Thursday, February 7, 2008

When Market Value Slips Out the Back Door

Are Owners stealing value by underfunding reserves and then selling out?

By Tyler P. Berding

We have written a lot on these pages about the damage that reserve underfunding can do to a community association. For ten years we have tried to focus attention on the long-term effects of failing to adequately save for the inevitable reconstruction or replacement of major building components. Nevertheless, we still see every day examples of what happens when a board fails to budget to meet these needs. Associations with less than half of the funds needed for a major re-construction project are common. Associations with no funds at all are less common, but becoming more so all the time. Other authors have also discussed this topic over the last few years, so it's not just our imagination!

With the evidence of underfunding so widespread, what I have not been able to fully understand is why more owners have not raised this issue with their boards. Why hasn't the subject of failing to fund proper maintenance and repair been raised at election time as a reason for turning out the board? After all, a properly funded budget adds real value to all of the units in the project. The answer is simple. No one likes to spend money, no one likes higher monthly assessments, and the condition of the reserve fund is often too esoteric of an issue to be fully understood by either boards or owners. Also, the pressure to keep assessments low easily outweighs any concern that might exist over the condition of the building until it gets so bad that no one can hope to sell their unit at anything close to market value.

I recently ran across the following quote in a memo from the Department of Real Estate:

"All condominium associations face the problem of high and ever increasing costs to maintain a condominium project, including reserves. To compound the problem, a number of condominium boards cannot, or will not, make 'hard and unpopular' decisions of raising maintenance fees to meet this problem and facing any criticism.

The law requires condominium association boards to study the project's particular maintenance and replacement needs of the common elements and to collect and establish reserves so that funds will be on hand when repairs and replacements are needed as well as emergencies. The law was enacted to provide relief for the vast majority of condominium associations, although a good number of well-managed condominium associations were already providing for reserves. If the reserves are properly calculated, each owner's share should only be what the owner ought to be putting aside each month for the true cost for
repairs and replacements. The law tries to prevent owners from taking value out of a condominium property by underfunding reserves, selling out, and leaving subsequent purchasers to pay for the underfunding...

Any delay in confronting and controlling reserve situations will not change the condominium association's need for repair or replacement or the common elements nor the need for funds. The Commission's research reflects that those condominium associations deciding on 50% funding of reserves and/or are substantially underfunded, especially if they face
major common area repairs and replacements in the near future, will have to dramatically increase maintenance fees, make special assessments and/or take out a loan."

Pretty timely stuff, right? Nope. That memo was written thirteen years ago, in 1995--By the Hawaii Real Estate Commission. The problem has obviously been around for a long time, and not just in California. Two statements from that memo stand out. Those associations that have decided to only fund their reserves at 50% or less had better start looking for alternate funding. It cannot be put off forever, and underfunding cannot usually be made up by merely increasing monthly assessments alone. It's too late for that ten years down the road. Special assessments coupled with bank loans (which also require monthly payments) are usually necessary, making the financial hit on the then owners that much greater and make units harder to sell.

But the statement that really had an impact on me was this one:

"The law tries to prevent owners from taking value out of a condominium property by underfunding reserves, selling out, and leaving subsequent purchasers to pay for the underfunding...."

That's exactly what happens when an association bends to political pressure and tolerates an
assessment level that is less than what is necessary for predictable maintenance and repair. The board allows current owners to take value out the back door by passing on the liability to future owners. The seller has taken value by failing to pay his share of the maintenance
and repair costs.

You could argue that the condition of the building and the budget will be reflected in the sales price. Perhaps it will be, if the seller's disclosures are adequate and/or the buyer is sophisticated enough to ask the right questions. However, more often than not none of this is apparent to the average owner who simply assumes everything is as it should be and no discount on the asking price is demanded. Underfunding should, however, be quite obvious to board members and managers who have a better working knowledge of the true financial health of the association. Their duty is to present and future owners when determining the proper level to set reserves.

So how do boards discharge this duty? By not permitting owners to walk away with value they didn't pay for. The way to do that is always the same: raise monthly assessments enough to reflect the true cost of ownership regardless of political pressure. Anything less is the easy way out.

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