A Loan for your Community Association – Some Real World Mechanics

https://www.hoalendingxchange.comAs we head into budget season it is time to think about where all the money for all of the maintenance and capital improvements is going to come from. A primary activity of operating a community association is planning for the repair and maintenance of the property and budgeting for those large cost capital improvements that will be demanded.

I am a major proponent of having a Reserve Study performed and updated at least every 3 years. I further believe that community associations should be required by regulation to properly fund themselves based on that Reserve Study. Of course, that is a utopian concept that rarely exists in the real world. The fact that so many community associations have not properly saved for the major capital improvement projects their communities need has actually created my career. The lack of sufficient reserves to fund capital maintenance projects has created a demand for community association lending. I have been providing community association loan products at a national level for almost 20 years, I have taught numerous banks how to build successful community association lending programs. I offer the following dialog to provide guidance to borrowers when it comes to getting the best deal from those banks that profess to be desirous of your business.

Here is a proven banking fact about the community association lending industry. Community Association lending is one of the safest asset classes a bank can loan to. Such loans rarely, if ever, become a problem. This fact has resulted in many banks entering the market over the past 10 years. It is easier than ever to find a bank that is active in community association lending. Just reference the vendor directories of your local chapter of CAI, ACTHA, FCAP or CACM. It is equally easy to get multiple banks to compete for your business. That competition will result in a competitive cost financing product for your community.

However, as is often the case, the devil is in the details. The devil in this case, so to speak, is the current state of commercial banking. The post-recession banking environment has left banks emotionally shell shocked and massively over regulated. The most influential departments in a bank these days are the Regulatory Compliance and Internal Audit Departments. That information is important to you because there is no longer such a thing as having a bank “relationship” which suggests understanding, trust and human compassion.

The reality is that the very nice person who comes to give you a sales pitch, brings cookies into the office, buys you drinks after an educational seminar, takes you out for golf, and so on is not the decision maker when it comes to approving your community association loan. That person has absolutely no power, no authority and only nominal influence over whether or not your loan is approved or over the terms and conditions of that loan. The back room of a bank, operating under tight FDIC regulatory controls and review, approves and structures loans without emotion or sense of “relationship”. It is a purely mechanical process based on the bank’s loan policy and staff skills. The point being is that it is a good idea to negotiate with multiple banks. Be firm with the lenders you do pursue and do not waste time with banks that you feel are being impractical.

To make a case of why your association qualifies for a loan, you need to have performed some due diligence. Know the projects that you want to have funded and get multiple bids. You are not going to get very far with any bank if you do not have a defensible perspective on what the project is going to cost. If the project is going to require a Special Assessment or increase in the Budget, be able to show the bank a communication stream that validates the unit owners are aware of the coming financial impact. Be prepared to communicate to the bank the additional future capital maintenance projects that might need to be addressed during the loan term. A bank is going to want to know that you are aware of the condition of the property and are prepared to support funding those future projects. These are the core talking points to be able build confidence with the bank’s credit analyst.

Supporting material for a complete loan application will be 2+ years of financial statements, the year-to-date financial statements and the current year budget. A clear report that reflects the age of delinquent unit owner accounts is crucial. A document that shows the number of units rented in the community is important. Beyond these core items, different banks will ask for other types of readily available information.

A unique difficulty has developed in the loan approval process which is a function of banker stress during the recession and currently existing unskilled credit underwriters. Some banks are measuring the ratio of the loan amount to the average retail value of the units. Banks have set arbitrary limits of 10% to 15%. There is no valid basis for this credit approval metric as there are no community association loans that have become troublesome while a high ratio existed. None the less, before you spend much time with a bank, you should come to appreciate their stance on this matter because it may cap your level of access to the funds needed.

In summation, the good news is that bank financing of community association financing is readily available. The challenging aspect is that banks are going to require well-considered financial plans for getting a project done and for the success of accomplishing future projects.


Should a Community Association Borrow Money?

https://www.hoalendingxchange.comThis commentary is colored by the horrible debt-induced recession that we have gone through. The recession was the worst and the longest since the Great Depression. Interestingly, both traumatic periods were sparked and exacerbated by speculation and over-leveraging (debt). Debt is a real easy way to get to live beyond your means. Debt leaves you vastly more exposed to financial instability because a cash flow disruption may cause an inability to satisfy a scheduled debt payment requirement and result in loan default. Debt is also an expensive way to acquire anything. But, a well-considered loan can be a valuable tool if there are no other alternatives to solving an immediate necessity.

Most community association or HOA loan requests are to support the need to make upgrades or improvements to common elements. The most common requests are for replacement of roofs, siding, windows and doors. But, a proper starting place is to be building reserves. It is far smarter to have a reserve study, review it annually, and fund it as recommended which develops large cash balances that are earning interest. You are in a much smarter position to earn interest income and perhaps pay taxes on that interest income versus borrowing money and paying interest.

There is also a certain fairness to building reserves. Every day, all the common elements wear out by some small but measurable amount as defined in a reserve study. The person that owns a unit/lot for a time period has the benefit daily of the common elements that are wearing out. That unit/homeowner should be paying in their fair share of the use of those common elements on a regular basis for the period they are members of the association. A portion of the routine common charges payable to the association by each and every unit/lot owner should be their proportionate share of the amount needed to support building reserves per the recommendation of the reserve study.

Sadly, the idea of building reserves is a well-studied, prudent and easy to follow methodology that is not commonly followed. The result is an underfunded association with common elements in various stages of disrepair and obsolescence. As worn out common elements must be corrected, the solutions are narrowed to be special assessments and borrowing. A special assessment is a uniquely unfair solution because it requires the unfortunate soul that “currently” owns in the association to pay, in full, for the replacement of a common element that has been utilized by the owners of the past 20 years. The unit owner subjected to a special assessment is that unfortunate person that is in the wrong place at the wrong time. A special assessment is also painful. Essentially, a lump sum special assessment will require that unit owner to provide some large dollar amount to be paid into the association over some short period of time so the association can engage in the project at hand.

The last alternative is for the association to obtain financing. There are many skilled banks that understand the nuances of lending to a community association. To get the best terms and conditions for such a loan it is recommended that a CAI member bank be approached. These are banks that have stepped forward and committed themselves to this industry. Banks that do not have the background in community association loans are going to be more challenging to negotiate with and you might find yourself needing to educate the institution. Loans to community associations have proved to be the safest market that a bank could ever lend to. Consequently, banks that have experience with them will be providing very good loan rates with nominal fees. The borrowing terms will be flexible. The length of a loan term available is typically up to 10 years and sometimes 15 year transactions are possible. You should never enter into a loan with a prepayment penalty as these loans are most often prepaid. Banks are very willing to fix the interest rate for as long as 5 years and sometimes 10 years. Stay away from concepts like “yield maintenance fee” and SWAP rate loan pricing. These are esoteric loan pricing concepts that can look inexpensive initially but by the end of the transaction can have the association paying the bank a financing premium. These Banks should never be requiring your cash balances as collateral. You need to have access to your liquidity. The bank’s collateral is normally an Assignment of the Association’s Right to Collect Assessments. Community associations are not engaging in real estate improvement activities as much as it might appear so. The funds being provided are for replacement of reserve funds. Any bank that wants to handle the disbursement of funds as if this were a real estate development project by requiring site inspection and lien waivers does not know what they are doing. It is a bank you need to avoid. The disbursement of funds should be handled essentially as an open line of credit for the association to draw on upon request. A typical loan structure is for the loan to be a line of credit with a term that matches the build out period of the project the association is engaged in. The line is then automatically structured to convert to an amortizing loan that pays off in full, principal and interest, over a period of time such as 10 years.

There are loan structures to avoid. They promote irresponsibility or can result in the association paying far too much in interest or can create a repayment trap. An association should never enter into a loan structure that has a balloon payment. Such a structure is alluring because it keeps payments low but it results in a large lump sum payment to be paid at a point far into the future. All this has done is gotten current unit/lot owners out of paying for the obligation and dump the burden onto future owners. Then, there is the question of where the money is going to come from. Chances are that reserves will not be available. That leaves a special assessment on the unit/lot owners in the future, or, refinancing the large remaining principal balance that causes a much larger overall interest expense to the association than if the loan had been paid over a normal amortization schedule.

The idea of a long term bond has been floated. This is just another balloon payment concept. The inappropriate over-riding enticement is for a loan payment to be a low as possible. But like any balloon payment model, the unit/lot owners in the future pay off the loan and not the people that are benefitting from the capital improvements financed. As well, the overall interest cost of the transaction will be a lot more regardless of the stated rate being lower.

The other poor loan structure for a community association is a revolving line of credit. Essentially, a large MasterCard that the association can use at will. Association loans should only be for specific projects. Keeping in mind that the Board in power today that thinks a credit line is a good idea might not be the same Board in power in a couple years. Like any credit card, what tends to happen is that it is used for inappropriate purposes over time and the principal balance is likely never paid off resulting in the association wasting money on interest expense.

Here is a thought to consider when negotiating the interest rate on a loan. Some banks will fix the interest rate for 10 years but the rate will be much higher than a loan that is only fixed for 5 year increments of a 10 year fully amortizing loan. Typically, community association loans have an actual life of 6 years on average even though they were initially set up for longer payoff terms. Associations prepay such loans for a variety of reasons. If it seems possible that your association will be paying off the loan near the 5 year interest rate locked period, it might be a lot cheaper to take the 5 year adjustable rate than the 10 year fixed rate. If you are like the average association that pays off in 6 years, the 6th year might experience an interest rate increase, but it will be for only one year and on a much reduced principal balance due to all the earlier prepayments. This would be a lot less expensive than having the whole amount borrower paying the 10 year fixed rate for those full 6 years.