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HOA Loans - Is a [Reserve Allocation] Loan A Good Thing?

It is not unusual for a homeowners association facing extraordinary construction costs (those that far exceed what is available in the reserve fund) to look at getting a rehabilitation or reconstruction loan. There are a number of advantages, not the least of which is that it affords the membership the opportunity, without having to rely on their own credit-worthiness or steam, to pay for the construction work over a long period of time. It gives the Board the comfort of knowing that the money will be there when needed and allows the Board to enter into contracts for substantial works of improvement without fearing that the Association is likely to run into financial problems trying to collect a large out-of-pocket special assessment from each of the individual members.

There are many kinds of loans available for HOAs with HOA-friendly banks (those that have a division specifically dealing with HOA loans). There are fixed and variable interest loans. Fixed, of course, provides stable long range planning as the payment is predictable for a specified period of time. Variable interest rate loans allow for repayment and interest to be based on some identified standard, generally a federal banking rate. They are historically lower interest than fixed rate loans although this may not always be the case today.

Most bank loans to Associations require a rather rigorous application process and the financials, delinquency rate, reserve study, cash flow and other financial information are examined. Associations with good cash flow and low delinquency rates are usually a good risk because of their ability and track record in collecting assessments. Some banks require that the Association be managed by a Certified Common Interest Development Manager. Self-managed associations may find it hard to get the help they need in this department.

There are a number of ways to fund the loans, depending on the type. Some are funded by a special assessment, meaning that an assessment must be approved by the members and then the assessment is repaid by payments made toward the loan. Sometimes the loan repayment is made by an increase in the regular assessments. Sometimes there is a combination of the two.

Then, there is the "reserve allocation loan". This loan is paid by redirecting assessments that would otherwise be put in the reserve fund to make the loan payments. Sometimes, this last method results in a minimal amount being put into the reserves each month rather than the recommended contribution in the legally required reserve study. It is important to understand this.

A reserve allocation loan sounds pretty good to a Board and to owners [if they are notified about it] as it does not require any out of pocket expense over and above the regular assessments, meaning there is no "dreaded special assessment." However, some questions arise and they concern me. If the budget shows a reserve allocation each month and there is no money going into the reserves, one could argue that this is really a "borrowing" from reserves. There are specific legal requirements in the Davis Stirling Act that pertain to borrowing from the reserves account. Disclosures to the membership are required about the decision of the Board to borrow from reserves. If the budget shows a reserves allocation each month and the budget does not show re-direction of the funds to pay a loan, then the budget is misleading. One would assume the financial statements would show the re-direction of the funds but it is possible they might be confusing if the loan payment is not linked with the reserves allocation in the paperwork. Some financial statements are quite difficult to read.

A reserve allocation loan can result in a considerable shortfall in the reserves for components coming due for work in the years the loan is being paid off, especially in the case where the work that it is paying for does not include all of the major components in the reserve study, and ESPECIALLY if the payment is a substantial portion of the reserves allocation. For example, if the money is needed for a painting/siding major repair/reconstruction job involving the outside of the buildings, and the loan payment will take up most of the reserve allocation, and the work does not include roofs, fences, common area facilities, or any other major component, the question arises as to whether that/those other components are going to be adequately funded during the payoff period of the loan. Even if the money is used to essentially rehabilitate the entire project (which is not uncommon), if the loan payment takes up most of the reserves allocation, the reserve funding is essentially being "put on hold" during the repayment period. Typically, repayment periods are 5 or 7 years but some loans are stretched to 10 years so the work is more affordable. Certainly, an Association does not want to throw owners into a debt that they have no chance of paying, so the longer repayment term can be an advantage.

If the Association has a reserve study done at the time of applying for a loan (which is commonly a requirement if there is not a current reserve study within the prior year available) and the preparer knows of the loan and reserve allocation diversion to loan payments, the disclosure can be made to owners with the new reserve study. However, disclosure of the reserve study comes at the end of the year and owners should be advised of the fact that reserves are NOT GOING TO BE FUNDED TO THE RECOMMENDED LEVELS if the borrowing occurs, if that is in fact what is occurring. If the Board is not required to seek owner approval of borrowing (be sure to check ALL of the governing documents when this question arises), then there is no real opportunity, unless the Board makes one, to notify the Owners of the consequence of borrowing. Who knows, some associations may use this tactic over seeking a special assessment to avoid going to the owners for approval, and may be purposeful in its failure to notify the owners of the fact that reserve allocation loan means taking the reserve allocation and diverting it to loan payments.

One other advantage, or disadvantage, of a reserve allocation loan, depending on whether you are a "glass half empty" or "glass half full" kind of person, is that there is no special assessment per individual unit that gets paid off when a unit sells, so the loan goes on now and until paid, irrespective of how many units transfer hands. On the other hand, if the loan repayments are based on a special assessment, the Association can generally require that when a unit transfers hands, the share for that unit must be paid off. This could result in earlier payoff of the bank loan. It also results in allocation of the special assessment to the current owner, not any future owners. Who knows what is fair in any given scenario? And using a reserve allocation loan precludes a lender from denying responsibility when a unit is taken back in foreclosure. In the event of a special assessment, a lender can deny responsibility to pay after foreclosure. In the event of a reserve allocation loan, the loan repayments come from the regular assessment, the reserve allocation portion, and so a lender that forecloses cannot avoid the obligation.

The important thing is for associations to work with professionals when getting into this arena, and becoming educated as to the pros, cons, and disclosures that are needed so no one gets "blind-sided" by forgetting something important. My guess is that Boards generally are not able to figure out all of this on their own, and that omissions and failures are due more to negligence rather than intentional motives. Boards may run into big trouble, and consequently run for cover, if they do not have the benefit of professionals to help them figure out what the right thing to do in funding major rehabilitation or reconstruction projects. Any Board had best get the help of a team of management, construction, lending and legal professionals at the first sign of the need for a big reconstruction project.

And as for funding projects, it is true that special assessments and increased assessments hurt, but failure to fund the reserves per the reserve study preparer's recommendations will at some point lead to extra out-of-pocket costs to the owners. It is tough to avoid the inevitable when using methods to fund projects that are severely underfunded in the reserves accounts that do not require any "out-of-pocket" expense. And realtors and buyers are getting more wary of this underfunding problem. In working with one advisor, buyers are advised to require sellers to put money in escrow for a period of time to cover unanticipated shortfalls if the reserve study shows that an HOA is underfunded in reserves. The amount suggested is the amount of the seller's proportionate share of the underfunded amount. For example, if the underfunded reserve amount is $50,000 and there are 10 units, the amount to be held or paid over to buyer would be $5,000. This may seem drastic, but you be the judge - would a buyer want to be strapped with this shortfall? Most do not have enough knowledge to figure this out on their own.

Underfunding of reserves will continue to be a topic of conversation among HOA professionals, legislators, California realtors, and others, forever (or that is, until, there is no problem to discuss!)

copyright 2005, Beth Grimm, all rights reserved

By Beth A. Grimm, Attorney. A "service oriented" attorney and member of ECHO and CAI and various other industry organizations in California and nationally, host of the website www.californiacondoguru.com; two Blogs: California Condominium & HOA Law Blog, and Condolawguru.com Blog, and author of many helpful community association publications which can be found in the webstore on her site.