Nothing lasts forever…and when it comes time to replace your high-rise roof, community pool or to add new amenities, your association will need to determine how to pay for it. All of these things – significant 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. This type of improvement, according to the Internal Revenue Service (IRS), is required to be any addition or improvement to a piece of property that is expected to last for longer than one year.”
So, capital improvements include everything from constructing a playground or spa to replacing your boiler or swimming pool filtration system. Because these projects are required to last longer than one year, these are not inexpensive undertakings. Thankfully, there are several options to pay for them.
Dip into your reserve fund.
Your community association’s reserve fund should be your first line of defense when it comes to funding repair and replacement of your existing assets. Reserve funds may be used for new construction projects in some states; others limit their use to what is planned for in your reserve study
, so always consult your association attorney before tapping into your reserve fund.
Unfortunately, up to 72 percent of reserves are “under-funded,”
meaning they are not funded sufficiently to pay for the things they are supposed to cover when they reach the end of their useful lives, according to Drew Ahrensdorf, vice president at FirstService Financial, which provides best-in-class financial services for FirstService Residential-managed communities.
It’s important to make sure your reserves are funded properly, or your association risks not being able to meet its obligations for maintenance of the community assets. Some states require reserves be funded to a certain level, so improper funding can cause legal trouble for your association as well. Not maintaining the property is one of the most common causes of residents suing their association for breach of contract, for negligence and even for injuries caused by improper maintenance. 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 properly fund your reserve.
Implement a special assessment.
If your reserves are insufficient to pay for what your association needs, you will need to look for alternate sources of funding. The most obvious, but least popular, way to fund a capital improvement is by levying a special assessment on the members of the association. The drawbacks and risks to this are immediately clear: angry homeowners will cause strife and dissent within the community and may even result in a lawsuit against the association for neglecting its fiduciary responsibilities. Another risk is the necessary funding may not come through in time if homeowners cannot afford the additional payment and require a payment plan. The only positive to a special assessment is the association isn’t assuming any debt. 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.
Take out a loan.
“Borrowing money for capital projects has become common practice in the community association industry. Unlike a special assessment, a bank loan allows unit owners to pay for the construction project over a long period of time,” Ahrendorf explained. “With interest rates at historic lows and a competitive banking landscape driving down the cost of capital, accessing financing has become an attractive funding strategy.”
Again, make sure you consult with your association attorney and governing documents before applying for a loan to ensure you don’t run afoul of your association’s bylaws.
Ahrendorf 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 the loan off entirely. In most cases, the only time a prepayment penalty applies is if the loan is refinanced with another lender.
- Second, most banks will lend 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.
How does that play out in the real world?
“The Gibson, an 80-unit condominium located in the heart of Washington, D.C., was constructed in 1981. As could be expected with a building of this age, the glass and windows were due for replacement, and the association board was tasked with sourcing a loan to cover the expense,” Ahrendorf said. “Not only would this project serve to fix issues with the existing windows and doors, it would also protect and enhance the value of the owners’ investments in their units. FirstService Financial was engaged to assist in the loan process, and ultimately the association and financial institution were able to agree to the following terms: $1,500,000 loan, 12-month non-revolving line of credit (draw period) followed by a 10-year term at 4.06%, fixed at closing.”
Capital improvements, and the costs of them, are inevitable. When your association has to invest in its property, whether for repairs or a new construction project, the financing for that work must be considered as carefully as the work itself. Whether you choose to use your reserve fund, levy a special assessment or take out a loan, it will affect the well-being of your association in a variety of ways. A financial management expert can provide advice on the risks of each and help you decide which is the best option for your community.
To learn more about how to keep your community association financially healthy, read our comprehensive guide about budgets, reserve funds and financial planning.