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10/14/2016: Condo Associations Should Build Up Reserves For A Rainy Day

By Benny L. Kass

October 14, 2016

A recent front page article in The Washington Post on the financial problems many aging condominiums in the Washington area are facing prompted me to write this column about the absolute necessity of maintaining adequate reserves.

Boards of directors can’t control when personal financial problems force owners into default and foreclosure, reducing the condo’s source of revenue. But they can learn to better manage the funds they have.

Every community association should have money set aside “in reserve” to cover the cost of emergency or major repairs. Reserves are — or should be — an essential part of every community association.

The Federal Housing Administration (FHA) is the dominant lender for condominiums — both sales and refinances — and under its rules, an association must demonstrate to the mortgage lender that the “funding of replacement reserves for capital expenditures and deferred maintenance” represents at least 10 percent of the association’s annual budget.

Although many property owners might not realize it, their community is a business and must be run just like any other business. Indeed, many associations are very big businesses, with large incomes and equally large expenses.

Each year, the board of directors — working through its management company, if there is one — must project its income and expenses for the next year. Often, this projection is speculative, based on previous years’ experiences. However, there are ongoing operating expenses that must be paid, such as insurance premiums, water bills, trash collection, payroll taxes and even legal bills. To determine the next year’s expenses, the board has to know approximately how much money will be available during the coming year. It should be obvious that the board cannot plan to spend more money than it will receive. Associations are not the federal government.

In addition to general operating expenses, boards will have to make major repairs, alterations and even improvements to the common areas within the association. Many buildings are old and not in the best shape. The driveway must be paved, the elevator must be overhauled, the piping and the roof must be replaced. All of this costs money, and these additional expenses must come from somewhere. And all of the numbers must be incorporated into an annual budget.

How does the board project reserves? Over the years, many boards have developed best practice processes using a “reserve analysis study” based on a comprehensive architectural and engineering review of the entire complex. The study would detail the projected useful life of the boiler, elevator, roof and other components, as well as the cost to repair them and the amount of money to be set aside each year to meet that cost.

For example, the report might show that the board would need to spend $40,000 in five years when an elevator’s useful life is expected to expire. To accomplish that, the board would have to set aside $8,000 a year to pay the cost.

This money should be collected from the owners as part of the overall monthly or quarterly assessment and deposited in a secure, interest-bearing investment — such as a Treasury bill or other government insured fund.

In light of the ridiculously low interest rate currently being paid by banks, there are those who advocate getting a greater return on these reserve accounts. Some want to invest in stocks and bonds. I cannot recommend that; the money belongs to all owners, and unless all owners agree in writing to invest in nonsecured funds, they must be protected and insured by the federal government.

In the past, there was no magic formula to determine how much is adequate. However, a reserve analysis study performed at least once every five years will guide the board in meeting the level of reserves that are required.

In the Washington area, only Virginia has addressed this issue — and only after a major scandal involving a property manager who stole a lot of money from one of his community association clients. The law in Virginia requires that a board of directors conduct, at least once every five years, a study to determine whether reserves are sufficient.

But no dollar figure or percentage of the budget is required.

Now, with the new FHA requirements, if the mortgage lender is not satisfied that the reserve requirements are adequate, the lender — according to FHA — “may request a reserve study to assess the financial stability of the project. The reserve study cannot be more than 12 months old. When reviewing the reserve study, consideration must be given to items that have been replaced after the time that the reserve study was completed.”

If reserve funds are not available if and when the need arises, what can the board of directors do? Oversimplified, there are three ways to raise money in a community association:

● Increase monthly assessments: The board could increase the monthly assessments by a certain amount or percentage. However, if the association needs the money immediately — and it is not there — the regular assessments will not be coming in fast enough to raise the needed money. More significantly, many owners can no longer afford their current assessment, let alone any higher number.

● Special assessments: In most associations, the governing legal documents authorize the board of directors to impose a special assessment on all owners. For example, if the board immediately needed $56,000 to replace the roof, and if there are 80 owners in the complex, this would require each owner to pay something in the range of $700 immediately. Keep in mind that assessments are usually calculated based on the percentage interest that each owner has in the association. Thus, the amount of the special assessment will vary; the fact remains, however, that each owner may be required to pay up immediately. Wouldn’t you rather pay a few dollars toward reserves each month instead?

● Get a loan: Many HOAs are taking advantage of this approach, and some banks are willing to make such loans. However, there are a lot of legal and financial hurdles that the HOA has to overcome, and it takes time for a bank to commit to a loan.

As nice as all these methods sound, if your owners are delinquent with their mortgage and condo payments because they have lost their job, there will not be enough money to do those important and necessary repairs. The net result: The complex will deteriorate, and market values will decline. And that is exactly why FHA has implemented the reserve guidelines.

A well-managed community association must have a long-range plan for major repairs and replacements. Dollar figures will be included in these plans, and these dollars will (or should be) added as “reserves” to the budget adopted each year by the board.

Boards of directors have a fiduciary obligation to the owners who elected them to make sure that the budget they prepare is adequate, including reserves.

FHA just released proposed regulations, some of which relate to the 10 percent requirement. FHA has indicated that it is open to a lower reserve contribution amount on the condition that the affected condominium present a reserve study that was completed within the past 24 months and which justifies the lower amount. Nov. 28 is the deadline for submitting comments on the proposals.

Benny L. Kass is a Washington and Maryland lawyer. This column is not legal advice and should not be acted upon without obtaining legal counsel. Send questions to [email protected]