Sunday, August 21, 2011

Staying in or Selling Out?

Whose Interest Comes First?

   The needs of short-term owners can conflict with the interests of owners who are in it for the long-term and with the overall interests of the homeowners association.  Community association boards which cave in to political pressure and avoid developer claims or artificially keep assessments low--are depriving the remaining and future owners of critical leadership.(1)

We hear it all the time, especially now with home sales so hard to close. Members of a community association who have their property listed for sale or those who are seeking alternate financing, complain that their association’s board is taking actions that are contrary to their interests. What actions? Raising assessments to comply with the recommendations of a reserve study. Imposing a special assessment or applying for a bank loan to raise funds for long-deferred repairs. Initiating an investigation of the condition of the project that might lead to a claim against a developer for construction defects. 

  No owner likes any of this, but owners whose interest in the project is short-term like it least of all. Higher assessments will mean it may be harder for a prospective buyer to qualify for a loan. A pending special assessment may have to be reflected in the sales price. Bank loans that the bard may secure for repairs will undoubtedly lead to higher owner assessments. The results of a construction investigation may have to be disclosed to prospective buyers. But these are—or should be—the realities of managing a community association and are often very important to the long-term financial and operational stability of the development. While actions like those above may be taken as contrary to the short-term interests of some owners, they are consistent with the long-term interests of the association itself.  So whose interests have priority?
            Boards of directors face this dilemma every day, especially if they are contemplating something that will create new disclosure obligations or raise assessments. Just like the dilemma that is faced by boards when certain long-term owners who live on fixed incomes cannot afford new assessments (2) they face a similar conflict when owners with short-term interests—investors, owners trying to sell or refinance—complain that actions on behalf of the association are contrary to their more immediate interests.
            No two owners have identical interests. Young couples anticipating a family know that they will not remain in a 1-bedroom condominium for much longer. Temporary workers, or employees on short-term assignments know that when their assignment is over they will be moving on. Retirees know that they may have to look for other living arrangements when they reach an age when independent living is no longer possible. The interests of each owner of a property in a community association vary depending upon their individual situations. Can a board of directors charged with the operation and maintenance of the entire project take each individual’s interest into consideration when making important decisions? Of course not. To do that would most likely mean that no decisions would ever be made. The board of directors of a community association represents the association of owners—not any one individual owner—and must, by statute, place the long-term interests of the association ahead of any one owner’s individual interest.
           The laws that govern most homeowner associations assume their perpetual existence. And, while that is likely not true for most communities,(3) it is nevertheless the premise upon which the law is based in virtually every state, and that law in turn defines the responsibilities of the board of directors. Simply put, the board is charged with properly planning for the long-term. So what obligations of a board are most likely to come into conflict with the short-term interests of owners? 
          The reserve program is a good example. Since the funding level of the reserve account contributes to the amount of the monthly homeowner assessment, the decision of whether to “fully fund” reserves (or to fund them at some lesser level) has an impact on assessments. The amount of the current monthly assessment is what concerns buyers and fully funding reserves usually means higher monthly assessments. When short-term interests prevail—e.g. by keeping assessments artificially low—the long-term interests of the association and the interests of later owners are sacrificed to satisfy these more immediate concerns. The assessment level necessary to properly fund reserves is geared, essentially, to a 10 or 20-year horizon, or longer. But the personal interests of some owners may have a much shorter horizon, setting the stage for conflict between their interests and the interests of the greater association. 
Another example is a board’s pursuit of a claim against a newer project’s builder for construction problems. These claims frequently expose an unfunded future repair liability. Missing firewalls; the effects of gradual and long-term water intrusion from inadequate flashings or improperly installed windows that slowly leak water into an interior wall cavity; and other relatively invisible problems. There are only a handful of options for funding the inevitable repairs. Raise regular assessments sufficiently to repay a bank or reserve loan; impose a special assessment; ignore the problem until it becomes a crisis; or pursue the developer for the necessary funding. Not surprisingly, the choice is often to initiate a claim. Why should the owners of a newer project want to foot that bill? But when that happens, owners with homes on the market may be adversely affected—buyers and lenders can shy away even when the scope of the problem is well disclosed, putting pressure on boards to back off of the claim.
We also see this problem with older associations when long-deferred repairs have to be undertaken, often without adequate funding. Or worse, when, during a normal repair, the association's contractor uncovers severely rotted framing, or discovers a plumbing system that has reached the end of its service life with no reserves to replace it. In each case hundreds of thousands or perhaps millions of dollars are required to address these unexpected and entirely unfunded issues.  
Because there are limited sources of funding for unexpected repairs it is understandable why responsible boards prepare for future contingencies by funding reserves and pursuing available claims. A conflict arises from those decisions, however, because the interests of owners with more immediate needs, say, to sell or re-finance, may suffer. They will have to disclose the results of any investigation. Any increase in assessments may limit the number of potential buyers who can qualify for a loan with which to buy the home. The very existence of a claim, regardless of its nature or size, can scare off some lenders.(4) A board will often receive complaints from those owners and in some extreme cases, will hear demands that the problems be ignored or the claims dismissed.
But it is clearly not just the interests of present owners that have to be considered. The interests of future members of the association are at stake as well. When a board decides, for political or other reasons, to bend to the will of owners with short-term interests, it sacrifices not only the interests of other owners, but also the interests of future owners who will eventually have to pay for any decision to underfund long-term reserves or to defer repair of a problem. Future owners have no vote in present decisions and their interests are often compromised in abstentia. Prior boards which have failed to provide leadership for years by kicking the can down the road to future boards and future owners do so often as the result of  political pressure asserted by owners who are only interested in the near horizon.
            Pay now, or pay later? Investigate now, or risk a funding or construction crisis later? It’s a tough love situation. Most owners who have a long-term interest in the property would agree that the problem and the funding should be dealt with sooner rather than later. Imposing assessments is never fun, and keeping them artificially low is relatively easy, but boards which cave in to the political pressure from investors seeking to flip properties, or owners with their homes listed for sale are depriving other and future owners of leadership. That’s not what the law and good management require.

[1] Full disclosure: Berding|Weil litigates developer claims. We also assist associations that are trying to deal with deferred repairs and rehabilitation without adequate funds. We have seen the conflict we describe in this article first hand.
[2] Berding, The Board’s Dilemma, 2009.
[3] Berding, The Uncertain Future of Community Associations, 2005.
[4] More and more, however, various lenders are finding that ongoing claims are not a sufficient reason, by themselves, to deny a loan application and are willing to look at an application for a loan to purchase or re-finance a home in an association pursuing developer claims.

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