What You Should Know About a Capital Improvement Fund

 

Has your board set aside sufficient reserve funds? Studies show that 72 percent of association-governed communities are underfunded – a 12 percent increase from ten years ago*. 

 

Many associations have not increased assessments at the pace required to adequately service an aging property. This deficiency has rendered some boards incapable of funding unexpected expenses, such as replacing major equipment or addressing structural or life-safety issues stemming from compliance with local laws. 

 

When it comes time to fund a restoration job or a capital project that will significantly enhance the value of the property’s units, your governance board should look at these three traditional funding pathways.

 

1. Reserves: Boards should undertake a reserve study that will predict future replacement costs and the timeline for restoring all community common elements. These studies are critical in guiding boards towards implementing appropriate increases in assessments and ensuring the economic security of the association. Boards should look first to their reserve study and their reserve fund to determine the ability to fund a project without increasing assessments to their unit owners or sacrificing the property’s financial stability. 

 

2. Special Assessment: If your reserve funds aren’t enough to cover the cost of the capital project at hand, many board’s resort to imposing a one-time special assessment. Typically, a special assessment requires that all unit owners make an unscheduled, one-time payment to the association. This strategy is the answer to avoid incurring debt, however, a special assessment can cause financial hardship on owners who can’t afford a large payment over a short period of time. Prior to any decision to levy a special assessment, the board needs to factor in the association’s governing documents, state laws and the structure of the payments.

 

3. Bank Loan: Borrowing money for capital projects has become common practice in the community association industry. Unlike a special assessment, a bank loan allows owners to pay for the construction project over a long period of time. 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. 

 

Qualifying for a loan requires meeting various criteria set by a bank’s credit policy. The main factors that influence a credit decision relate to delinquencies, the number of rented units, ownership concentration, developer involvement, and the relative size of the projected assessment increase.

 

Typically, association loans are fixed rate, self-amortizing term loans that are structured one of two ways: 

 

 Fully-Funded Term Loan: This method allows the building to take all the loan proceeds at closing, and begin paying principal and interest in equal installments for the life of the loan (like a typical home mortgage). If the board knows exactly how much the project will cost and is sensitive to interest costs, this is the preferred method. 

 

 Non-Revolving Line of Credit Converting to a Term Loan: This method begins with a non-revolving line of credit, commonly called a “draw period.” During the draw period, the association draws down the funds necessary for ongoing capital work and pays interest-only payments on the outstanding amount. As the project nears completion and final invoices are submitted by the contractor, the association “terms out” the loan and begins paying both principal and interest to amortize the loan balance. 

 

This option is more expensive because principal is not being paid down during the interest-only draw period. However, many boards prefer the flexibility of borrowing only what they use, and are comfortable paying a premium for that convenience. 

 

There are many attractive features of association loans that give boards a tremendous amount of flexibility:

 

 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. The collateral of an association loan is the assignment of the assessment income (in the event of default, the bank steps in and receives the assessment income). 

 

Bank loans are a creative way to establish a payment plan for owners. Banks are willing to customize the financing structure to fit the needs of each project. As more and more banks service the community association industry, this drives down the cost of financing, enables better terms and conditions and provides associations with more options.