3 Ways to Pay for an Association Capital Improvement Project
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How can your association keep up with the Joneses (and improve property values)? Performing preventive maintenance on your building or community is just the start. You also need to ensure you’re investing in strategic capital improvements that keep residents happy and potential owners excited. From modernizing your clubhouse or lobby to adding more electric vehicle (EV) charging spaces in your parking garage, these projects are key to enhancing your reputation in an increasingly competitive market.
But what do capital improvements include? 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 cover a broad spectrum, from lobby renovations and elevator modernization to replacement of mechanical systems, 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. Some capital improvement projects may also be material alterations, which may be subject to certain restrictions in your association’s governing documents or state law. Consult your association’s attorney before undertaking a capital improvement project.
These projects generally last longer than one year and tend to be expensive. They’re investments in the future of your community or high-rise building. The question is, how do you pay for capital improvements?
Option 1: Use your reserve fund.
Your community association’s reserve fund should be the first place you go to when funding repair and replacement of your existing assets. Boards must be aware of how the law allows these reserve funds to be used, and that laws impacting reserves can change. For example, beginning January 1, 2024, Tennessee law will require condo association boards to have a reserve study done on or before January 1, 2024, if the board has not had a reserve study conducted on or after January 1, 2023. The law will also require boards to have an updated reserve study done within five years of the original reserve study date and every five years thereafter. The legislation further outlines that if an association has performed a study after January 1, 2020, it will count as the first study and start the five-year clock. To learn more, read our article, and always consult with your association’s attorney before considering tapping into reserve funds, to ensure compliance with the law.
According to FirstService Financial, approximately 72% of 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. Material 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. Note that condominium and cooperative buildings that meet certain requirements are obligated to conduct a structural integrity reserve study at least every 10 years. Updating your reserve study, is a good reminder to build incremental assessment increases into your budget regularly and communicate the reasoning to residents. As staffing, material and utility costs inevitably go up, your budget for capital improvements will be affected. To have a healthy and reputable association, you need to have the budget to take on essential maintenance and capital improvements.
The Federal Housing Administration (FHA) requires that associations fund their reserve in the amount of at least 10% of their annual operating budgets. If you anticipate that any homeowners in your association take advantage of FHA programs, then it’s in your best interest to make sure that your reserves are funded appropriately. However, keep in mind that the 10% funding level will not meet the levels required for most major capital improvement projects.
Whether required by law or not, properly funding your reserves is the best action to take, as it also helps protect your association from liability in many cases. For instance, not maintaining the property is one of the most common reasons that residents sue their association for breach of contract, for negligence and even for injuries caused by improper maintenance. And one of the primary reasons for improper or inadequate maintenance is lack of funds to make those repairs and replacements. Keep your residents safe and avoid the risk of costly lawsuits by properly funding your reserves and making repairs and replacements as needed.
As an alternative to reserves, there are some capital improvement projects associations may be able to fund by including the costs in their operating budget. This is typically the least favorable option, as it means those costs are passed onto the membership in their regular assessments. “We don’t often recommend funding capital improvements via operating funds,” said Hector Vargas, president at FirstService Residential. “This can have a major impact on homeowner assessments, which can deter potential buyers. When assessments are high because capital improvements are included in the operating budget, it may adversely affect marketability and property values.” Boards should always consult their association attorney before funding a capital improvement project with their operating budget.
Option 2: Levy a special assessment.
If your reserve account does not include enough funds to cover your capital improvement project or if you have not reserved for the specific project you’re considering, you will need to look for other funding sources. The most obvious, but least popular option, is to levy a special assessment on association members. While in some cases, it’s unavoidable (for instance, emergency maintenance work might be needed, even when your association has a robust preventive maintenance plan), you may be faced with the prospect of a special assessment to pay for an unexpected project. Whether or not it can be prevented, homeowners are usually not happy with the prospect of a large special assessment, and it may even lead to conflict between the membership and board.
One of the biggest causes for this conflict can be the potential for financial hardship that comes with a special assessment. If your board plans to levy a special assessment, consider the impact on the membership and offer convenient 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 biggest positive to a special assessment is that the association isn’t taking on any debt. Before imposing a one-time special assessment on your members, make sure that you check your governing documents and consult with your association’s attorney. Also, as with standard assessment increases, the key to maintaining a peaceful environment and alleviating resident concerns is proactive and consistent communication. Make sure you are actively communicating with the membership about the necessity of the special assessment and how it will positively impact the association in the long-term. Your ability to special assess may be limited by your association’s governing documents or state law. Consult with your association’s attorney before levying a special assessment.
Option 3: Finance the project with a loan.
The third option for funding capital improvements is to use a loan. Borrowing money for capital projects has become common practice among associations. Unlike a special assessment, a bank loan allows unit owners to pay for the project over a long period of time and to potentially spread the cost of an improvement over generations of homeowners. Of course, loans do come with interest and fees, but they can be a viable option for associations taking on a large and costly project.
Your property management company and financial services partner should help guide you to the right loan for your association. By working with providers that have a large network of and strong relationships with financial institutions, you’ll typically be able to save money on fees and get help with the application process. For example, because of its existing relationships with financial institutions, FirstService Financial negotiates on behalf of FirstService Residential partners to typically help them get better rates than they would on their own.
Your ability to borrow money may be limited by your governing documents or state law. Again, make sure you consult with your association attorney and governing documents before beginning the loan application process to ensure compliance.
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 many banks extend amortization to 15 or 20 years. This reduces the monthly payment and eases the financial burden for 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 are necessary in order to maintain your property, enhance your reputation and keep residents and future owners happy and invested. 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 or your operating budget, levy a special assessment or take out a loan, it will directly impact the well-being of your association in a variety of ways. Work closely with your property management company and financial partner to determine the best option for your community.
Watch the full video!
How will you fund your next capital project? Watch our video to learn the pros and cons of the most common capital improvement funding options.