Four Questions Current and Potential Homeowners Should Ask
Many of us appreciate living in a community with a homeowner association or HOA. Millions of people are attracted to a lifestyle that allows them to be part of a local community, gain access to amenities, or enjoy worry-free maintenance. The fact that there are more than 355,000 HOAs across the country is a strong indicator of the popularity of HOA living. Despite this immense popularity, too few of the seventy-four million people who pay into an HOA question or understand what happens to their HOA dues.
Far too many people have a narrow understanding of the financial health of their HOA. Their lack of interest is unfortunate because the monetary well-being of the community has implications for property values, insurance rates, and even personal safety. Whether you are a current or potential homeowner, below are some critical questions to be asked about an HOA.
How are our HOA dues being spent?
Homeowners have a right to know how their board spends the association’s money. Along with reviewing an annual budget, homeowners can see yearly and interim financial statements. These reports should show how income and expenses are measured relative to the association’s plan.
If expenses exceed budgets or income projections are not being reached, owners have the right to understand why. There may be no reason for alarm. Nevertheless, the board should provide an easily understood explanation for material variances to their plan. However, if a board is reluctant to share financial information, it should be viewed as a red flag.
Too often, unit owners pressure HOA boards to keep dues irrationally low. While that may sound good on the surface, maintaining dues payments at a consistently low level is akin to driving a car with the check oil light flashing. The driver will undoubtedly save money in the short term, but what happens when the engine ultimately blows up? For this reason, HOA dues need to account for both short-term spending and long-term planning. There are two buckets to consider when developing a budget.
Are there short and long-term budgets?
The short-term also called the tactical or operational part of an HOA’s annual budget, is relatively straightforward. The HOA’s yearly budget is akin to making a personal budget. Projected income and expenses for the upcoming year are forecasted. It is best practice for HOAs to request more than one bid or proposal for high-cost services. HOAs often overpay for services. This may be due to a long-term relationship that should be periodically examined. Perhaps a prior board entered into a relationship without looking at the competitive landscape. Or the competitive environment may have changed. New technology may allow for automating a previously manual or labor-intensive process.
Operating expenses can and should be reduced when it is practical to do so. The board has a fiduciary responsibility to look at these opportunities. Unfortunately, and more commonly, most expenses tend to increase over time.
It is relatively easy to monitor and understand the ongoing income and expense parts of a budget. Since financial plans are forward-looking, actual expenses commonly vary slightly from the projections. Actual expenditures rarely are a perfect match to budgets created before the year began.
A budget’s long-term planning component, also known as a strategic plan, can be more complicated and is often discounted. When planning long-term expenditures, boards must first take inventory of the community’s essential assets. They then need to assess the amount and possible timing of these assets’ repairs, maintenance, and/or replacement.
Boards should estimate and account for these future expenditures in savings accounts commonly referred to as reserves. To get an accurate estimate of these likely expenses, an HOA must have what’s called a “reserve study” conducted.
Do we need a reserve study?
HOA board members are generally fellow homeowners who have volunteered to serve in these unpaid positions. It’s not surprising that only a few understand engineering, construction, legal, and sophisticated accounting. Yet, many of the far-reaching decisions HOA boards make will require some level of expertise in each of these areas. To ensure board members are doing what’s best for their community, they should engage experts who can advise them on issues relevant to the needs of their community.
Long-term financial planning for an HOA is best achieved through a reserve study, which almost always requires the assistance of outside experts. These reports commonly list the essential assets to be addressed through the reserve accounts. A full reserve study assesses each asset’s anticipated useful life, remaining useful life, and replacement cost.
A reserve study will develop a multi-year plan for the annual funding requirements of the reserve accounts. Deposits into these accounts are based on projected future costs and the timing of when they are likely to occur. Ideally, when it’s time to replace or repair a high-value asset, the appropriate amount of funds will be readily available from a reserve account. Current actual cash balances related to recommended balances indicate the strength of the reserve fund. This breakdown is typically expressed as a percentage of the recommended funding.
Are future reserve balances appropriate?
Boards that choose to sacrifice appropriate dues increases by ignoring or downplaying reserve funding are acting at the peril of the entire community. The situation becomes more complex when the previous board’s neglect has put an association behind the 8-ball by historically underfunding reserve accounts. Having to play financial catch-up is tricky.
When reserve accounts are underfunded, and no necessary repairs or renovations are imminent, a board may choose to quickly right-size reserve funding. They can try to replenish reserves through special assessments or dues increases. The degree of underfunding and timing of upcoming expenditures may help the board determine the extent of catch-up funding needed.
Too often, deficiencies in reserve funds are not uncovered in time. Some boards face impending capital-intensive projects with inadequate reserves to address costs. Delaying repairs may only compound the problem. Moreover, deferring maintenance or repair projects can depress property values. Often when repair projects have been ignored, costs increase. More importantly, ignoring repairs can be dangerous. Common areas in need of repair may put residents, workers, and families at risk of injury.
Remedying shortfalls in reserve funds for immediate problems can be tricky. The simple answer is to ask all residents to fund the shortfall through a lump-sum special assessment. However, not all unit owners are financially willing or able to make their payment. Spreading a special assessment over an extended period may be a better resolution. However, this approach may not refill the reserves quickly enough for immediate projects.
Where projects need immediate attention and reserves are inadequate, the board may consider taking out an HOA loan. These loans are association obligations rather than the individual unit owners’ responsibility. Future income (dues and special assessments) are used as security for these types of loans. Because of this feature, HOA loans are considered cash flow loans. This distinction differentiates these loans from more conventional loans that consider the underlying assets (such as a home or car) along with personal guarantees.
HOA loans can be complex. Their uniqueness and peculiarities can confuse borrowers and inexperienced lenders. However, like many financial transactions, their simplicity comes through once the curtain is lifted. When used responsibly, HOA loans can be an ideal tool for helping associations meet monetary challenges that demand innovative solutions.
Owners living in condos and homeowners associations should ask questions concerning the current budget and the long-term plan. They should ask to see a reserve study. If that study was prepared more than five years ago, they should request that the board update the report.
The same goes for potential purchasers considering buying a unit in an association — they should examine both the budget and the reserve study. Suppose the reserve study shows inadequate funding for the association. In that case, they should be prepared for a dues increase or a special assessment. They may also want to see which components are underfunded to assess any future liability associated with the funding gap.
A poorly-funded reserve account should serve as a warning light like a low-oil engine gauge. Maybe it will be okay to go a few more miles or years with the light on. Eventually, though, the owner will have to pay the piper.