Financial Articles

Setting Assessment Levels
Question: Our association charges quite a higher monthly assessment than the association next door. What is a reasonable level for monthly condo assessments?

Answer: There is a popular misconception that low assessments are better than high assessments. In other words, the board should set the fee level at the lowest rate possible and make the services fit. This goes contrary to the Board’s fiduciary duty. The Board's job is not to keep assessments low. It is to maintain or increase property values. If inadequate money is collected to properly maintain the association common property and the resulting neglect causes owners' property values to slide, the board has failed in its duty.

Comparing fee levels with other associations is meaningless since assessment level is a product of size, age, level of reserve funding, quality and quantity of maintenance and the owners' desire for specialized services. Like fingerprints and DNA, each association is unique.

To get to the meat of the matter, is to establish the reasonable cost of maintenance, administrative, management and financial services adequate to keep the operation running smoothly and the market values at a reasonable level. Annual budget must show a learning curve that improves in detail and accuracy with experience, and not merely repeats the mistakes of the past. For major repairs and replacements, the association needs a formal reserve study and funding plan. The reserve requirements melded with a realistic day to day operating budget will yield the answer to the $64,000 question: What is the proper assessment level? BACK

Associations under IRS Attack
On October 2, 1995, the IRS published a Tax Advice Memorandum “deletion's copy” (all company information deleted to avoid the public from knowing what company it relates to). This Tax Advice Memorandum (TAM) No. 9539001 related to the audit of a time-share condominium association. The TAM has "authoritative significance" and gives added insight into the IRS’s position on certain issues relating to filing Tax Form 1120. Does the audit of a timeshare affect condominium and homeowner associations? The answer appears to be yes.

In the eyes of the IRS, all homeowner associations are the same. When a homeowner association files tax Form 1120-H, the IRS considers it a homeowners association. When that same homeowner association files Form 1120, the IRS considers it a nonexempt membership organization, which is identical to a time-share association. Associations benefit from filing Form 1120 rather than Form 1120-H because the tax rate for form 1120 is 15% for the first $50,000 of taxable income compared to a flat rate of 30% for Form 1120-H. Associations may elect on an annual basis to file either Form 1120-H or Form 1120. However, filing Form 1120 puts associations at risk if they do not comply with all IRS procedures.

The following list taken from The Ledger Quarterly addresses the IRS’s rulings and describes steps to be taken by associations in order to safely file Form 1120:

Maintain three separate categories of bank accounts:
        1. Operating accounts
        2. Capital reserve accounts
        3. Non-capital reserve accounts such as painting and contingency reserves.
Conduct a reserve study that supports the specific capital use for the reserves.
Prepare a budget that agrees with the reserve study.
Separately account for operating and reserve transactions in the association’s financial statements and general ledger.
Have the members annually approve the association’s election under Revenue Ruling 70-604. The Board of Directors may not approve this on behalf of the membership.
The association may not conduct any inter-fund borrowing between the operating bank accounts and the capital reserve bank accounts.
If operating and reserve assessments are collected together, deposit them first into the operating account. The reserve dues should then be transferred to the appropriate reserve bank accounts within two weeks.
Take reserve expenditures directly from the reserve bank accounts. If reserve expenditures are paid from the operating account, that account should be reimbursed in the exact amount of the reserve expenditure at least monthly.

This list describes association responsibilities. Tax return preparers should also be aware of additional tax return issues and supporting schedules addressed by this TAM. BACK

Reserves Revisited
Fall is the time when most community associations do budget and reserve planning for the coming fiscal year. It is also an ideal time to adopt a reserve plan if none currently exists. There are a number of very good reasons:

The board has a fundamental responsibility to protect the assets of the corporation. Property values between well maintained and poorly maintained units vary significantly. Planning ahead, well ahead, for expensive maintenance projects is essential in order to avoid hitting owners with unnecessary special assessments which could have been collected systematically over time. The budgeting tool that helps board members accurately plan ahead and prevent costly oversights is called a Reserve Study. Because of its importance, reserve studies are mandatory in a number of states and will probably be adopted by all eventually.

The Reserve Study is a decision-making tool which projects the funds required for predictable future maintenance needs. The study results in two valuable pieces of information:

Statement of Condition This is NOT a statement of the physical condition of the property, but rather a statement of the funds currently available in comparison with the ideal reserve fund balance. This is expressed as a ratio called "Percent Funded". The "percent funded" is an accurate indicator of the financial strength or weakness of the association. The goal of the association should be to approach 100% Funding. This means that the association is accumulating reserves according to a recommended schedule.

Funding Plan This is the "where do we go from here" plan that usually suggests the amount of monthly contribution needed from each association member to create or maintain the ideal reserve fund balance.

The Reserve Study:
1) Enhances the board's ability to make responsible, businesslike judgments;
2) Protects and enhances the assets of the corporation, and, through a timely, planned contribution schedule
3) Avoids hitting owners with unexpected or unfair maintenance assessments. BACK

Reserves: The Reason Why
"Reserves" for community associations is money set aside to pay for major repairs like roofing and painting. A reserves funding plan is a critical component of a community’s maintenance plan. The cost of most reserve projects is usually beyond the scope of the regular operating budget so when it comes to paying the cost, the unprepared Board often relies on special assessments. Needless to say, special assessments are extremely unpopular and sometimes difficult to collect. To avoid the unpleasant task, many Boards simply delay reserve maintenance thinking a year or two more won’t matter. It does.

There is a better way called the Reserve Plan. The Reserve Plan includes a Reserve Study that identifies all the major components for which the association has maintenance responsibility. These components require repair on a cyclical basis of between three and thirty years . The Study determines each component’s remaining useful life and the cost of repair. Once the Reserve Study is complete, a Funding Plan provides a way to systematically collect reserve funds from the owners in smaller manageable amounts. Once in place, part of each monthly assessment is earmarked for reserves and placed in a separate account for that purpose.

There are many practical reasons why the Board should adopt a Reserve Plan:

It's the Law In many states, there are statutory requirements for reserves. For example, both the Oregon Planned Community Act (ORS 94.595) and the Condominium Statutes (ORS 100.175) state:

Reserves shall be established for replacement of those common elements all or part of which will normally require replacement in more than three and less than 30 years.
The reserve account must be funded by assessments against the individual unit assessed for maintenance of items for which the reserve account is being established.
The amount assessed shall take into account the estimated remaining life of the items for which the reserve is created and the current replacement cost of those items.
The reserve account shall be established in the name of the association of unit owners that will be responsible for administering the account and for making periodic payments into it. The amount of the payments shall be adjusted at regular intervals to recognize changes in current replacement costs over time.
The reserve account is to be used only for replacement of common elements and is to be kept separate from assessments for maintenance.
Restrictions on the use of the reserve account do not prohibit its prudent investment subject to any constraints on investment of association funds imposed by the declaration, bylaws or rules of the association of unit owners.
Assessments paid into the reserve account are the property of the association of unit owners and are not refundable to sellers of units

Reserve Plans are Fair Since reserve funds are collected monthly (usually), whether an owner lives there for one year or ten, a proportional share of the reserve costs is paid. Subsequent owners no longer get "stuck" for prior owner obligations.

No More Special Assessments The Reserve Plan identifies every major maintenance component and establishes a funding plan so money is available when needed. If the Board follows the plan, special assessments will no longer be necessary anticipated expenses.

Continuity The Reserve Plan philosophy provides a thread of continuity that ties one board to the next. Subsequent boards are less likely to "raid" the reserve funds for operating expenses.

Reduces Conflicts Since the Reserve Plan is usually performed by an outside consultant, there is less chance for disagreements based on conflicts of interest. Reserve Plans are thus based on the interests of the association and not that of individuals.

Improved Maintenance Since the association will have the funds when needed, overall maintenance will improve. More timely maintenance extends the useful life of the assets and increases the value of the homes due to improved curb appeal.

Recommended by Professional Managers Reserve Planning is recommended by the Community Associations Institute, national educational body for condominium and homeowners associations.

Whether required by law or a matter of practicality, the reasons why an association should adopt and maintain a Reserve Plan are indisputable. The Reserve Plan is basic brick in your community’s foundation. Is it missing from yours? BACK

Garden Variety Budgeting
Many community association boards shudder at the prospect of doing an annual budget. While a budget is fundamental to the community’s success, it involves confusing projections and numbers that few understand, right? A budget has been called "a plan of action expressed in figures." For some, the budget is "how to calculate next year's dues". Neither description gives much direction.

Let’s strip away some of the mystique by using the "garden" approach. "A budget is a living instrument that requires pruning and fertilizing. It’s the financial expression of the Board's plans for maintenance and preservation of the Association's assets." Now the picture becomes clearer. Duplicating or adding an inflation factor to last year’s budget will not address the goal of maintaining and preserving assets. The issue of "effectivity" looms: Are you getting the biggest bang for the buck and maintaining Association property values?

Effective budgets integrate the prior year’s operating budget (routine expenses like utilities, repairs and accounting) with a long range reserve budget (major expenses like painting and roofing). Both ingredients are necessary to properly maintain the association’s assets. Neglecting to include reserve funds monthly on builds a time bomb which is commonly called "Special Assessment". Making annual budget adjustments in the routine expenses and factoring in major reserve costs long before they are due will provide consistent maintenance and preservation. Say "good bye" to management by crisis.

There are four basic parts in planning the budget:

1. Resources Identification. Resources come in two forms: physical and people. Physical resources include all common area components. Review your governing documents to help make a list of common area components. People resources include vendors, Board Members, Budget Committee, the management company, involved homeowners and others who may have information about the history of the Association.

2. Expenses Evaluation. To determine next year’s line item expenses, recurring expenses like landscaping and pool maintenance should include any annual fee increases. Ask all contractor vendors about this and cost of other needed repairs. Consider possible ways of getting a better value for certain services like utilities, pool maintenance and other contract services. Example: Has your association converted outside association lighting to compact fluorescent bulbs and other high lumen, low energy alternatives? The energy cost savings are huge and will generally pay for the cost of conversion in 1-2 years. Example #2: Is your pool equipment energy efficient or the water temperature correctly set. Both can save big bucks. Look hard at each line item for ways to save without cutting services. That being said, it is possible that there are some unnecessary expenditures or line items in the budget. Consider eliminating those that don’t create a political firestorm.

3. Outside Input. Request a "wish" list from homeowners, committees and the manager. Integrating homeowners in the budget process is an important public relations move. They are much more likely to be supportive for something they had input to.

4. Formulation of Final Plans. Once all the information has been compiled, the Board, Budget Committee and manager need to work on a draft budget. Include explanatory notes for any item that isn’t obvious. Circulate the draft to all owners well in advance of the approval meeting. And invite the homeowners to attend the meeting. This integration approach will bear much good fruit.

These steps to a "garden variety" budget will build an effective financial plan that becomes more refined and beautiful every year. Remember that the budget is a living instrument that needs pruning and fertilizing by a caring Board. Plant and grow one today! BACK

Fraud Avoidance Techniques
Most states assign significant responsibility to an account holder for preventing and detecting fraud. It is important for a community association to maintain sufficient controls, to review bank statements in a timely manner and, to notify the bank promptly when fraud is suspected. Prevention and early detection are two of the main factors in reducing exposure. The following guidelines help you avoid losses from fraud and embezzlement. Consult with your accountant for controls appropriate to your particular operations.

Store your reserve supply of blank checks, canceled checks and bank statements in a secure, locked location accessible only to authorized personnel.
Before signing a check, verify the check number, date, amount and payee.
Never use a "rubber stamp" for signing checks.
Avoid signatures that are illegible or easily forged.
Notify your bank immediately when persons authorized to transact business change.
Periodically review bank signature cards, funds transfer agreements and access codes. This will ensure that you are aware of all authorizations that have been granted.
Review check orders when they arrive from the printer to verify all account information, including consecutive check numbers. Report any missing checks to the bank and the printer immediately so that stop payments can be placed.
Reconcile bank statements monthly.
Have someone other than the bookkeeper pickup, open and review the bank statements.
Insist that your bookkeeper be bonded.
Periodically assign bookkeeping duties to others as a quality check.
All disbursements except petty cash should be made by pre-numbered checks.
All petty cash disbursements should be supported by properly approved vouchers.
Checks should be signed by someone other than the bookkeeper.
Do not issue signed blank checks.
Always have your bank return canceled checks.
Mail checks promptly after signing.
Issue checks in number order.
Retain and account for voided checks.
Do not make checks payable to "cash".
Check all invoices to make sure there are no unexplained past-due notices.
Review all supporting documents (invoices, delivery receipts, etc.) before signing checks. BACK

Collections: Gathering the Late Harvest
There are few things more basic to a community association than the maintenance fees it takes to keep the place running. When one or more owners default in the payment of fees, the impact is felt by all...and the longer the delinquency, the deeper the cut. It is a situation that many boards dread because of having to deal with neighbors. Here are a number of ways to reduce the impact of, cure or avoid collection problems in your community:

Establish a collection policy with teeth. While this sounds simple enough, many communities have nothing more in place than the often inadequate provisions of the governing documents. The collection policy needs to be clear and concise. Some of the basic provisions should include the date the fee is due, the date it’s late, the penalty for late payments, how late payments will be applied to outstanding balances, legal procedures that may be invoked after a certain period or level of delinquency is reached and who pays collection costs, lien rights on an owner’s property if payment is not received and foreclosure provisions in the worst case scenario. The goal of the well written collection policy is to move the association’s bill to the top of the payment pile.

Apply the policy consistently. Once the policy is agreed upon, do not deviate from it. While there are great excuses still to be heard, remember that the Board has a fiduciary duty to protect the association’s rights. If one owner doesn’t pay, others have to ante up the difference. Absolutely avoid selective enforcement due to a friend's, family member's or a personal default.

Apply the policy in its entirety. The typical collection policy is made up of a series of events that are triggered by time and dollar amount. Once put into motion, allow it to run its course. This typically ends in placing a lien on a member’s unit. Garnishing wages, seizing property and foreclosure are possible but usually not invoked unless the case is extreme.

Use an attorney well versed in legal collection procedures. While attorneys needn’t be the first line of defense, there is a set procedure that must be followed once the size or age of the balance reaches critical proportions. Liens and foreclosures are an attorney’s domain. The impact of an attorney letter alone may be sufficient to turn the collection tide.

Consider hiring a property manager. Collections and rules enforcement are the main reasons folks don’t want to serve on the board. A manager doesn’t live there and it’s business as usual. If your community is experiencing greater than normal collection problems, this may be the best step to getting collections back in line.

Let’s face it...collections are an unpleasant but necessary part of community living. Rather than react or overreact, prepare for them with a strong yet fair policy. If the members know the will of the Board, most won’t tempt the process. BACK

Reserve Study Tutorial
Every association should exercise a plan to repair and replace major common area components like roofs, siding and decks. Healthy Reserves are critical to a healthy association because:
1. Buyers examine the Reserves before buying.
2. Lenders examine the Reserves before approving a loan.
3. The board has a fiduciary responsibility to protect the association from financial hardship.
4. The costs of maintaining the property will be shared by all owners now and in the future.
5. It provides a predictable, manageable contribution plan
6. A healthy Reserve Fund will enhance the value of your home.
7. Most importantly, avoid special assessments.

To conduct a Reserve Study, you need the following information: Item/Component Description, Number of Units per Item /Component, Replacement Cost per Unit, Year Built or Placed in Service, Life Expectancy in Years.

Step 1 - Make a List of all Common & Limited Common Elements These are defined in your association's governing documents (Declaration of Condominium, Site Plan and Floor Plans). Some examples include: Decks/Patios, Gutters, Roofs, Siding, Elevators, Fire Protection Equipment, Pavement (Resurfacing, Sealcoating, Restriping), Pool (Equipment, Furniture, Replastering, Deck Resurfacing), Fences and Signage.

To ensure a thorough list, consider all structures on the property, not just the most obvious ones. For example, dwelling roofs are obvious. However, don’t overlook garages, clubhouse and shed roofs. If similar items are built or placed in service in the same year, lump them together as a single line item and note the total number of items; if not, list them as separate line items. This will be the case in associations which were built in phases.

Avoid combining dissimilar items together, like clubhouse roof and dwelling roofs. Separating these gives a more accurate picture of your Reserve needs and reduces confusion should questions arise in the future. If you feel you must combine items, document the rationale behind it.

Document any assumptions made to eliminate confusion. By doing so, anyone unfamiliar with the association will be able to understand the report. Note, for example: "The boat dock located in the SW corner of property is not being reserved. Although a common element, it was decided by an association vote to remove it at the end of its useful life. Refer to the May 94 Board minutes."

Step 2 - Determine Life Expectancy & Replacement Cost These items go together. A question about one leads directly to the other. Check association records for work that has been done in the past. This will provide an indication of an item's Life Expectancy and Replacement Cost. In a development where the developer is still selling units or has recently completed all sales, ask the developer to provide this information. If you are in an older development, ask qualified contractors or equipment manufacturers, getting a minimum of three estimates. The lowest estimate is not always the best indicator of the quality of work, so ask for and check references.

Some contractors may require a nominal fee for a detailed estimate. However, most will credit payment for an estimate toward any work done within a reasonable time frame. If an item is nearing the end of its useful life, getting a detailed estimate (regardless whether it is free or not) is a good idea. If the item in question has a long remaining useful life, pursue getting a conservative, general estimate. This is usually sufficient for planning purposes.

You can also obtain costs for labor, material, and useful lives through sources that provide national averages indexed to your local area. This is generally sufficient for long range general planning. If you use national averages, always get a detailed estimate near the end of the useful life of a component for a more accurate picture.

Step 3 - Establishing a Funding Plan You now have all the required information to complete a Reserve Study. Next, you must select a funding strategy. This decision is very important and has serious financial implications for your association. The preferred funding strategy accountants and professional Reserve Study providers use is a Cash Flow Analysis. In general, it examines and projects the Reserving needs (contributions and expenditures) over many years, combining funds from all components, in order to determine a stable annual contribution.

In order to establish your funding plan, you need to determine:

What is your current reserve balance?
Do you currently invest the money in your Reserve Fund? If so, what is the investment rate?
What tax rate applies to the interest or dividends earned on the invested Reserve Funds? [see past tax records or the accountant]
What is the current area inflation rate? This is important because in a cash flow analysis, you examine the contributions and expenditures over 5 or more years.

Once you have determined these parameters, you are ready to put together your cash flow analysis.

Review your Reserve Analysis annually and make adjustments as needed to the three areas listed below. A change in any will have an effect on your Reserves.

Life Expectancy Can vary due to use, weather, workmanship, etc. As items get close to the projected end of their useful life, closer monitoring is warranted.
Replacement Cost As items get close to the projected end of their useful life, you will need to get a minimum of three bids for their replacement from qualified contractors.

Addition/Removal of Items As time passes, items may be added or deleted from list of Common and Limited Common elements, like removing a boat dock or adding a gazebo.

Healthy reserves are critical to the well being of every community association. Investing in a comprehensive reserve study and following a carefully charted funding plan will reap huge dividends in the coming years. If your association hasn’t already done so, get the ball rolling today! BACK

Reserve Fund Investment Strategies
How can the association maximize its return on reserve funds (money set aside for major repairs and replacements)? The starting point is a Reserve Study. A Reserve Study allows the Board to realistically anticipate its reserve expenses 5-30 years into the future. If your Board has wisely invested in a Reserve Study, the next step is to prudently invest the money while it waits to be used.

All too often, associations deposit all reserve funds into money market checking or passbook savings accounts so the funds will be immediately accessible. The rate of return offered in these accounts is often below inflation. Your association governing documents [CC&Rs] sometimes restrict reserve investments to those insured by the federal government. If they don’t, there is some latitude in directing the funds into higher return investments. Stocks are usually not recommended due to the higher risk involved. Fortunately, there are several investment strategies that can produce higher returns with low risk.

Zero to Five Year Strategy
Staggering or laddering. This strategy allows the association to invest in treasury bills and CDs (certificates of deposit) that mature at different times. Because the investments mature at predictable intervals, the association maintains a steady cash flow and the flexibility to change its investments.

Let’s take a look at a CD investment strategy using staggering. In this example, based on the Reserve Study and future cash needs, the Board invests one third of available reserves in a one-year CD. In month four, another third is invested in another one-year CD. In month eight, the remaining third is invested in another one-year CD. In month one of the next year, the first CD matures. If the funds are not needed, the CD is renewed for another year. Or, if only a portion is used, the remainder is rolled over. Additional reserve funds that have been collected by this time can either be added to the CD or another CD can be purchased.

This process can be used with any term CD. It can be adapted so funds mature more or less often, depending on the needs of the association. For example, a new association that won’t need funds for some time may be able to consider two or even three year CDs in their portfolio. The longer the term, the higher the yield. This process can be used with other investments or only a portion of the reserve funds. A Reserve Study is an educated estimate and that a contingency or emergency fund of 5-10% should be factored in.

5+ Year Strategy
Asset Allocation. All investments have two components: level of risk and rate of return. The higher the risk, the higher the return...the lower the risk, the lower the return. (Risk is measured by volatility or how much a given investment’s value fluctuates). Asset Allocation is an investment concept that previously was available only to large institutional investors. It is now available to modest investors due to computer technology. Asset Allocation provides a proven plan to maximize return while maintaining a low level of risk. Under this plan, reserve funds are invested in multiple asset class mutual funds [For example, reserve funds are invested 30% stock funds, 30% bond funds and 40% cash funds] and the performance is monitored. If changes occur in the allocation percentages, the portfolio is rebalanced to bring it back in line. This allows the association to take advantage of a diversified portfolio that can generate a higher rate of return than say, CDs, with no more appreciable risk.

Conclusion. It’s time to get off your reserve assets! By using a Reserve Study to develop holding periods and reserve amounts, the association can take advantage of higher return investments with lower risk. Higher reserve growth means the association will be able to reduce fees to its members over the long haul. Lower fees make happier owners and enhance property values. BACK