I 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.