There’s a new building going up down the street. You’re hearing that it’s going to have the latest in amenities, energy efficiency and even parking spaces for electric vehicles. Looking around, you realize that your already-gorgeous building may need to do a little work to keep up with the Joneses. That means 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.”
“Capital improvement projects fall under some pretty wide descriptions of anything that could go on at a property, from alterations and improvements to the common areas and replacement of mechanical systems, to 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.
Because these projects are defined as lasting longer than one year, they tend to be expensive. They’re investments in the future of your community or building. Thankfully, there are several options to pay for them.
Use your reserve fund.
Your community association’s reserve fund should be your association’s go to for funding repair and replacement of your existing assets. Florida law limits the use of reserve funds for “authorized reserve expenditures unless their use for other purposes is approved in advance by a majority vote at a duly called meeting of the association.” Always consult your association attorney before tapping into your reserve fund.
Florida law requires that reserves be fully funded; however, your community membership can vote to fund reserves at less than the full amount or not at all. This is strongly discouraged for obvious reasons: you may not be able to fund needed work. According to FirstService Financial, up to 72% of homeowners associations in the United States have underfunded reserves and may run into financial trouble because of it. Your community should invest in updating your reserve study on a regular basis. Materials and labor costs go up over time, and updating that study every year or every two years will help keep your association from being caught off guard by a budget overrun.
Keep in mind that the Federal Housing Administration requires that associations fund their reserve in the amount of at least 10% of their annual operating budgets. If you anticipate homeowners in your community taking advantage of FHA programs, then it’s in your best interest to make sure that your reserves are funded appropriately.
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. Keep your residents safe – and avoid the potential for costly lawsuits -- by properly funding your reserves and making repairs and replacements as needed.
Levy a special assessment.
If your reserve account is not enough to cover what your association needs, you will need to look for other ways to pay for projects. 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 dissent within the community.
Special assessments can be a real financial hardship for some homeowners. If your board plans to levy a special assessment, consider the impact on your homeowners and offer payment plans if possible. Of course, that means that you may not get all of the money in time to complete the necessary work. In a non-emergency situation, that might be okay, but in a time of crisis, you may need to consider other options.
The significant positive to a special assessment is that the association isn’t assuming any debt. Before imposing a one-time special assessment on your community, make sure that you check your governing documents and consult with your association’s attorney.
Finance the project with 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 and to spread the cost of an improvement over generations of homeowners. Of course, loans do come with interest and fees. But 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.
If you work with a property management company that is large enough to leverage relationships with financial institutions, you may be able to get better rates working with that company than on your own. They may be able to assist in connecting you with the most favorable institutions, save you money on fees and even help with the application process.
Again, make sure you consult with your association attorney and governing documents before beginning to apply for a loan to ensure you don’t run afoul of your association’s bylaws.
There are three major benefits to 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 all this come together in the real world? Anthony Gragnano, regional director at FirstService Residential, recalls a complex financing project at one of his high-rise properties. “The community had voted, for most of its existence, not to fund reserves at all. Several years ago, the board realized that some reserve funding was needed,” he explained. “When it came time to redo the second-floor amenities deck, we were able to partially fund it from reserves. In order to get the work done quickly, the association took out a loan to cover the rest of the work, and then the repayment of that loan was financed through a special assessment spread over several years. The work could be completed but the burden to homeowners was lessened, thanks to being able to take out a loan.”
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.
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