Worst-Case Scenarios When the Reserves Won't Cover It

Worst-Case Scenarios

New Jersey has had its share of hurricanes and weather disasters over the years, and while sometimes there's ample warning before something calamitous happens, that's not always the case. A bad situation can be made immeasurably worse when a building or association isn't economically solvent enough to weather an emergency, or when insurance coverage doesn't actually cover the ensuing damages.

Budgeting for the Bad

Any financially solvent condo or HOA community has both an operating budget to cover the day-to-day expenses associated with running the community, and a reserve fund that's intended to pay for larger repairs and capital improvement projects. Still, you can’t plan for everything and not having enough funds in an emergency can be the downfall of most building communities.

It’s not just the weather that can cause concern. A hypothetical emergency could be anything from flooding without having proper flood coverage to fraud or malfeasance on the part of a board member, to massive legal bills because of a board member acting in bad faith and coming out on the wrong side of litigation. That’s why having a plan for such emergencies is vital for any condo or HOA.

Other situations that may land a residential common interest community such as a co-op, condo or HOA in financial jeopardy include major capital projects that weren’t funded appropriately, being over-leveraged in terms of debt as a result of having borrowed too much, an increase in interest rates and a failure to pay down debt, or an unrealistic operating budget based on the board’s fear of instituting an increase in maintenance/common charges.

Andrew Lester, president of FirstService Financial, handling property management, says that in his 20 years in the industry, he has never seen a co-op or condo go bankrupt, although some have come alarmingly close. “The development-owned condos were the ones most impacted by the economy,” he says. “It falls short when it cannot collect and have delinquency issues with its unit owners, and that goes for both condos and co-ops.” To combat this, an association or condo may raise owners' fees on an annual basis, or try and get financing to help pay the bills.

Another option is to reduce services. Lester says when fees become difficult for unit owners, something has to give. “If you can’t raise revenue, you must cut costs.”

Don’t Rely on Reserves

By definition, an emergency is something that comes at you fast, with limited warning ahead of time. A building can be condemned because of a steam-pipe explosion; a condo devastated by hurricane damage can be determined unstable by a building inspector, with residents having only hours to pack up their stuff and leave. Even moderate structural damage can be an enormous expense that requires immediate attention—and according to Lester, reserves are not the place to look for funding to set things right in these situations.

“In New Jersey, it’s very common for communities to have replacement reserve funds. There’s no such a thing as a free lunch. The only place the money is coming from is the unit owners. It’s pay me now, or pay me later,” says Jules Frankel, CPA, and a shareholder at Wilkin & Guttenplan, a certified public accounting and consulting firm in East Brunswick.

Most professionals will tell you that using reserves for emergencies is a bad precedent to set. “Dipping into reserves is a slippery slope,” says Karen Sackstein, CPA at The Condo Queens in Fair Lawn. “You really have to have a plan for repayment, so a lot of the times it’s just kicking the can down the road. Most associations have very tight budgets as it is. It’s pushing off the inevitable. Whether they’re way over normal on their snow removal,” she says, or on track you have to properly plan for contingencies. “It’s a lot easier for people to swallow a special assessment. Everybody knew what was going on.”

Another consideration is simple fairness. If boards use reserve funds for very acute financial issues, it’s likely that people who have lived there longer are paying the brunt of the new costs. “The trick is, over what period of time, should people be paying for something?” says Frankel. “If you have a major snowstorm and you don’t have enough money for snow removal, the people that ought to be paying for it are the ones that benefit from the snow removal. You shouldn’t take out a loan for the snow—you might have people move into the building five years later who now have to pay for that loan. If you’re putting up a new roof, and someone else is going to be living under it in the future that makes more sense.”

In such a scenario, the primary difference between a co-op and condo is a co-op can mortgage its property, so it has a financial vehicle that can potentially help in an emergency, Lester says. Condominiums are at more risk than co-ops, because their offering plans and/or bylaws often include restrictions on how they can raise money—such as requiring a super-majority of unit owners to approve assessments. Also, unlike condominiums and HOAs, debts to the co-op come before shareholders’ first mortgages. If a mortgagee forecloses on a shareholder, it does not foreclose the co-op’s lien.

Warning Signs

While nobody can predict when a true emergency is going to hit, there are warning signs resident owners and board members alike should pay attention to that might indicate that their building or HOA is in serious financial trouble and at risk for default or bankruptcy in the event of a crisis.

“The first tell-tale sign we see is when a financial statement is not being produced on a timely basis,” Lester says. “The signs on the financials are very clear when an association is running into problems. Are they holding to their budgeted forecasts? The other thing to be looking at is the amount of delinquency reports. If those are increasing, that could be a problem. Ultimately, there’s a line called ‘member’s equity,’ and when that goes negative, you’re on the road to bankruptcy.”

Also of concern are buildings where maintenance or common charges have not been raised for several years or increases do not keep pace with increased costs of operation.

“If you suspect that your manager or management company is ripping you off, that’s not who you go to first,” says Frankel. “Often we see this going to the lawyer first, unless the accountant discovers it as part of his or her audit procedures. In that case, the accountant will speak to the board’s attorney as well. It depends if we’re dealing with an individual member, or the management company.”

Personal Problems

A major financial catastrophe will hurt more than just the building, it can impact the individual unit owners as well. If a cooperative corporation is in such deep financial distress that it goes into receivership, that's very bad news for the shareholders.

Under all circumstances, if a building is in financial turmoil, and/or if shareholder/unit owner maintenance/common charges is very high, and/or if the building is severely over-leveraged, it’s going to hurt the value of the apartments and the building as a whole, which can lead to it affecting individual owners' investments. However, as long as unit owners maintain their own obligations to the bank, they shouldn’t be affected by anything that happens because of a building’s financial problems.

Final Thoughts

If a building defaults on a loan or files for bankruptcy and recovers, Lester says where it would hurt its credit going forward is within the community. Still, if an association or condo building manages to survive a financial meltdown, its financial prospects in the future will be greatly compromised but money won’t be impossible to borrow.

The bottom line is that when an emergency arises, the normal way of doing things goes out the window. After Hurricane Sandy, many associations knew they shouldn’t tap into their reserve funds, or how hard it would be to ask for another assessment. “Sometimes you just can’t help it,” says Sackstein. “There were certain situations that involved lots of damage not covered by insurance. So they needed to track the repair expenditures with the expected insurance reimbursements. As soon as they knew there was a shortage they came in and special assessed.”

That kind of flexibility and leadership will guide communities through the toughest financial circumstances.                             

Keith Loria is a freelance writer and a frequent contributor to The New Jersey Cooperator. Editorial Assistant Tom Lisi contributed to this article.

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