. So, I wouldn’t look at an emergency line of credit as a source of funds for a capital project. Instead, you want to go back to the bank and say, ‘We are undertaking a capital project, and here are our sources and uses of the funds that we’re asking for,’ and secure a loan for that capital project itself,” said Lee.
How can an association verify if they have sufficient reserve funds?
Unfortunately, up to 72 percent of reserves are “underfunded,” meaning there aren’t sufficient funds to repair or replace listed assets when they reach the end of their useful life.
It’s essential to ensure your reserves are appropriately funded, or your association risks not being able to meet its obligations to maintain the community assets. Some states require reserves to be funded to a certain level. Therefore improper funding can result in legal trouble for your association as well. Additionally, improper property maintenance is one of the most common forms of litigation brought forth by residents for breach of contract, negligence, and even injuries.
When planning your annual budget, first look at your reserve study to know how much should be deposited in your reserve fund, then make sure your association’s assessments are sufficient to fund your reserve properly.
Special AssessmentIf your reserves are insufficient to pay for what your association needs or the project is not outlined as a reserved item, the community will need to look for alternate sources of funding. This means potentially levying a special assessment, an additional HOA fee that allows homeowners to make payments and finance the project's cost over time.
The initial drawbacks and risks of this source are:
- Distressed homeowners may challenge the decision or direct a lawsuit against the association for neglecting its fiduciary responsibilities.
- The timeliness of collecting sufficient funds. If homeowners cannot afford the additional payments and require a payment plan, the association may need more funds to begin the project and pay it in full.
On the other hand, levying a special assessment means the association isn’t assuming any debt, which is usually a better financial decision. But before imposing a one-time special assessment on your community, it is critical to check your governing documents and consult with your association’s attorney.
What best practices should an association follow when passing a special assessment?
While each community is different, John Lee suggests two best practices to help ensure a smooth process. “My first suggestion is to overcommunicate. Provide updates in every board meeting, host town halls specific to the project, and ensure timely updates via newsletters, weekly updates, etc. The second one is transparency. Walk through the financial aspects of the project, physical progress, account for the special assessment during board meetings, and document in the meeting minutes will help answer owner questions.”
LoanA loan will require a special assessment, but it allows the community to pay a significant portion of the project upfront and have the owners make payments over a more extended period of time to repay the loan.
When should an association consider a loan to fund a capital project?
An association will take out a loan for a capital improvement project when the cost of that project is far too great to ask owners to pay upfront. Lee outlined three benefits of using a loan to fund capital improvements:
- First, there are typically no prepayment penalties for making additional principal payments or paying off the loan. In most cases, a prepayment penalty only applies if the loan is refinanced with another lender.
- Second, most banks will lend for up to 10 years, but increasingly banks are extending amortization to 15 or 20 years. This reduces the monthly payment and makes financing more affordable for unit owners.
- Third, 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 was involved.
- Communities managed by FirstService Residential have exclusive access to its affiliate FirstService Financial (FFI), which delivers best-in-class financial and insurance programs and services to protect and enhance the value of our client’s properties through extensive buying power, potentially reduced interest rates, all through local banking institutions.
Like all critical decisions, communities must consult with their legal counsel and governing documents before applying for a loan to ensure compliance with the community’s bylaws.
Real-world applicationOne recent example of a FirstService Residential community undergoing a capital improvement project was Building A in the Myrtle Beach Resort. This community was notable for implementing preventive capital improvements and avoiding an emergency evacuation for hurricanes Ian and Nicole. They also partnered with FirstService Financial and obtained a $1.8 million construction loan with a 10-year special assessment plan to reduce the financial strain on homeowners.
Because of the community’s forward-thinking, residents were not required to evacuate their homes (unlike their neighboring towers), and the property did not exhibit any signs of water intrusion or storm damage.
You can read more about this story by accessing our article Myrtle Beach resort avoids evacuation with FirstService Residential partnership.
Capital improvements, and the costs of them, are inevitable. When your association invests in its property, whether for repairs or a new construction project, its financing must be considered as carefully as the work itself. Whether the association chooses to use its reserve fund, levy a special assessment, or take out a loan, it will affect the well-being of the community in a variety of ways.
If your community is struggling with finding sufficient funds for a capital improvement project, FirstService Financial delivers best-in-class financial and insurance services to protect and enhance the value of our clients’ properties. They can help your community find the best program that fits its needs. Learn more by contacting a member of their team.
Get our capital improvements guide, Capital Improvements: A Blueprint for Success.