Do You Know How to Pay for Capital Improvements?
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.
Because capital improvement projects are meant to last, they tend to be expensive, an investment in the future of your high-rise building or community. So how can you pay for them?
Rely on 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. According to FirstService Financial, the financial services arm of FirstService Residential, up to 72% of community associations in the United States have underfunded reserves and may run into financial trouble because of it.
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, 20 or more years in the future. “I once worked with an association that funded their reserves fully to do a roofing replacement,” explains Richard Breske, director of client relations, client accounting, at FirstService Residential in Atlanta. “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 cost ended up being $1.4 million and they had to look for another source of funding to bridge the gap.”
Breske noted that Georgia doesn’t have any legal requirement that associations fund reserves to any degree, but he cautions associations that there are other requirements they 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.
Failure to maintain your community property 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.
Impose a special assessment on the community.If your reserve account doesn’t have enough money to fund your association’s needs, your board will need to pay for projects in another way. 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. Some owners may sue the association for not having enough reserves available, even though these claims will be extremely difficult to prove in court. The primary positive to a special assessment is that the association isn’t assuming any debt.
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.
Always check your governing documents and consult with your association’s attorney before imposing a special assessment.
Use a loan to pay for needed work.
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, so that work is paid for by all the people who enjoy the benefits of it. 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. “One of our communities, Spire Residential, 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 for only $500 in closing costs,” explained 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.”
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 covenants and 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.
Capital improvements, and the costs of them, are inevitable. When your association has to invest in its property, no matter the reason, 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, take out a loan or some combination of the three, 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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