Published in the ECHO Journal, September 2010
Hawaii made it Mandatory—Sort of: Is it California’s Turn?
The prognosis, issued almost seven years ago, that association reserve accounts would fail to keep pace with growing costs of repair, has been found to be accurate. It is no longer fairly debatable that the unfunded repair liabilities in many community associations now exceed even the most optimistic balance in the reserve accounts. The experience of the past two decades has given us numerous examples of association inability to raise the necessary funds to properly maintain and repair the buildings. Associations have found it increasingly necessary to rely on bank loans and extraordinary special assessments to fund major rebuilding projects. Many have been unable to overcome these deficits at all with either borrowed or owner-contributed capital, and continue to defer necessary re-construction projects.
The long-term effect of this phenomenon can now be viewed in the present. Failed or failing community associations that are flirting with markedly reduced living conditions and maybe even eventual condemnation are here now. Anyone who works regularly in the community association industry knows that and has seen at least one. So, if we are faced with the prospect of associations that are financially paralyzed, what do we do about it? The pat answer is: “Do reserve studies religiously; push the inspection of components beyond just the reserve line-items; fund early and often.” The problem is that by the time many of the really expensive repairs are uncovered, it is late in an association’s life and too late to save for them in small increments. But when even the known and expected repairs are under funded, it doesn’t take much to push the association over the financial edge.
There are guidelines to reserve funding. There are also statutory requirements. But the California statute only relates to an association’s obligation to disclose its funding practices; it does not require funding at any level. Hawaii, however, has a mandatory funding statute. The Hawaii statute requires immediate funding of reserve shortfalls to at least the 50 percent level by assessment if the association uses a “straight-line” reserve projection, or 100 percent if it follows the cash flow (“just in time”) method. Also, the association must collect each month, all reserve assessments required by the funding plan. Any owner can enforce these provisions. It has been suggested that similar legislation in California is necessary to impose discipline on reserve funding to protect owner’s equity and a large inventory of affordable housing. But what would be the consequences of such legislation? Would it provide the funding that the present voluntary system has failed to achieve?
Definitions
But first, let’s define our terms. By “voluntary” we do not mean that the owners get to decide whether to pay or not. What we mean is that the board of directors decides whether to fully fund the reserve program, or not, and the owners get to decide whether to approve “extraordinary” assessments, or not. A “mandatory” reserve program is one that a state statue requires and it imposes funding at some prescribed level. In California, the only reserve program that is mandated by the state is the one blessed by the California Department of Real Estate at the inception of the project. After the project leaves the hands of the developer, the Davis-Stirling Act[i] takes over.. That statute does not require funding at any level.
Under the California statute, the board of directors decides whether or not to follow the funding recommendations of the reserve study and the owners get to decide whether or not to approve regular assessments that exceed the prior year by more than 20 percent. They also get to approve special assessments that exceed a certain percentage of the budget. If boards of directors have funded “early and often” as discussed above, these statutory caps should not impede a board’s efforts to maintain a “fully-funded” reserve program, since extraordinary increases in regular assessments or large special assessments will not be necessary.
It is only where, as is increasingly the case, the board has failed to stay even with the funding plan, or where unexpected damage to a major component is discovered late in the project’s life, that special assessments requiring owner approval will be needed. It is at that point that the true “voluntary” nature of the California assessment scheme is understood. If the owners approve the special assessment, fine. But very often owners vote “no” on large special assessments as it is their privilege to do under California law. It then becomes apparent that although approved assessments are mandatory, owner approval is optional. Hence, under this definition, California has a voluntary assessment scheme.
Hawaii’s Statute
A regulation like the one in Hawaii does not permit owner (or board) discretion as to whether to fund the reserves or not. It does, however, allow an association to choose which accounting method it wishes to follow. If it chooses the “straight-line” method, (where all useful lives of major components are divided into the cost of repair and after interest on deposits is factored in, you arrive at an annual funding plan) the statute allows the association to fund at only 50 percent of the plan. On the other hand, if it chooses the “cash flow” method (or the “just in time” method) wherein the funding plan looks at the amounts needed for repairs in each ensuing year, then the statute requires the board to fund that method at 100 percent. Since a recent survey found that the average California association is about 50 percent funded, a statutory requirement like Hawaii’s would not change things much.
Collection of assessments is, however, not an option. The Hawaii statute simply says: “For each fiscal year, the association shall collect the amount assessed to fund the estimated replacement for that fiscal year reserves, as determined by the association’s plan…” Notice the operative phrase is: “shall collect” as in: “no discretion.”
It also says: “(d) No association or apartment owner, director, officer, managing agent, or employee of an association who makes a good faith effort to calculate the estimated replacement reserves for an association shall be liable if the estimate subsequently proves incorrect.” This is fine as far as it goes, of course, but this can also be viewed in several ways. First, it implies that if you don’t have a good excuse for why your reserve plan is wholly inadequate, look out. Second, please note that it doesn’t
say that “good faith” will protect you if you fail to collect the reserve assessments. Only an honest, albeit faulty, estimate of needs confers immunity from liability under this statute.
According to our sources in Hawaii, implementation of this statute was pretty chaotic in the beginning but settled in later on. Associations that know and understand the law appear to be complying with it. So, from the example provided by Hawaii, we can see that their mandatory reserve program has not caused mass default by condominium owners. This statute came into effect in 1993, so there was considerable time for associations to bring their reserve program into compliance with state law. The statute’s gradual compliance program was instrumental in avoiding mass default or non-compliance.
Would mandatory full-funding work in California? That depends upon at least two important factors: The patience of the legislature with the pace of compliance and the basis for the reserve investigation. A short-term 100 percent compliance law would surely cause chaos in an industry that is only about 50 percent funded right now. If it adopted a 7-year phase-in like Hawaii’s, then California community associations could gradually comply. But don’t forget, the 50 percent shortfall (the flip side of being only 50 percent funded!) that the survey discovered is as of today. During the 7-year period, not only would the existing shortfall have to be made up, but future funding would have to be 100 percent of the reserve plan. Hawaii’s requirement for 50 percent funding of reserves computed by the straight line method appears inadequate to us. As stated, the average association in California already meets that goal. Something closer to 100 percent for all accounting methods, perhaps with a longer phase in—say 10 years. After all, the goal is to educate boards of directors on the necessity for sound financial planning, not to introduce chaos. A full-funding statute would gain a lot of attention in the community association industry.
The other factor is the nature of the reserve study investigation that would be required. A comprehensive investigation undertaken as the basis for reserve funding is critical. The present California statute only requires that there be a “…visual inspection of accessible areas…which the association is obligated to maintain and repair.” A great many, very expensive, problems are not visible until they have caused major damage. They occur in areas that require the removal of siding, or stucco, or trim boards or sheetrock, to see. Water intrusion may not be seen until it has caused significant damage to interior wall cavities.
Plumbing corrosion on the interior of pipes will not be discovered until numerous leaks begin to occur. Dry rot in the sub-areas beneath the floor will be unknown for years. Each of these problems requires occasional intrusive investigations to uncover. A reserve study that includes this intrusive testing will be able to predict costs associated with such hidden problems in time for the association to fund it. Wouldn’t such a comprehensive reserve investigation just increase the amount of the assessments for reserves making it harder to comply with full funding? Yes, but the choices are find it and fund it early or find it late and not be able to fund it at all. Full-funding of a repair projection that misses the most expensive repairs is not “full-funding.”
Conclusion
It costs a lot to maintain property in a first class condition. But that level of maintenance is necessary if community associations are not to be just temporary rental housing. Full funding of reserves at levels that allow for proper maintenance and repair will test the resolve of owners and managers alike to confront the inevitable issues that such legislation would promote. If nothing else, however, full-funding legislation and the debate leading up to it, would educate us as to the true costs of home ownership. Ignorance of these expenses will only perpetuate an illusion of ownership as the ever-increasing reserve shortfall that we see every day erodes the owners’ perceived equity. Even the rapid inflation of the price of many community association properties will not keep pace with the parallel inflation in both the cost of repairs and the under funding of the reserves. Full-funding would both protect the long-term interests of the owners of these investments and insure that our inventory of low to moderate income housing will not be depleted. It deserves consideration in California.
Tyler Berding is a former board member and the immediate past president of the ECHO board of directors. He is the managing partner at Berding & Weil, a construction defect and homeowner association law firm.