Q&A with the HOALendingPro: What’s the difference between a bank loan and an HOA loan?

https://www.hoalendingxchange.comI was recently presented with the following question from one of my clients. I am publishing it here, along with my answer, in hopes of sharing the knowledge. It is a common question that all of us within the HOA lending field should be able to answer.

What are some differences between a construction loan or line of credit from a “normal” bank and an HOA loan or line of credit as a specialized lending option? I’m having trouble understanding the pros and cons between them.

The differences are very stark. A construction loan handled by a traditional bank reflects that there is real estate involved. The financing provided might be to construct a building, expand a building or recondition a building. In all cases, the real estate has different degrees of value during the build out period. The bank’s collateral is the value of the real estate. Depending on the bank’s loan policy, the borrower will need to provide 20% to 30% cash into the project in advance. Consequently, the bank has a vested interest in the value of the property during its various stages of change. Therefore, the bank will monitor the project in some way and they will release money from the credit line once stages of build-out have been achieved based on a budget submitted in the beginning of the project.

A construction line of credit to a community association from a bank that is skilled at providing such financing operates on an entirely different logic. There is no real estate interest in a community association. The community association has common elements that are not separable from the association and the property owners have an indivisible interest in the common elements. Consequently there is no real estate value. The financing does not rely on the value of real estate as does a traditional construction loan discussed above. What is being financed is the lack of reserves. In essence, the association should have accumulated cash reserves over time in order to pay cash for any project that needs to be done. The collateral for such a loan is the Assignment of the Association’s right to levy and collection regular and special assessments. It is a cash flow based loan. The bank looks to the level of budget increase that needs to occur to support the loan in order to make a credit worthiness judgment. It is typical for a community association specialized bank to provide 100% financing of the project. Depending on the loan policy of the bank, the bank might simply provide the funding to the association as a lump some and want to have any interest in the construction activity of the project. Other banks might provide a line of credit that is available to be drawn on at the sole discretion of the association. In other cases, the bank might want to see evidence that the project is being performed before they release funds from the credit line. Not because they have a value concern but only to be sure a project is being done at all.


HOA Loan Structures & Long Term Budget Shortfalls

https://www.hoalendingxchange.comHOALendingXchange.com has made financing for community association capital maintenance needs easily accessible.  Financial institutions that are truly skilled in serving this unique industry can be particularly flexible to the differing needs of each community. Not only does each association have a unique culture but the projects all need to be approached in a tailor-made fashion to suit what they desire to have accomplished.  The financing available is typically low cost because the transactions are acknowledged to be of low risk and the associations often provide the institutions with deposits that allow for buying down the interest rate or loan fees.

The one aspect that permeates the vast majority of all communities is the handling of financial affairs.  However, a very important responsibility has been broken in most communities. I know this to be true by virtue of years of experience as a lender financing communities throughout the country and my involvement with the Community Association’s Institute.  As well, interacting with professional Reserve Study professionals that reflect most associations are typically not more than 20% funded. That is to say that Reserve Studies indicate that a certain level of reserves is needed to support expired common elements but only 20% of that specified funding level has actually been accumulated.

The reason is also very consistent. No one wants to spend any money. A culture of “keep monthly association fees minimal” exists almost universally. Now, I am not a spendthrift. But, I have witnessed nothing but adverse effects to this “ostrich head in the sand” mentality. The reality is simply this: a community association regardless of size is a very complicated miniature town. The buildings and infrastructure are a sophisticated system of structural materials that are constantly in a state of deterioration and components are becoming obsolete.

Because of the desire to keep the annual budget low for the sheer sake of it, there is typically a huge cost impact put upon the unit owners when a project needs to be addressed. Because of the prevalent under-funding issue, the cost has typically been accomplished via large special assessments.  The availability of obtaining an association loan has smoothed the impact. Get started with your own HOA loan by simply filling out the HOALendingXchange inquiry form and HOA loan experts will get busy preparing their very best HOA loan concepts for your consideration.


Beware the Bank Lenders. They are here to help…

https://www.hoalendingxchange.comI have been a lender to community associations for more than 20 years and I suspect that some of my banking colleagues are going to string me up after reading this article. When I started lending to this market, there were very few banks that were providing such a lending instrument.  That is to say very few had a defined program with a marketing effort. There were very few community association managers who thought that getting a loan was a possibility. Equally, few associations had an interest in obtaining a loan. Associations were either building appropriate levels of reserves or resigned to levying special assessments as their only other option of raising capital. It is my understanding that banks providing loans to associations may date back at least 30 years in states like California and Florida. Largely, banks that have programs to provide loans to community associations are relatively new phenomena of the past 15 years.

I am a perpetual student at heart so I have been spending my more than 20 years of involvement in the industry quizzing other banks on their views to providing such loans. I looked to appreciate differing points of view. I wanted to expand my knowledge of unique methods that successful lenders have engaged in to keep themselves safe. I became a member of a community association banking professionals networking group whose primary goal has been self education. A group first started under the auspices of Community Association Institute later spun off as a separate group. With all this open-minded investigation over many years, I have seen “The Good, the Bad and the Ugly” when it comes to community association lending practices.

People need to keep in mind that there is nothing holy about the lending philosophies of banks. Just because you can obtain financing from a bank does not mean that you should have been given the money or that the borrowing was in any way a smart step. As we have seen through this current horrible recession, it has been the poor lending practices of financial institutions and unconstrained borrowing attitudes of governments that have collapsed our nation’s economy. It is excesses in sovereign borrowing that is threatening the financial stability of several countries around the world.

A community association must always first keep in mind that the correct step to take in paying for capital maintenance improvements is to build adequate reserves based on a professionally prepared reserve study that is updated periodically. If the association has not taken that basic step, what is left are only painful and more costly options:  special assessments and long term financing. I have yet to hear a valid argument as to why building a proper level of reserves over time is not the least cost option or the fairest option spread across all unit owners that enjoy use of the building common elements for varying periods of time.

Needless to say, building appropriate levels of reserves has been the exception versus the rule. Enter the financiers. A very important lesson to appreciate in obtaining a loan for a capital maintenance project is that the loan is not to fund the project. The loan is in reality replacing the lack of reserves that should have been in place so the association could self fund the project.

The next unfortunate mistake that a community association makes is trying to take the loan out for as long a possible because of the desire to keep assessment dues low. The real result of that desire is the cost of the project is increased via higher total loan interest costs. This issue is turning out to the most dangerous problem that the banks are creating for themselves and the associations they have stepped forward to help. The variations of this unfortunate evolution have been the advent of interest only loan, loans that amortized over 25 or 30 years and balloon payment structures. One of the worst financing tools that has been brought forth in recent years is the idea of a bond structure. Such a structure allows for interest only payment for 20 years with the principal coming due in full at maturity. If you appreciate the nature of community associations, it is highly unlikely that the association will create what is referred to as a sinking fund that accumulates the cash needed to pay off the bond after 20 years. It is far more likely that the debt will be refinanced by some willing banker over some long term. The end result really is a seemingly never ending life of paying interest on a debt that financed a common element replaced that has expired and needs to be replaced again.

This is the crux of why poorly provided financing tools are not a help to a community association that truly wants to keep its budgetary costs low. Keeping budgetary costs low should not be viewed a circumstance of the moment. It should be viewed as a series of steps that keep costs low over the long term. As a loan is to replenish reserves that should have been organically grown, there needs to be an appreciation that there are multiple common elements that are in varying stages of deterioration. The loan needs to be paid off as soon as possible in order for the association to recapture its cash flow. That debt service needs to disappear so that the association can use that cash flow for self funding future projects or perhaps to support a new loan for the next cycle of common elements that need to be upgraded. The intrinsic failure of loan structures that are too long, that have balloon payments or are interest only is that they do not recognize that the many common elements are at varying stages of needing be replaced and that the common elements upgraded with the provided financing will once again need to be replaced. A loan that outlives the lifecycle of the common element that it was put in to replace is dangerous. The association is going to have to come up with new money to replace that once again worn our common element. The cash flow strain on the unit owners may put the bank at risk for having the original loan repaid. After all, the life, safety and enhancement of property values are the first priority of the association. Servicing a debt that no one remembers what it was originally provided for is going fall into question as capacity to perform becomes strained.


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.


It’s Time to Start Thinking About the Annual Budget

https://www.hoalendingxchange.comEgad! The year is more than half over! Most of us haven’t even enjoyed our summer vacations yet. I know I have not yet gotten my summer tan to where I want it to be. Most HOAs are just hitting their financial stride this year. And yet, time marches on and budget planning season is upon us. HOA Boards of Directors need to be anticipating the challenge of successful budget preparation because it is going to be a hard budget to properly evolve. My advice is to start the planning, debating, and negotiating now. The pressures of this budget are likely to be unlike any you’ve seen before.

A perfect financial storm brewing has been brewing for some time now. As a generality, the financial woes of our nation really became noticeable in July of 2007. It’s already been years of broad-based economic stress. In my experience of dealing with the financial condition of all sorts of community associations across the country, I have noted a general progression of decisions that have been consistent since July, 2007.

When the 2008 budgets were being plotted, many associations decided to hold their budget level to the prior year. That meant deferring projects that they would have liked to do but felt that holding off one more year would be prudent. As 2008 progressed, layoffs began, financial alarm bells went off, and then came the September “near collapse” of the American financial system. The general response to these traumas was the cancellation of proposed maintenance projects and, in very many cases, operating budgets were cut back. Draconian cost control was the over-riding concern.

Through 2009, many associations experienced operating deficits as delinquencies exploded with real operating costs outpacing what was budgeted. 2010 budgets were constructed with little interest in performing maintenance work on the properties as Boards looked to further cut operating costs.

This trend has continued. Looking at current budget and operating expenses that continue to increase. Many associations are still running real operating deficits from prior year(s) because the “balanced budget” approved for the current year was truly impractical given the fact that true market-driven operating costs are higher. I have watched reserve accounts continually being depleted over the past two years to keep the associations afloat. The limit to these “extreme measures” in budgeting seems to have reached its conclusion.

Operating budgets cannot go into a third year of increasing deficits as costs continue to increase. Deferred maintenance that needed to be addressed in 2007/2008 has been stretched beyond its limit of practicality. By all appearances, community associations are likely and largely about to go into a 3 to 5 year period of strongly increasing budgets or strenuous special assessments.

Prudence would suggest that a responsible Board step forward early to be prepared to propose the budget increases that will be needed. Recognize what the real costs will be for the coming year and plan for those cost increases. For instance, due to world economic pressures, it is likely that oil prices will rise dramatically in the very near term. What will that do to your utility costs? The investment portfolios of insurance companies are stressed. To restore their needed reserve balances, insurance companies are likely to increase premiums. Local and state property taxes will be increasing dramatically in order to halt municipal budget deficits. That will squeeze the profits of vendors so they will need to increase their prices to associations to survive.

Deferred maintenance just cannot go on any longer for many of the common elements. It is becoming common circumstance that municipalities are fining and ordering associations to perform work within a time frame to satisfy life and safety issues. Since there was no money in the budget to repair the roof that was leaking in 2008, today, it is almost raining in the building. Clearly, building’s components need to be addressed and time has run out. The good news is that the cost of construction labor and materials in under control for the time being. The difficult news is that projects have a multi-thousand dollar impact on a per unit basis. Boards are going to have to plan for these projects to be done through combinations of using existing reserves, applying special assessments and seeking external financing.

The end result is that Boards will need to do good research on the line items in their budgets so they can have a real strong handle on what might occur throughout this upcoming year. Having individual line items becoming budget busters is just not going to be workable any longer. Boards need to get contractors to provide cost estimates right away so planning can be made on how these now unavoidable items can be paid for. Getting the new budget approved is going to be a major stress. Unit owners are still reeling from how the economy has affected them.

The best thing that the Board can do to get the new budget approved is to communicate early and communicate well. Present the case clearly with lots of detail. Bring in outside professionals to help explain the importance and benefits of proposed repairs, maintenance, and construction projects. Let the insurance agent explain why the insurance premium might be what is proposed and then show that you have shopped around. In demonstrating the need to get a capital maintenance project done, bring in a panel of experts to do a presentation to the unit owners:  engineer, contractor, financing representative.