In a perfect world, the answer to the question posed in the title would be a definite – NEITHER! Unfortunately, we don’t live in a perfect world and many communities find themselves in a predicament where simply raising fees won’t get them sufficient reserve funds to pay for various reserve or capital improvement projects.
The primary source of reserve related projects should be the association’s reserve fund. It is a cost effective and fair option as the reserve fund can be built up over a series of many years by residents who have paid their fair share while living in the community. Regularly updating your study is key and everyone should pay attention if the budgeted reserve line item differs dramatically from what has been recommended. Ask why and don’t fool yourself. The money won’t magically appear and underfunding will eventually lead to the question of “Loan or Special Assessment.”
For years special assessments were seen as the answer to underfunding of reserves. There are some advantages to using special assessments, including:
- Quick and often low cost to the association.
- Can raise funds without raising underlying assessments.
- Permits a project to be done all at once (at least if the special assessment raises sufficient funds to cover the full cost) instead of spreading out over a series of years.
Then there are the disadvantages, including:
- Immediate equity hit to homeowners, meaning they must come up with hard cash, even if they decide to sell and move out. Once implemented, the owner at the time the special assessment was passed is typically responsible to pay that assessment.
- Owners may not have the cash available to pay a special assessment.
- History of frequent special assessments may have a negative impact on the community’s reputation which can impact resale values.
- Often very unfair. Special assessments penalize the unlucky owners who happen to own when the special assessment is put in place, thus limiting the fairness factor addressed by adequately funding reserves. (Just because the roof wasn’t replaced while you lived in a community doesn’t mean you didn’t benefit from having a roof.)
- Often require a vote by the community. This can impact how quickly a special assessment happens.
Loans to community associations are becoming a standard tool in a board’s toolbox of ways to raise funds. Part of the reason loans are becoming more frequent is simply the scale of projects many associations, especially condominium associations, are facing. Many condo buildings built in the 70’s and 80’s are facing large infrastructure projects such as pipe replacement and balcony refurbishment. Costs to do such a project all at once are often outside the scope of available reserve funds. Loans can offer a bridge across this infrequent shortfall in funding, especially when a special assessment of the project would easily be in the thousands, and often tens of thousands of dollars per unit.
Advantages of a loan include:
- Equity hit to owners is done over a series of years instead of in one swoop as is often done with a special assessment. The most common loan terms for large projects range from 10 – 15 years, thus permitting costs to be absorbed into ongoing assessments over a much longer period. In other words, owners get to hang onto their money for longer before paying the association.
- Obtaining a loan at the association level takes the burden off owners from having to find their own financing options through home equity loans, etc.
- Helps address the fairness issue since payback is made over a series of years. Do take into consideration how loan payback is structured. A line item in the general budget versus a loan special assessment can have implications for when a sale happens.
- A loan, like a special assessment, allows all the necessary funds to be raised at once instead of spreading a larger project over a series of years. Pricing is often significantly better if a contractor does not have to do multiple mobilizations.
A loan also has it disadvantages compared to a special assessment:
- Higher cost – closing and interest costs.
- More time commitment from board members and/or management.
- Like a special assessment, an owner vote is frequently needed. However, many owners do not understand loans at the association level so you will need to hold townhall meetings, etc., to explain the process and why it may be advantageous over a special assessment. This takes time.
- Reporting requirements. While fairly minimal, a loan does come with some strings other than simply making payments. Strings includes such things as insurance requirements, annual financial reporting, minimal reserve requirements, etc.
As you can see, there is no one size fits all answer when it comes to which option – loan or special assessment, may work best for your community. Quite honestly, the best answer is, “It depends.” If the amount of money you need to raise can easily be paid in cash by the majority of your owners, consider a special assessment. It’s not worth the time and effort to go through the loan process. On the other hand, if the amount of the special assessment will cause many owners to either request a special payment plan or require them to shop for their own financing options, do the responsible thing as a board and explore possible loan options. A board/management know their community best. There is no one size fits all. Consider your options, pick the brain of a trusted banker and then consider what makes sense. Finally, consider updating your reserve study and funding appropriately. Your best option of all is to set up your community so neither a loan or special assessment is needed.
Written by: Don Plank, National Cooperative Bank