The Board's Dilemma

Every board faces this dilemma sooner or later: how to raise revenue without raising assessments. Since the only revenue the average association can obtain is from owner assessments, that's usually impossible. Owners want the board to maintain and repair the association's property, but they don't want to pay more each month, especially in these difficult economic times. Boards of directors of community associations find themselves torn between two masters--their obligation to care for the project and the political will of the homeowners. This publication was written to help directors find their way through this morass.

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What You See is (Not Necessarily) What You Get!

“Visual and Accessible” is not enough: Let’s amend the Davis-Stirling Act to delete Limitations on Reserve Study Inspections

It’s the responsibility of every California community association to commission a reserve study every three years. These studies are used to calculate the amount that each association will need to save for future building maintenance and repairs. It is critical to the financial health of every association that this funding projection be as accurate as possible. The Davis-Stirling Act governs these studies. California Civil Code Section 1365.5(e) states in part:

“At least once every three years, the board of directors shall cause to be conducted a reasonably competent and diligent visual inspection of the accessible areas of the major components that the association is obligated to repair, replace, restore, or maintain as part of a study of the reserve account requirements of the common interest development...”

Note that this requirement is limited to a “visual” inspection of the “accessible areas of the major components.” But the assessment responsibility of the board of directors is not similarly limited. Civil Code Section 1366(a) says that the board of directors shall assess as necessary to meet the requirements of the governing documents and the Civil Code. But what are those requirements exactly? And how does a board know for sure, if only the visible and accessible areas of the project are investigated?

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Predictions of the Future in an Uncertain Present

Common interest developments are reliant on member assessments to provide long-term maintenance and repair. Since the association’s governing documents and state statutes give directors and members control over the amounts raised, funding decisions tend to be more political than practical with the result being that critical funding is often deferred to future residents and boards who are unable or unwilling to handle this unexpected obligation. If the problem isn't solved, many communities will be unable to discharge their responsibilities and will become obsolete in the coming decades. With that in mind, just what does the future hold for common interest communities? What do prospective buyers need to know about the state of the association's funding? What options are available to attorneys, association leaders and legislators? Read this new publication to find out.

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What Happens When a Community Association Fails?

Does the experience in Florida presage the future for California?

We have written many times about the difficult future of the housing industry and that of common interest developments in particular.[1] Underfunded reserves have given way to underfunded operating budgets as the economic crisis deepens and community associations are finding layoffs and foreclosures beginning to impact their ability to pay for even daily operations as assessment payments dry up. What we once predicted as a future problem has been escalated to the present by the economic downturn.

This problem is not confined to California. Other states are experiencing the effects of the economy on community associations. In Florida, the problem is epidemic. In a recent article Jim Loney, writing for Reuters.com, tells the story like this:

“Florida's condominium and homeowners' associations are facing what experts call a trickle-down disaster from the property crisis. Dozens and perhaps hundreds of condo buildings have budget shortfalls as thousands of owners, under water on their mortgages or in foreclosure, stop paying monthly fees.

"I call it a death spiral," Miami Beach city commissioner Jerry Libbin said. "It's a catastrophe in the making." [2]

Community associations rely on the monthly cash flow from assessments to pay virtually all of their expenses. In most cases, they have no other source of income. When that income is seriously curtailed, the ability of the board of directors to protect and maintain the project is in jeopardy. Borrowing from reserves works for a while, assuming there are reserves in the first place. But that lasts only so long as does the available cash, and then what? We’ve written about this situation recently, and it leaves boards in the position of making some very tough decisions.[3] Landscape or pool maintenance? Painting or insurance premiums? Management or the water bill? When we get down to life-safety issues, like paying for electricity, security guards or the sewer bill, its time to re-evaluate the very survival of the association. Loney shows us that the problems in Florida are similar: “Rust pokes through the peeling paint on the railings, pest control has been curtailed and the palm trees are no longer being fertilized at the 1940s-era Miami Modern condominium building in Miami Beach.”

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[1] Berding, “The Uncertain Future of Community Associations,” 1999; 2005.

[2] Loney, Jim, “U.S. property bust threatens condo ‘death spiral;’” Reuters.com, April 3, 2009.

[3] Berding, “Your Association is Broke—Who do you pay when the cash runs out?” CondoIssues.com, December 3, 2008.

Private New Towns--A promising new concept saddled with an old problem?

The City of Hercules, once known for The Hercules Powder Company, a manufacturer of dynamite, is redeveloping its old industrial properties into what has become one of the most explosive new ideas in housing and one of the finest communities of its type on the West coast. Call it the anti-suburb plan; Hercules has employed smart growth and green planning concepts to create commuter and retail-friendly spaces among new housing, commercial and office space. A whole new downtown--"Market Town" will rise from this once industrial area on San Francisco Bay. Various environmental groups, including The Greenbelt Alliance, have supported this new mid-density development.

As a way to counter the suburban sprawl that has consumed our farm and pasture lands at a dizzying pace (some of the fringes of which now lie half built or abandoned) incorporating housing with commercial spaces in a re-vitalized downtown can't be beat. You can add many times the density in a much smaller area. But more than that, bringing goods, services, and transportation within walking distance of residences cuts reliance on automobiles in a way unseen anywhere outside of a few big California cities in recent years.

The Problem with Privately Owned Public Spaces

But like all new ideas, there might be a dark side, one that we have seen and written about many times. While many of these new “transit villages” appear like traditional towns, in most cases, multiple private owners own them, just like in the more traditional residential condominium. Mixed-use common interest properties in high-density buildings require a way to manage and maintain them and the means to fund those repairs. Normally, a building owner who leases space in buildings in a typical downtown area pays for building maintenance from rental proceeds. The established municipality pays for street and utility maintenance from property taxes...

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Is Reserve Funding Mandatory?

Can an Association Legally Defer Funding Reserves Necessary for Repairs and Renovations?

There is a continuing debate in community associations over how much cash an association must set aside to adequately fund its operations and reserve accounts, and at what level the assessments must be set to obtain that cash from the members. Boards of directors frequently face the dilemma of whether to raise monthly assessments in the face of member resistance, or to defer funding certain budget line items--typically reserve funds--to a later time.

California has a mandatory funding statute for community associations. Civil Code Section 1366 says: “Except as provided in this section, the association shall levy regular and special assessments sufficient to perform its obligations under the governing documents and this title.”[1] It uses the term “shall” and that means assessments adequate to do the job are mandatory up to the limits of the board’s authority. In California, the board has the authority to increase regular assessments up to 20% over the prior year and can impose a special assessment of up to 5% of the gross budget, all without a vote of the members.[2] So the authority is there. But does the board have to use it?

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[1] California Civil Code Section 1366(a)

[2] California Civil Code Section 1366(b)

Hang Together or Hang Separately?

Selling a Distressed Common Interest Development

as a Single Parcel: Is Partition an Alternative

to Losing it to Individual Foreclosures?

To view the future of many common interest developments take a look at the present-day reality of those recent condominium conversions that were born with serious maintenance issues and a major cash deficit. The financial condition of these projects shows us what other associations will encounter as their need for maintenance and repair overwhelms their budgets.

If an association cannot pay for essential maintenance, the value of the units will drop, similar to the recession-caused loss of value today. But they will fail to sell notwithstanding lower asking prices, and the owners, many now under water, will stop paying their assessments. When the association gets to the point where it cannot pay for essential services or do critical maintenance, the local municipality will have to decide if the units remain habitable. If the answer is “no,” condemnation may be next step.

But the owners may not have to wait for the local municipality to act. The O’Toole case which was discussed in a previous post (November 17, 2008) decided that a board of directors of a community association not only has the obligation to pay the debts of the association, it also has a duty to specially assess the members sufficiently to pay those debts, and not only that, a receiver may be ordered to insure that these obligations are carried out. So then the question arises--what if an owner decides to sue the association for failing to adequately maintain the project and the owners cannot afford the special assessment levied to pay the resulting judgment? If a court orders an assessment that the owners cannot afford, the next logical step would be for the court-appointed receiver to initiate foreclosure of the properties to collect the unaffordable assessment!

Whether this is a likely scenario or not is irrelevant--it is one of the few legal options available if a court-ordered assessment were to exceed what the owners have the ability or the willingness to pay . With no way for the homeowners to satisfy the court judgment, foreclosures would no doubt ensue. If the owners could not afford the assessment or if the assessment exceeded their equity, (again not surprising, especially in the seriously depressed market that exists today,) a court-appointed receiver may have no choice but to empty out the development, substituting banks or other lenders in place of homeowners and most likely turning the property into a rental apartment that would be owned and maintained by the foreclosing lenders, who would likely also take a loss on the deal. The court in O’Toole obviously ignored an essential truth--that while it may ultimately be up to the owners to pay for maintenance and repairs, if they lack the cash to do that, the project will likely default to multiple lender ownership and no one will win.

But there may be yet another alternative. In California, and in other states, there is a legal remedy for an obsolete common interest development, its called "Partition." Now, "partition" may sound like division, but actually it allows an entire project to be ordered sold as a single parcel. California law allows partition of a community association in one of three instances: (1) Material damage or destruction occurring more than three years prior to the partition request and repairs have not been made; (2) At least three-quarters of the project has been damaged or destroyed, and 50% or more of the separate interest owners oppose re-construction; and (3) The project is 50 or more years old, is obsolete and uneconomic, and more than 50% of the owners oppose restoration.

Many associations are approaching the 50-year mark. But even before that, could a seriously deteriorated infrastructure qualify as “material damage” to the point where it would qualify under the statute above? Would a court, looking at a project that has deteriorated to the point of becoming uninhabitable amid claims of improper maintenance, order partition in lieu of ordering the owners to pay an unaffordable assessment? Could a majority of owners force the project to be sold in its entirety to avoid individual liability for such a judgment, and if they did would they realize more value than trying to sell their individual unit in a badly deteriorated project?

The answer is, that in the right circumstance with the right facts: yes. What are those facts? If the special assessment necessary to achieve basic habitability exceeds the ability of the present owners to pay, you may not need anything else. A majority of owners, or a court, could force a partition of the property and sell it as single parcel. We have discussed many times the possible greater value that an older project may have sold or redeveloped as a single parcel than as a collection of individual condominiums.

This situation, played out over time, may await many common interest developments today. They are under-funded for critical maintenance, values have fallen, and owners have no incentive to contribute additional capital. But rather than wait for a judgment creditor or lenders to foreclose, the association should look critically at the possibility of selling the entire project and thus potentially realize greater value from a sale or redevelopment as a single parcel than as multiple individual interests that cannot continue to survive on their own.

This may seem like a draconian reaction to an inability to raise sufficient funds to maintain a common interest development, but if the owners wait long enough without taking any alternative action, their individual interests may become worthless. So rather than watch the project deteriorate to the point where it is no longer habitable or is vulnerable to lender takeover, owners of severely distressed common interest developments might want to consider an outright sale of the entire project.

Clearly, we are talking about a project in a great deal of financial distress, but our experience with hundreds of old and aging projects tells us that some are already there. If you believe that this situation may exist in your association, talk to your legal advisor about your options. Using partition to maximize the value of the project by selling it as a single parcel could be an alternative to handing it over to the banks and walking away.