By: Sal Sciacca of Chicago Property Services
Now more than ever, associations must spend money wisely and plan ahead to ensure that their reserves are properly funded. Proper reserve funding will allow the board of directors to properly maintain the association and maximize the real estate values of the owners.
Duties and obligations of board members
One of the fundamental obligations of board members is to maintain the common elements. In fact it is their fiduciary duty to maintain the common elements as stated in the law. The common elements consist of physical characteristics that involve regular maintenance as well as capital replacement. The focus of this article is on capital items. Which capital items should be replaced and when should they be replaced are the most important questions to ask. It is not a question of whether the items should be replaced. All capital items have a finite life expectancy.
Reserve studies are recommended
One of the questions that board members should ask is who determines what are the capital items, how long will they last and how much will it cost to replace the times. To answer those questions, associations should ideally hire a company that specializes in reserve studies. The reserve study is a document generated by experts that incorporates the life expectancy of all capital items over the span of 30 years into a detailed report. The report will indicate what items need to be replaced, when they need to be replaced, and how much it will cost to replace them. It will also detail how much the association will need to save to fund the capital item replacements on an annual basis. In principle, this sounds like a very sound idea. A reserve study is generally at least $3,000 for a 30 unit community association to over $10,000 for a larger community. replacement.
Reserve studies are recommended
Practically speaking, many associations cannot afford to pay for a reserve study. In Illinois, there are over 40,000 communities and about 30,000 are under 25 units. Most of the associations under 25 units probably don’t have the funding to afford a reserve study. In addition, there are associations that have paid for reserve studies and have not followed the recommended plans. Certainly, this is not recommended but it is the reality for many associations based on their financial constraints.
5 Year Capital Plans are Essential
Regardless of whether an association has a current reserve study or not, it makes the most financial sense that ALL associations large or small, well funded or underfunded, have a 5 year capital plan. The capital plan needs to incorporate the reserve study data if available and create a road map of exactly what capital items will be addressed during which calendar year.
Capital Planning Saves Money
Planning ahead and proactively addressing capital projects actually saves money. This is especially applicable to exterior facade, masonry and tuck pointing issues. Simple masonry issues can easily escalate into major expenditures. Costs associated with exterior masonry issues typically raise exponentially and not linearly. This means that the longer associations hold off with repairs, the more costly the repairs become. It is cheaper to make the capital improvements sooner than later. Given this fact, the best approach for a board is to have a capital plan and to plan ahead. It is always best to plan long term and to keep the homeowners informed of expenditures especially larger ones. As a result, it is quite important for the board of directors to create and maintain a 5 year capital plan.
Capital planning cycle
The capital plan is a guide and a road map detailing exactly what capital items will be addressed over the next 5 years. The capital planning process should start in the spring and finish up with the plan that the board will present to the homeowners at the budget approval meeting which is typically held in October or November of each year. Ideally there is a capital committee that reviews the capital plan every year and submits the recommendation to the board each year in September. This allows the board to incorporate the capital planning process into the operational budget planning process that typically starts in September. Once the operating budget and capital plan is approved, the cycle starts all over again in the spring. It is an ongoing process that continues on through the life of the association.
Proactive Planning or Deferred Planning
It is best when associations plan ahead and pre-fund the reserves for capital projects. But what happens when associations don’t plan ahead? The answer is simple. It costs MORE money. The project costs are higher and the board is often forced to pass special assessments and raise more through bank loans. In addition, there is typically more frustration among the homeowners as the amount the homeowners are asked to pay is often larger than the regular monthly assessment amount. It is much cheaper to raise regular assessments and save over time and have the funds necessary for capital projects versus raising funds for capital projects as necessary. The following sections discuss the most common capital funding scenarios.
Funding Options – Reserves Only
In this best case scenario, the association has planned ahead and has built up the reserves sufficiently over the years and has enough to pay for the capital projects as necessary per the capital plan. This is the ideal situation. This means that the assessment levels are sufficient to build long term reserves. The association can move forward with the capital project at any time in this scenario and does not have to wait to collect additional funds. This scenario is the least stressful to the association and to the homeowners.
Funding Options – Reserves and Special Assessments
In this scenario, the association can only partially fund the capital project from reserves and it is necessary to raise additional funds through a special assessment to fully fund the capital project. In this scenario, the association will need to wait until the special assessment funds are collected before proceeding with the project. This scenario would only apply in cases where there is low urgency in the project completion timeline.
Funding Options - Special Assessments Only
In this scenario, the association is severely underfunded and must raise funds completely through a special assessment. This is a viable option only if the project is not urgent in nature and can wait until the special assessment funds are collected. This scenario is the least common and would only apply in cases where there is low urgency in the project completion timeline.
Funding Options – Special Assessments & Bank Loans
In this scenario, which is the least desirable scenario, the association is seriously underfunded and urgently needs funds to complete a capital project. This can be attributed to an unexpected event that has created the need to complete a capital project. Other scenarios include poor planning, deferment of capital projects, and/or under funding of the reserves. There are banks that do lend to community associations which allow associations to access the capital necessary to complete the capital projects in this scenario. In this case, the association applies for a bank loan and at the same time will need to pass a special assessment to cover the cost of the project. The bank loan will allow the association to take on the project fairly quickly as a loan approval usually takes about 6 weeks to complete. Once the loan is approved, the association has the funding available to take on the project. The payback period of the loan is usually over 3 to 5 years. The special assessment is also usually drawn out over the same period of time. This is the most expensive scenario due to borrowing money and it creates the most stress on the association and homeowners.
Communication is key
In the end, the best approach is to communicate information to owners on a regular basis. By communicating the information, they will know the issues and not be surprised to hear about upcoming capital improvement projects. In addition, if additional funds are needed, the owners will not be surprised by the need to pass a special assessment or obtain a bank loan. The way to do this is by holding regular quarterly board meetings that are officially noticed and distributing meeting minutes to all the homeowners so that information is shared to those who were not able to attend the board meetings.
In summary, associations are encouraged to plan ahead especially regarding capital expenditures. These are the greatest expenditures that associations will undertake. As a result, it is advised that an association obtain a reserve study if financially affordable and to incorporate this information into a 5 year capital plan. Each year, the association should revise the 5 year plan and every 3-5 years the association should get an update to their reserve study. This proactive approach will result in the lowest amount of operating costs for the association Conversely, associations that wait until the last minute to make capital repairs will often times need to pass special assessments, obtain bank loans, spend greater amounts of money to complete the projects and create the greatest stress and strain on the association and homeowners.
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