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®
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:
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.
Large 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.
Large 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.
No 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.
No 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.
Less 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.
High 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.
Liabilities 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.
Large 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.
Pooled reserve funding in when there are many components requiring reserve funds; No reserve study; reserve study not being followed or not realistic.
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, LCAM, CPM is a consultant to the community association management industry and managing member of Certified Residential Management Group – A Florida-based property management company.