Federal backing for condominium loans has been a topic of much discussion lately. Many condominium communities, in a bid to remain compliant with Fannie Mae, Freddie Mac, and new lender guidelines, are seeking capital to fund essential improvements. RISE Association Management Group wrote about the new guidelines here and here. In this post, we’re focusing on how to fund condo capital improvements.
The anticipated federal loan program for funding improvements necessary to keep condos compliant with the new guidelines has not materialized. This has forced many condominiums to seek conventional funding options. The good news is that with the right support and practices, most Condo Associations and Homeowners Associations (HOAs) can qualify for substantial loans to help fund their capital expenditures. However, before you embark on the path to obtain a loan, here’s what condominium communities need to understand about securing traditional bank loans. This is the story of how RISE helped the Condo Board of a 65-year-old building qualify for a $2.5 million capital improvement loan.
Importance of Proper Accounting To Obtain Loans for Condo Capital Improvements
Many self-managed condominiums may lack standard accounting practices. In the case of one particular RISE client, we had to untangle several years of accounting before we could start the process of obtaining a loan. This was needed to complete the required audits for those years. Banks require audited financial statements and require the Condo Association’s accounting to comply with recognized standards, including accounting controls. Thus, having professional management to handle accounting becomes crucial. Experienced Community Association management companies like RISE can ensure clean audit opinions on financials, which banks demand.
Debt Servicing Capability
Every loan must have a clear debt servicing plan. Communities might levy special assessments that owners can repay over years, matching the bank loan term and interest rate, to service the loan for condo capital improvements. Some communities, with surplus funds, allocate a part of their condo association reserve funds for this purpose. The key is demonstrating consistent revenue. The revenue can come from either new assessments or existing financial health that is specially designated to make the monthly payments. Remember, if you offer long-term payment options to your homeowners, those who choose to pay upfront represent money you do not need to borrow. Subtract these upfront payments from your loan amount. In the case of our condo client, we used a surplus of reserve contributions and earmarked it for debt servicing, therefore we did not need a special assessment.
Managing Accounts Receivable
Banks scrutinize accounts receivable. Proper management practices and legal support for debt collection ensure a healthy AR. Banks like this. Banks examine AR for bad debts, emphasizing the importance of robust collections practices and ensuring minimal outstanding debts. In the case of our client, we had them implement our 3-and-out collections process, which reduced outstanding accounts receivable to less than 2% of owners.
Make sure you’ve had a conversation with your Association’s insurance agent before starting the loan process. Lenders have required and preferred insurance they look for.
Master policy considerations
Associations need to carry full replacement cost on your property which, in this very hard insurance market, many condominiums have opted not to carry. In addition, the bank may have issues with any sort of pooled insurance programs. They prefer Associations to be on a stand-alone insurance policy with full replacement cost coverage.
Ordinance or Law and Business Interruption coverage
Banks also frequently require Associations to carry Ordinance or Law as well as Business Interruption coverage. These are standard features of condominium property insurance, however, the limit you carry may need to be increased to meet the bank’s requirements. In the case of our client, we added them to our master insurance program which carries full replacement cost valuation for the building, and reduced their insurance expense by nearly 30%. This isn’t typical of all situations, but it does happen more often when a property hasn’t used a professional management company that can advise on best practices for insurance.
Liability and D&O Coverage
The Association will also need to carry sufficient Liability and Directors & Officers (D&O) coverages. The bank is typically requested to be a certificate holder for all coverages, meaning that they are notified of any changes, renewals, or cancellations of coverage in advance.
Your chosen contractor for your condo capital improvements project will also need to carry insurance naming the Association as an additional insured. Typically, this evaluation of insurance is restricted to the contractor’s liability coverages, but in some cases may require they carry Workers Compensation or other coverages. RISE has not seen any unreasonable requirements in this regard that reputable contractors have been unable to meet.
Professional Management for Condo Capital Improvement Loans
Many banks require condos to have professional management as part of the loan agreement. This offers better financial record-keeping and collections practices. Professional management ensures compliance with basic financial standards as well as ensures proper records availability and retention. Banks often have established relationships with such companies, making the loan process smoother due to established trust. Do not underestimate the value of relationships in banking. In the case of the RISE client, our banking relationship was one of the single largest factors in establishing an understanding of the risk of the client. Since we knew the client, RISE was able to speak confidently about their situation and plan for the future. The bank likely does not know your condominium Association; banks do know association and community management companies and often rely heavily on their narrative to evaluate the viability of a loan.
The Long-Range Plan
A forward-looking approach, combined with a reserve study, assures banks of an Association’s financial stability and a realistic plan in place to repay this loan. This is NOT a reserve study, although you need one of those too, but rather a plan on how you will financially deal with the infrastructure needs called for in the reserve study. A reserve study should include future projects, assessments, your proposed loan repayment method, future reserve contributions, and anything else material to your future financial planning. If you need a template for where to begin, RISE developed this tool – Reserve Planning Templates for Board Members. RISE also wrote a detailed article about how much to keep in Condo Association reserve funds you might want to check out.
Competitive Interest Rates
Working with a management company that has good relationships with banks can help in securing favorable interest rates. HOA management companies that work on these sorts of loans often will know what banks are offering in terms of rates and repayment terms. Such expertise can provide Associations with an advantage that will save considerable time and potentially, some money too.
Detailed and Realistic Project Budgeting
Accurate project budgeting is essential. Apart from contractor estimates, allowances for change orders and project management costs should be factored in. You’ll need a contract for each line item in this contract budget and for large projects, you’ll almost certainly need to ensure you have a project manager. Sometimes this can be the management company but for technical or mechanical systems outside experts are often necessary.
Using Industry Standard Contracts to Administer Condo Capital Improvements
Banks favor the American Institute of Architects (AIA) contract form. AIA contract documents are available here. Having these standard contracts prepared and in place can expedite the loan process. If this isn’t an option, having a professionally written contract may suffice. Note that Associations will nearly always need a written contract from all the contractors who are part of the project.
Legal Check on Governing Documents
Ensure there’s no member approval requirement in your governing documents that might hinder the loan process. Association attorneys should review these documents and provide an opinion letter for the bank’s confidence. This is critical as the loan may need a membership vote before closing. In other cases, if you plan to use special assessments to repay the loan, you’ll need to verify whether that will require a membership vote and plan accordingly.
Out-of-pocket Cash and Loan Amounts
While banks may finance most of the project, be prepared to cover some costs out of pocket. Efficient management of loan proceeds and assessment payments is pivotal, and this again highlights the importance of having a competent accounting department and management company. Some banks may cap loans on a certain multiple of average home values, while others may allow you as much as you’re able to repay.
Typical loan terms do not usually exceed 10 years. Most are 3 to 5 years, with jumbo loans tending to be 5 to 10 years. There is usually flexibility within this framework but there may be a give-and-take on other loan terms to get your desired term. Here again, an experienced community management company can help navigate the negotiations to achieve the Association’s goals.
Loan Funding Period Interest
It’s crucial to note that most loans have a funding period during which only interest on the amount borrowed is paid. This is typically during the phase when you’re taking draws on the loan as the project progresses. This interest is separate from the total interest paid over the loan’s lifespan. Funding periods can range from a few months to a couple of years, so this expense should be accounted for in the budget.
Bank Covenants and Financial Review
Complying with bank covenants, including periodic financial reviews, is essential. Banks will examine ongoing accounts receivable, special assessment repayments, and other financial parameters. If you’re using special assessments to repay the debt, typically, those special assessments are repaid much earlier than initially planned. This happens due to Unit sales where the entire balance, which represents a lien against the Unit, must be paid at closing to convey clear title. When these funds are remitted, you can expect to have to pay them to the bank and apply them against your loan balance. This is because the lien you have on those funds, which is the bank’s collateral, is now satisfied because you’ve been paid. As a result, you must now pay the bank. They will not want to carry that risk without mitigation.
Your Condo Association CAN Fund Capital Improvements Too!
The success story of our RISE client, a 65-year-old condominium that borrowed $2.5 million for their project, without a special assessment, stands as a testament. Following the steps above ensured a streamlined process and successful financing. These outcomes are achievable for you too with the right support and guidance. Talk to one of our Condominium Banking and Accounting experts to learn a little more.