Letters To The Editor: Stealth Reserves Uncovered

Published in the ECHO Journal, September 2007

Editor’s Note: The May 2007 issue of the ECHO Journal included an article titled “Stealth Reserves” by attorney Tyler Berding. In the article Dr. Berding introduced a novel suggestion to help associations fund the association’s reserves adequately, that of giving the owners some slack through payment deferral. ECHO received two letters about the article, which are printed below, followed by a response from the author.

Stealth Reserves Uncovered 

From Mr. Stephen Hohs

Dear Mr. Berding,

We have corresponded in the past. I agree with your article assessment that:

1. ALL (or if not the VAST MAJORITY) of condo associations in the 20 to 30 year age range are totally unprepared for the rough times ahead.
2. Echo’s basic thesis “Get an expert,” while nice in theory, does not work well in fact. Having been the victim of watching numerous projects throughout my Association with so-called “experts,” I (along with other board members) have learned the hard way that the board needs to almost become an on-site supervisor of the project. And it is a prerequisite that some board members use some “common sense” to the extent of almost becoming an “expert” in construction management. Even with a construction manager “supervising” the job, surprisingly often the Association is paying for nonexistent supervision. The end result is that the Association quite likely is paying for unsupervised work at a contract that alleges supervision.
3. There are NOT enough Association members that are willing to be competent board members. It probably takes at least two, probably three years, before one can competently say that “he knows what he is doing.” “Knowing what you are doing” consists of more than showing up to a board meeting.
4. Most board members are unwilling to give out bad news. The few board members that I trust are the ones that are willing to take an unpopular stand; i.e.; raise HOA dues. While my dues of $260 per month funds the reserves, I would feel more comfortable with higher dues. It gets more and more difficult (particularly now new owners probably having negative equity willing to abandon the property) to find the financial resources to do repair work.
5. The vast majority of the deferred maintenance is avoidable. The best long range solution is to start managing the condo HOA like a commercial property. Have a handyman go building by building taking care of little stuff before they become big problems.
6. Owners worry too much about minor issues; i.e., parking instead of major issue; i.e., dryrot repair. I had one annual meeting with owners complaining about non-existent parking issues, leading to my response of “If we DO NOT take care of the dryrot in the next couple of years then we could be looking at MAJOR BILLS”

No easy solution exists. It would be nice if one could mandate mandatory funding for adequate reserves. The obvious problem is one could get into a long winded issue of what constitutes “adequate reserves.” Unfortunately, the vast majority of associations appear to take the attitude “Not my problem about issues five year hence.” Mine is one of the few and it is often to get the consensus of “It is the Association responsibility to leave for the next purchaser an Association adequately maintained without needing special assessments.”

*****

Stephen M. Hohs

Stephen Hohs has served the board of directors of the association in which he resides since 2000 and has held three offices on that board: treasurer, secretary and president. 

From Gayle L. Cagianut, CPA

Dear Mr. Berding,

With all due respect to your industry knowledge and the creativity that you called upon to come up with the idea in your article of assessing homeowners for additional reserve funding monies to be paid at the time of escrow closing (when a home sells), I see nothing but disaster for such a plan. Here are a few of my concerns:

1. What about the numerous homes that have no equity and are just barely hanging on without going into foreclosure? I would think that this would be another great reason to walk away from the home. I realize that if the special assessment were levied all at once, the same thing could occur; however, if the board works out a reasonable payment plan, they might get payments as long as the homeowners choose to stay in the home.
2. Would a lien be filed immediately on the home to ensure that the assessment is advance of any additional mortgages that might come along? Would the assessment need to be repaid if the owner refinanced?
3. How would a reserve preparer even begin to do its cash flow planning? How would they be able to ascertain when the funds would be available to the association? At a minimum, there would need to be sunset date when the monies would be due and payable.
4. As Robert Nordlund states, reserve studies are an “art and a science.” So, what if the projections are wrong and the monies are needed sooner rather than later? Do you special assess again, give credit to those people that have already paid, and assess just the ones who have not paid?
5. You mention that interest should be charged on this “loan.” Do you realize that management company accounting departments are already dealing with assessments, late charges, other fees, special assessments (for everything from specific items to bank loans) and now they will have to compute interest on a receivable that is not collectible for years to come?
6. For collection purposes, the computerized accounting system would have to be sophisticated enough not to apply payments to this “assessment” and not to send foreclosure notices on this past due amount. Or, are you suggesting that this be kept “off the books”? If so, what is the chance that the management company will remember to collect the money in escrow if it is not part of the A/R balance at the end of the year?
7. When associations change management companies, we find difficulties in transferring the knowledge of what is due and payable on special assessments that secure bank loans. The transition is rarely smooth and we find unit owner payoff balances incorrectly carried over from one management company to another. I can imagine that this scenario would result in the same type of issues.

Anyway, these are a few of my very quick thoughts. I hope that you come out in the next Journal and say “just kidding!” I do not think that this is a good business decision nor do I think that the current industry is ready for the accounting nightmare that this could cause. However, I think the homeowners would vote for this and not consider the ramifications of their decision.

The Author Replies

Hello, Gayle.

No, I actually wasn’t kidding.

First and foremost, please understand that I do know and appreciate the vulnerabilities of most community associations that you describe and the danger that anything that gives someone an excuse to forestall the inevitable might be abused. On the other hand, after 33 years of watching associations march deeper into the quagmire of deferred maintenance, mostly by default, I’m pretty well convinced that without some radical new ideas a lot of housing is destined to deteriorate to the point of zero value. There are several reasons for this.

The present system of assessing for future repairs is almost entirely subjective and voluntary. Boards are only required to include components that have a demonstrated useful life of less than 30 years. The decision to include a component in reserves in the first place (less than 30-year life,) and then accurately assess both its projected life and the eventual cost of repair is, and here I would paraphrase Robert Nordland, art and not even close to science. I have seen plenty of examples of reserve budgets so far off the mark as to be mostly irrelevant. So right off the bat we are deep into speculation as to how much an association should be putting into the bank. Therefore even the funding that a board does choose to adopt may be inadequate.

Second, and more important, even if a board does obtain accurate predictions of necessary funding, it is rare that they will summon up the resolve to meet those obligations by imposing periodic increases in regular assessments or by imposing allowable special assessments even to just keep pace with inflation. Our statistics show that average funding is roughly half of the required amount which means that there will be nowhere near enough money to do major repairs at the appropriate time. That results from a combination of inflationary increases in the repair costs coupled with growing shortfalls in prior funding goals.

Boards are reluctant to approach the members for significant contributions until the need is of crisis proportions and then it is usually too late and too much. Members, on the other hand, even when a board has campaigned aggressively to raise the necessary funding, will more often than not refuse to accept the board’s or management’s recommendation if it means paying a substantial additional assessment. The consequences of these demonstrations of human nature are gradually diminishing reserves, leading many projects to the point of failure.

So against this background we search for other ways to accomplish what’s needed—funding sufficient to maintain a community association for the rest of its perpetual life. I say “perpetual” because the code only discusses individual building components that have less than 30 years to live. There is no “service life” assigned to an entire project, hence no legislative consideration whatsoever that a community association might become obsolete. As a result, there is absolutely no practical exit strategy under California law. This will eventually leave some owners with no options.

Yes, it would be great if the owners could be convinced to approve a monthly assessment that would get the job done, but we are wasting our breath if we think that is going to happen other than sporadically. We can either ignore the inevitable, wait for the legislature, or look for options. As you know, I choose the latter course because the Legislature cannot be relied upon to tighten funding requirements at all, and frankly, the deferral option is not as offbeat as it may seem. We have entire communities for which that is a major source of funding. Retirement communities, where a fixed income is the norm, realized a long time ago that raising significant funds through monthly assessments wasn’t going to cut it and have allowed the owners to “endow” the association with funds payable when the unit is sold. Yes, the demographics of that particular group make funding a little more predictable, but it does serve to provide cash flow at a rate that over the years has fairly well addressed the needs of the association.

No, I haven’t even begun to work out the details, and perhaps I am remiss for putting the cart before the horse, but I see my job as one of stimulating thought and raising awareness, and clearly we have done that. But let me address, as best I can, the concerns stated in your letter. I will respond to the paragraphs by number.

1. No Equity. The option of deferring all or part of a special assessment to some later date would not be without regard to the owner’s ability to secure that obligation with home equity, any more than a lending institution would lend without security. But as you point out, special assessments are levied all the time without regard to security, so if we actually got some security in return for a deferral for a defined period of time, why aren’t we better off ? Especially if it can be made to fit our cash flow requirements and is the difference between passing the assessment or not passing it?
2. Liens. There would be no deferral unless the owner agreed to give the association the necessary security in the form of a lien on the property, the same as any lender would require. Yes, a refinance or a sale would trigger payment.
3. Cash Flow Predictions. Yes, there would have to be some outside payoff date if the home did not sell first, just like any loan.
4. Cash Flow “Surprises.” Unknown how we would deal with this and there isn’t a lot of experience with it since it doesn’t happen very often that a special assessment is approved and then another is needed soon after. I suspect, however, that there would have to be, going in, some discussion with the members about the number of “deferrals” that could be accommodated and that if too many owners indicated that they would approve, but elect to defer, it may be that the assessment could not be approved unless more agreed to pay currently.
5. Interest. I’m not as concerned as you are about this, and have used outside companies to service loans and if management or the association’s accountant could not do it, that could be done with this.
6. Collections. Again, a mechanical detail that would have to be worked out, but not a deal killer.
7. Management Changes. Perhaps the answer to your concerns in paragraphs 5,6, and 7 is simply to assign servicing of deferrals to an outside agent equipped to service loans and which would transcend any management changes, or, as another option, simply sell the group of deferred assessments to a lender for cash and let them deal with collection, accounting, etc.

Nevertheless, I don’t mean to minimize the concerns of an accountant for accounting problems when that is not what I do. But right now I’m focused on the concept and not the mechanics as you can see, and so far I haven’t heard any arguments compelling enough to snuff out further exploration of the idea. Thanks for the stimulating reply and the opportunity to flesh out this proposal. Let’s keep in touch.