Allow For “Bad Debt” In Your Budget!

Published in the ECHO Journal, February 2008

Builders, who couldn’t build homes fast enough a year ago, are now offering substantial discounts and/ or incentives such as swimming pools and upgraded amenities, even cars, to sell new homes.

Not only is there a substantial inventory of new homes on the market, resales of existing properties are on the rise, in addition to hundreds of homes and condominium units that have been foreclosed on by banks and associations, which are now being offered for sale.

Hardly a day goes by without some news report addressing the rising number of foreclosures. According to DataQuick Information Systems, Californians lost their homes to foreclosure in record numbers. They report over 24,000 foreclosures in the second quarter of 2007, “besting the previous record by 39%.” Default notices – the first step toward foreclosure – rose to 72,571 for the first three quarters ended September 30, breaking a record set in 1996.

The Associated Press recently reported that foreclosure filings across the United States nearly doubled in September 2007 compared with September 2006 “as substantially strapped homeowners already behind on mortgage payments defaulted on the loans or came closer to losing their homes to foreclosure.”

RealtyTrac, a service that lists foreclosed properties for sale, reports that across the country, there were 223,538 foreclosure filings in September 2007, up from 112,210 in the same month a year ago.

Foreclosures are a major problem throughout the country, particularly in certain states, including California, where its foreclosure rate was one filing per 253 households. California reported the most foreclosure filings of any single state with 51,259 in September 2007 alone, a fourfold increase from September 2006. The U.S. housing market has seen sales decline and home prices fall or remain flat, making it harder for homeowners who can’t afford to make their mortgage payments or pay their association assessments to sell their homes or seek refinancing. Many of these troubled homeowners were among those who took on adjustable rate mortgages that are now adjusting to higher interest rates, translating into payments they can no longer afford to pay. Many of these homeowners were first time buyers of condominiums.

The rising number of delinquencies and foreclosures has lead the mortgage industry to tighten money standards, further limiting options for homeowners struggling to pay their mortgage. The effects of the “subprime crisis” are trickling down to community associations. In your budget for 2008, you need to have a line item for an allowance of perhaps as much as 10 percent of the association’s total budget to address the possibility that some of homeowners will lose their homes to foreclosure, wiping out any association lien and with it the ability of the association to recover any unpaid assessments. Chasing down these homeowners in small claims court may result in a judgment but not result in a recovery —if homeowners can’t pay their mortgages or association assessments, they probably don’t have the money to pay their debt to the association.

We realize that boards of directors for many associations may not have considered how the subprime loan crisis was going to affect their associations’ bottom line. The fact is that we are entering a real estate market recession. If you owned property back in the early 90s (the last time we saw a serious decline in property values), you will remember a time when many properties were “upside down,” meaning that the owner owned more to the bank than the value of the home and had no equity. Today, this situation is also known as “negative equity.”

For about the past twelve years, community associations have not needed to worry much about the effect of delinquent assessments on cash flow. As home prices increased, homeowners had equity they wanted to protect; so foreclosures, especially by associations for unpaid assessments, were a rare circumstance. This is evident by the fact that the number of foreclosures has quadrupled during the last twelve months alone. There is no question that many, if not most, California community associations will suffer some financial loss resulting from homeowners who lose their property through foreclosure. Most businesses budget for “bad debt;” and, because associations are mostly small businesses, we are recommending that for 2008 you seriously consider allocating a bad debt allowance in your association’s budget.

This situation means that boards of directors will have to pay more attention to the association’s delinquencies. Each month, boards must carefully review the delinquency list and strictly comply with the association’s delinquent assessment policy. Associations can no longer afford delaying action if they want to protect their ability to collect assessments. And, despite what you may have heard, California community associations do not have to wait for the owner to owe $1,800 (or be one year delinquent) before beginning the collection process, including the recording of the all-important lien to secure the obligation.

David C. Swedelson, Esq. and Sandra L. Gottlieb, Esq. are partners in the community association law firm of Swedelson & Gottlieb and are principals of Association Lien Services, with offices throughout Northern and Southern California.