Investment Opportunities within Association-Controlled Communities

How to Spot Red Flags when Reviewing Association Financial Information

How to Spot Red Flags when Reviewing Association Financial Information
Part 1 of a 2-part series – By Perry C. Rohan, MBA, LCAM, CPM® CANDIDATE and Uriel Uribe, LCAM

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Many of today’s real estate investors are finding their opportunities inside of condominium or homeowner association-controlled communities. It is important to understand that these communities are directed by volunteer residents, many of whom no prior experience applicable to their roles as board members. Consequently, the financial stability of these associations are inconsistent at best, so it is important to closely review the books and records of an association before making an investment in that community. This article intends to help you, the residential real estate investor, understand and evaluate the financial health of condominium and homeowner associations, from the perspective of running a rental business inside one of these association-controlled communities.

ANALYZE THE FINANCIAL HEALTH OF THE ASSOCIATION

A community association is a business. It generates income, pays its bill and hopefully has a little money left over at the end of the year to help fund special projects or make emergency repairs. Just like an investor would probably do extensive research before buying stock in a public company, real estate investors should be fully informed about the financial health of a community association, before purchasing a property within it. Here are some financial documents to review and what to look for:

Operating Budget: Represents projected income and expenses for each year. You will probably want to review the last 3 to 5 years if possible as well as the current (or upcoming) year.

  • Look for changes in assessments. A healthy association has small, regular increases in assessments every few years. An association with large jumps in assessments each year may indicate issues with emergency repairs or deferred maintenance that finally caught up with the board. Associations without any recent changes in assessments could indicate an under-funded maintenance and repair budget which could require a “special assessment” that you will be on the hook for if you buy into this community.

red-flag-animated-clipart-red-flag-clip-art-1050_1150Large year-over-year increases in assessment fees or no increases in assessment fees for many years.

  • Review the line items in the budget. You will probably see things like legal & collection fees, allowances for bad debt and/or contingency. If the amounts budgeted in these categories are high, for example, greater than 10% of the total assessment income, then this association is probably having a difficult time collecting assessment fees from its owners, or is not able to properly anticipate future events. This situation could create a short-fall in the budget which would spell trouble for you and the rest of the paying owners in the community.

red-flag-animated-clipart-red-flag-clip-art-1050_1150Large budget allocations for uncollected assessments, legal collections and/or contingencies.

  • Analyze Reserve Transfers. A healthy and well-run association will transfer money regularly into a separate bank account called a “Reserve Bank Account”. The reserve account is money set-aside to make repairs to, or replacement of, major items such as roads, gate entry systems, pool & clubhouse, roofs, landscaping overhauls, etc. Some homeowner associations do not have reserve accounts so in these situations, you have to dig a little deeper. Does the association need a reserve account or is there is nothing in that community that requires major repair or replacement by the association? Some condominium associations have specifically opted to “waive reserves” and therefore, are not putting any funds aside for major repairs. Communities without proper reserve funds will ultimately require residents to pay for repairs and or improvements via a special assessment at some point in the future.

red-flag-animated-clipart-red-flag-clip-art-1050_1150No reserve fund when there should be a reserve fund, or there is an under-funded reserve fund.

  • Insurance. You should see a large allocation for insurance on the budget. You may not know what type of insurance is in place by looking only at the budget, so you will want to review a current insurance certificate so you can see exactly what insurance policies are in place and what level of $ coverage for policies are specified. An adequately protected community association should have insurance coverage in place for commercial general liability, directors and officers, workers compensation, crime or a fidelity bond, and an umbrella policy. Depending on where the association is located, additional insurance for unforeseen disaster events (i.e., hurricane, flood, tornado, etc.) should also be in place with limits that adequately protect the association.

red-flag-animated-clipart-red-flag-clip-art-1050_1150No funding for insurance. Insurance coverage is limited, policies expired or not adequate to properly protect the association in the event of a loss.

Balance Sheet: Represents the list of assets and liabilities of the association. Just like any business enterprise, there is also an Owners Equity section which collectively represents the group of homeowners in this community. Again, you want to review the current data but also try to go back a few years so you can understand what has happened in the past. Look for the following:

  • Cash on hand. This line item should be separated in to multiple accounts. You should see an Operating Account(s) and a Reserve Account(s). Review the operating account and see if there is enough money in that account to cover three (3) months of operating expenses in that bank account. If there is less than 3-months of “back-up” cash, then this could become an area of concern. What would happen if a hurricane hit the area or a fire or flood, or the major employer for the area suddenly closed and half the community stopped paying their assessments? Associations are not allowed to dip into reserves to pay regular bills. Healthy associations have cash-on-hand to see them through emergencies.

red-flag-animated-clipart-red-flag-clip-art-1050_1150Less than 3-months of cash on hand to cover operating expenses.

 

  • Accounts Receivable. This is the amount of money owed by homeowners to the association by residents. What is the % of the annual assessment income that this accounts receivable amount represents? Is it 5% or is it 25%? A healthy association will usually carry no more than 5% to 8% of its annual assessment amount in an accounts receivable balance. However, high accounts receivables do not always tell the entire story. Some associations may have high accounts receivables as a percentage of assessment income, but it may be only one or two residents that account for most of the delinquencies. You will have to make a judgement call here.

red-flag-animated-clipart-red-flag-clip-art-1050_1150High accounts receivable balance relative to the annual assessment income.

  • Liabilities Section. A liability on a balance sheet is simply a “snapshot” of what bills may be outstanding at that moment in time. However, you should review this closely to be sure that the amount is reasonable. Also, and we have seen this in many cases, an association may have borrowed money in the past to make some kind of large repair or improvement. This debt would appear on the balance sheet and should also be reflected on a subsequent schedule outlining the original amount of the loan, hopefully with an amortization schedule showing when the loan will be paid off.

red-flag-animated-clipart-red-flag-clip-art-1050_1150Liabilities too high relative to the annual assessment income.

 

Income & Expense Statement: This may be a single year statement or month-by-month report showing what happened in each month as the year progressed. Either way, you want to closely review a report that shows columns for “Actual”, “Budget” and “Variance” so you can see a true picture of what is happening. Look for the following:

  • Large Variances. Healthy associations budget accurately and are usually paying their bills within a reasonable range from their budgeted amounts. Associations in trouble are frequently going over budget on many of their line items and some of these expenditures represent major issues to be concerned with. For example, frequent overages in legal fees and collection write-offs indicate trouble collecting fees from homeowners. It could also represent liens and foreclosure issues with the properties. Regular overages in maintenance and repair items is cause for concern that there has been a trend in deferring maintenance and there is no telling if or when that situation might end.

red-flag-animated-clipart-red-flag-clip-art-1050_1150Large negative variances between budgeted and actual expenditures.

 

Reserve Schedule: A detailed review of individual association components, including their life expectancy and anticipated replacement costs. The Reserve Schedule also shows how reserve funds are allocated to those specific association components. Note: Not all reserve schedules are the same. Look for the following when reviewing reserve schedules:

  • Is reserve funding straight line or is it pooled? Straight line reserve funding is when there is a specific amount of reserve funds tied to specific items. For example, there is $15,000 set aside for the gate, $10,000 for a clubhouse roof and $60,000 to repave the roads in the community. Straight line set-asides cannot be changed, so you cannot take the $10,000 from the clubhouse account and use it for something else. Pooled funding is just one big dollar amount that can be used for whatever item needs to be repaired or replaced. Pooled reserves are much easier for the board to manage, however, it can lead to short falls in funding necessary projects, unless a proper reserve schedule is followed.
  • When was the last official reserve study performed? Prices for repair and replacement change all the time. Additionally, life expectancy of association components (i.e., roofs, roads, etc.) can change over time or as a result of damage. Healthy associations fund a reserve study on a regular basis, and in some states, Florida for example, condominium associations are required to fund a study every three years. Check the reserve study of your target association. See if it makes sense to you. You will probably want to drive through the community to review things, like if the reserve study says the roads have 10 years left on their life, but you see pot holes and cracks all over the place could spell trouble for a real estate investor.

red-flag-animated-clipart-red-flag-clip-art-1050_1150Pooled reserve funding in when there are many components requiring reserve funds; No reserve study; reserve study not being followed or not realistic.

 

CONCLUSION:

The business of investing in residential income properties can be challenging. Property must be purchased, mortgaged, insured and maintained, all within a cost structure that falls below income received from rents. Add to this the complexity of operating a rental business inside an association-controlled community where the investor is not in control of the association’s finances, but can be negatively impacted by them. Therefore, it is important to understand the financial environment before you make an investment in any association-controlled community.

About the Author:

Perry C. Rohan, MBA, is the Director of Business Development and Client Services in the central Florida region for FirstService Residential – perry.rohan@fsresidential.com

© Copyright – All Rights Reserved

Investment Opportunities within Association-Controlled Communities

How to spot Red Flags when reviewing the operating environment of the community.

Condo 1

Investment Opportunities within Association-Controlled Communities
How to Spot Red Flags when Reviewing the Operating Environment of the Community

Part 2 of a 2-part series – By Perry C. Rohan, MBA, LCAM, CPM® CANDIDATE and Uriel Uribe, LCAM

Many of today’s real estate investors are finding their opportunities inside of condominium or homeowner association-controlled communities. It is important to understand that these communities have a wide-range of rules, regulations and restrictions that are designed to protect the lifestyle of the residents who live there – And these conditions can make being a landlord easy money or can turn your dreams of rental riches into a living nightmare. This article intends to help you, the residential real estate investor, understand and evaluate the operating environment of condominium and homeowner associations, from the perspective of running a rental business inside one of these association-controlled communities.

UNDERSTAND THE OPERATING ENVIRONMENT OF THE ASSOCIATION

When a real estate investor buys into an association-controlled community, the investor is agreeing to abide by the rules, regulations and restrictions of that community. This is what we refer to as the Operating Environment – the terms under which the investor will have to follow, in order to operate a rental business inside the community. These terms are all available for review and understanding, but you have to know where to look to be able to make an informed decision.

Covenants, Conditions & Restrictions (CC&Rs) – Otherwise known as “The documents”. You will probably receive an initial set of these documents from the real estate agent (or the seller) from whom you are purchasing the property. It is important that you get on-line with the clerk of the county court where the property is located, and find any and all amendments to these documents. The original documents may have been created years ago, but the amendments through the years will modify the original documents. You have to review just about everything in here so find a comfortable chair and start reading, watching for things that will be important to you and your rental business, such as:

  • What are you responsible for and what is the association responsible for? In a condominium, for example, unit owners typically have responsibility for the interior (drywall) or in some cases, just the paint on the drywall. Many condominiums are responsible for the roof and exterior walls, and of course, all the common walk-ways, roads and other elements of the community.
  • What type of insurance do you need? The paragraph above will help determine that, but so will an understanding of what the documents say with regard to describing what the association insures within your unit(s). This is important – The most frequent issue between the association and neighboring residents, is water leaks. How does the association handle a water leak between units? Who is responsible for what? This is all spelled out in the documents and can determine the extent of the insurance coverage an investor will need for the property.
  • What else has been amended through the years? We have seen amendments requiring no storage other than cars within garages. Amendments that added language requiring capital contributions by new purchasers, or amendments requiring that seller first offer their unit for sale to the association. Red flags in this area would be anything that makes it harder for an investor to operate their rental unit or sell their property at a later date.
  • What are the rules on rentals in the community? This seems an obvious research item, but many communities have added amendments through the years to change the original language in the documents. Some communities began with a lot of flexibility in rentals, then as the economy changed and rentals proliferated, board members began changing the rules, making it more difficult on landlords. Some communities allow rentals but require tenant approval. Some communities allow rentals only after one (or two) years of ownership. This is your business so you have to be clear on what the rules are.
  • What are the requirements or specifications on pets? As a landlord, it is a double-edged sword as to whether allowing pets in your unit is a good idea or bad. Pets allow you to charge a little more for rent, but also often cause a little more damage to the unit. But for an association, the rules on pets are important to understand. For example, if an association doesn’t have any pet restrictions, in many cases, this could be a red flag. Think about it, an association without restrictions on pets means that tenants with vicious breed dogs will be attracted to that community. If you are an investor who wants tenants with vicious breed dogs, then this is perfect for you. But if you are not a fan of these dogs, or you think it might be harder to rent your property without restrictions on pets, then you will want to avoid these communities.

 

red-flag-animated-clipart-red-flag-clip-art-1050_1150 Increasing rules on rentals and control of tenants. Condominiums that require unit owners to carry too much insurance. Pet policies that do not agree with your investment objectives.

 

Articles of Incorporation/By-Laws: As a legally formed association, the entity is required to form as a not-for-profit corporation, and therefore, must have by-laws describing how this corporation operates. Areas of potential concern to real estate investors include:

  • Who has the power? In some cases, the developer of the community is still in control of the board of directors, and the by-laws will specify how control of the association is turned over to the residents. The by-laws might also specify how voting rights are distributed between developer and residents. Communities that no longer have a developer on the board have probably turned over to the residents, which leads to other questions such as follows.
  • Who can be on the board and how many board members can you have? How does one get removed from the board? This is a big area of concern for most real estate investors. Who can be on the board is usually the owner of a unit within the community. But what if you are a bulk owner and you have 20 units in the community? Does that equal 20 votes? What if you are a corporate owner and want to be on the board, but just don’t have the time? Do the rules of the association allow for a “corporate representative” to be on the board? Knowing the procedure by which a board member can be removed is also important, as in some cases, it is as easy as a majority vote by the other board members. If this is your rental business you are protecting it by being on the board, then this information is very important to your decision process.
  • How is quorum established? Quorum is defined as the number of board members “present” in which a legally permissible meeting can be held, and in which resolutions can be made. Watch for deviations from the norm – Anything less than “a majority of the board of directors is necessary for quorum” as a red flag.
  • What are the rules for amending the documents? Most communities require a vote of the majority of the members (that means 50% plus 1), other communities require 2/3 of the voting membership, which makes changing the documents harder. Remember, changes in the documents [in the future] can cause problems for real estate investors if these changes affect their rental business.

 

red-flag-animated-clipart-red-flag-clip-art-1050_1150Limitations on real estate investors becoming board members. Restrictions imposed by developer-controlled association communities.

 

Association Minutes: These are the records of board actions and decisions (resolutions) made over time and are an essential element of the files of the association. Associations are required to keep these records for a period of years (7 years in Florida – May vary by state). Review the last year or two of minutes and try to learn more about the business decisions being made by the board of directors, and assess their impact on you and your investment objectives.

  • Is the board regularly reacting to maintenance and repair situations?
  • Is the board proactively managing maintenance and repair projects?
  • Are there legal issues that seem out of control?
  • Are there excessive homeowner complaints and what are they?

Reviewing the minutes of the association about which you are to enter, will give you a good idea if this is the type of community you want to run a rental business in. While there are no pre-defined red flags (as each situation is different), your understanding is vital to the success of your rental business.

Rules & Regulations: Here is another area where there are no pre-determined red flags, but understanding what rules & regulations are in place, can help you spot potential problems within an association-controlled community. For example, if there are extensive rules on pets, pet waste, pets on leashes, noise from pets, etc., it’s a good bet that the community is having issues with pets.

In many communities, you will probably find rules and regulations concerning tenants, in fact, there may even be a whole separate set of policies and procedures about rentals and how tenants are to behave. Many landlords do not like association rules that require tenant approval [by the board] or associations that have the right to remove tenants for not following the rules, but I think these requirements are actually a benefit to landlords as a whole. Think about it…. If an association approves tenants for residency in the community, then theoretically, you have a tenant with a clean background and one who obeys the rules within the community. Therefore, the community is not overrun by tenants who are out of control, and the community lifestyle remains good. Then when it comes time for the landlord to sell, the quality of the “product” should be better, and the landlord maximizes return on the investment.

Conclusion:

The business of investing in residential income properties can be challenging. Property must be purchased, mortgaged, insured and maintained, all within a cost structure that falls below income received from rents. Add to this the complexity of operating a rental business inside an association-controlled community where the investor is impacted by rules, regulations and restrictions that govern just how an investor can operate a rental business. It is important to understand the operating environment inside of a community, before making an investment in that community.

About the Author:

Perry C. Rohan, MBA, is the Director of Business Development and Client Services in the central Florida region for FirstService Residential – perry.rohan@fsresidential.com

© Copyright – All Rights Reserved