Loan officers who concentrate on loans to individuals are very familiar with the variety of situations in which a homeowner seeks a home improvement loan. Typically, the amount of the loan is based on the equity that the owner has in the home, and the lender secures the loan by taking a second mortgage on the residence.
Loans to community associations could from the simplest perspective be viewed as collective home improvement loans. However, the legal and financial structures of community associations dictate that loans to such entities have more characteristics of commercial loans than residential loans.
Lenders should be aware that the borrowing demands for community associations around the country are growing. And those demands will continue to grow as more and more American home buyers choose a home that includes some form of common interest as an integral part of home ownership. According to estimates of the Community Association Institute, there are more than 85,000 community associations in the U.S. today, a majority of which are condominium associations. Moreover, the same source estimates that more than 50% of new housing in the 50 largest metropolitan areas in the U.S. is now being built within a community association structure.
Already 15% of the U.S. population belongs to a community association of some type. The Department of Housing and Urban Development has estimated an even greater housing trend toward the community association form of ownership and has predicted that close to half the U.S. population will be living in condominiums by 1995. Particularly with regard to the condominium form of ownership, lenders should also be aware of the growing number of commercial buildings that are coming under this form of ownership-including condominium hotels, office buildings, warehouses, medical office buildings, and condominium parking garages.
The purpose of this article is to inform lenders about the financial needs of the various forms of community associations and to suggest structures for such loans that could be attractive additions to lenders' loan portfolios.
A community association typically takes the legal form of a nonprofit or not-for-profit corporation under the corporate laws of the state in which it is located. The three most common forms of community associations are the condominium association, the homeowners association, and the cooperative association.
This article will concentrate on the first two forms - condominium associations and homeowners associations with mandatory membership. The cooperative form of ownership presents a different lending situation. Furthermore, the cooperative form is found principally in a few large metropolitan areas around the country, particularly New York City.
Unlike the other two types of associations, cooperatives own and are the mortgagors of the cooperative building. Individual residential owners hold shares in the cooperative corporation which give the owners their use rights in a particular unit. In this situation, a cooperative, which hold title to the entire structure containing cooperative units, could provide a second mortgage position on the building itself as collateral to a lender on a capital improvement loan. The other two types of associations would not be able to provide this form of collateral and would thus much more resemble the commercial borrower as opposed to a residential borrower.
First, it is necessary to address the legal bases for a condominium association and a homeowners association with mandatory membership. In condominium ownership, which will have a statutory basis found in every state's condominium or horizontal property legislation, individual owners hold fee simple title to their condominium units and a percentage fee simple interest in the common elements. A state's condominium act will also require the formation of a condominium association or council of co-owners as a nonprofit corporation. Typically, the condominium association does not own any real property at the development. Nevertheless, through the state's condominium act and more precisely through its declaration (or master deed), the association will have a duty to maintain and govern the condominium property.
The individual owner's unit will be defined in the condominium documents in terms of horizontal and vertical boundaries. Typically, the unit will be the space bounded by the finished or unfinished interior walls. Thus, exterior surfaces, structural elements, and roofs will be common elements for which condominium associations will have maintenance responsibility. The individual condominium owner will be a mandatory member of the condominium association, and there will be a statutory duty to pay a condominium assessment based on the budget requirements of the association.
The level of assessments for any particular condominium will depend very much on the type of structure and the breadth of maintenance duties as outlined in the condominium documents. For example, at a high-rise condominium with elevators, central hot water, and central heating and air conditioning, the monthly condominium fee will be higher than that in a suburban low-rise or garden-type condominium. Figure I shows a sample maintenance responsibility clause from a typical condominium document.
FIGURE 1. Sample Maintenance Clause
Section ____. Maintenance Responsibility.
- By the Owner. Except as otherwise provided in subsection (b) hereof, each owner shall have the obligation to maintain and keep in good repair all portions of his unit, and all windows and entry doors, except that the Association shall be responsible for the painting of the exterior surfaces of window frames, doors, wood trim and ornamental iron railings. The unit owner shall also be responsible for maintaining the air conditioning and heating apparatus, the patio, if any, appurtenant to his unit, the fireplace and the interior of the fireplace flue appurtenant to the unit. Maintenance by any unit owner on any portion of the Condominium, other than the interior of a unit, shall be done in accordance with the architectural standards as may be applicable in the Declaration, By-Laws, or rules and regulations of the Association.
- By the Association. The Association shall maintain and keep in good repair, as a common expense, all of the Condominium property not required to be maintained and kept in good order by an owner. Except to the extent that insurance required to be maintained or maintained by the Association covers any damage or loss, the Association shall not be responsible for any maintenance or repair to the interior of any unit. The Association shall be responsible for, as a common expense, the maintenance and repair of the common elements, including all limited common elements except patios. The Association shall be responsible for the exterior care of each unit as follows: painting as specified in subsection (a) hereof; preservation and repair or replacement of exterior building surfaces, roots, gutters and downspouts as the Board of Directors may from time to time deem reasonable and appropriate. The Association shall be authorized to perform, after notice, any maintenance upon a unit for which the owner is responsible and to charge the owner, as provided for assessments herein, with the actual costs of maintenance.
The other borrowing entity being investigated in this article is the homeowners association which has mandatory membership and, like the condominium association, mandatory assessments. Such homeowners associations have had certain common areas deeded to them by the developer. These common areas often include green belts, streets, and recreational facilities such as swimming pools, tennis courts, and club houses-the so-called amenity package at a planned community.
In contrast to a condominium, the legal basis for homeowners associations will generally not be statutory but will be a set of covenants usually in the form of a "declaration of conditions, covenants, and restrictions" which are recorded in local land records. The restrictive covenants will impose use and architectural control restrictions not only on the owner's residence but also on the common areas owned by the homeowners association. In the typical declaration, the maintenance assessments will be imposed as a covenant running with the land.
The homeowners association, like the condominium association, will take the legal form of a nonprofit corporation. The homeowners association will have assessment collection powers as set forth in the declaration and will have the ability to place a lien on the units of owners who are delinquent in payment of assessments.
The legal duty of the condominium or homeowners association to maintain the common elements or common areas gives rise to most borrowing situations. The purpose of a typical loan is to make capital improvements to the common areas or the common elements.
In the case of condominiums, this can vary widely. In older high-rise condominiums, there can be a need for retrofitting an entire heating, ventilating, and air conditioning system which might cost from $500,000 to $1 million. Larger associations own miles and miles of roads that might need resurfacing. Other recurring borrowing situations are for replacement of roofs, replacement or installation of siding on condominium units, and renovation and repair of recreational facilities such as clubhouses, swimming pools, and tennis courts.
When the board of directors of a community association is faced with the necessity of making capital improvements that could range from $100,000 to $1 million, depending on the size of the community in question, the natural source of funding is to assess the individual owners. In addition to the regular monthly assessment which a condominium or a home-owner association pays, in almost all cases, the community association declaration and bylaws will provide for a special assessment.
Problems with Special Assessments
Faced with the fiduciary duty to maintain the property, the board of directors can propose a large one-time special assessment to the membership to pay for the needed improvement. Such a special assessment can become a volatile political question among the members of the community association. Many times the documents will require at least a two-thirds vote of the membership to impose a special assessment. Therefore, if the board of directors cannot convince the membership of the need for a special assessment or if members simply vote against it because they cannot afford; such a lump sum special assessment, the board of directors finds itself between the proverbial rock and a hard place. On one hand, it has a fiduciary duty to maintain the community, but, on the other hand, it might not be able to muster owner support for a one-time special assessment.
Complicating the board's position under such circumstances is the fact that delay in making capital improvements will often prove even costlier because of deteriorating conditions in the capital resource. The board's logical recourse is to borrow the needed funds.
Of course, seeking an outside loan will provide the association with a chance to make the capital improvement or replacement immediately and pay the loan back over time through the association's regular assessment process.
Unfortunately, experience has shown that many lenders turn a deaf ear to the borrowing requests of condominium or homeowners associations once they learn there is no second mortgage position with which to collateralize the loan. As is the case with a condominium association, a homeowners association owns no property, yet it would be the entity seeking the loan. By comparison, the homeowners association does own and does hold title to the common areas of the development. In a practical sense, however, these common areas would not be of value as security to a lender because the land and recreational facilities are so burdened by easements and use restrictions that they would have little marketable value upon which a lender could collateralize a capital improvement loan.
To service this growing market, lenders must look beyond the traditional approach of requiring a second mortgage position for such loans. Lenders must view the community associations as commercial borrowers that have a guaranteed cash flow based on the assessment and collection powers of the association. The assessment and collection powers of the community association will be a key in a loan officer's decision.
Assessment and Collection Powers
Powers of collection and assessment will vary from state to state. In the case of the condominium association, a state's condominium act will be the primary source of collection powers. An example from Georgia's Condominium Act is given in Figure 2. The condominium documents will supplement and delineate the powers for a specific condominium within limits of state law. (See Figure 3.) Courts have repeatedly upheld the powers of condominium and homeowners associations to collect assessments through court action.
The typical homeowner association's collection power is not based on state law but on recorded restrictive covenants. The lien is not statutory and must be recorded. Furthermore, homeowners associations are more limited in terms of recovery of attorney's fees, in some cases to the extent that it becomes economically unprofitable for the homeowners association to pursue a delinquent owner.
FIGURE 2. Excerpt from Section 109 Georgia's Condominium Act
- All sums lawfully assessed by the association against any unit or owner or condominium unit, whether for the share of common expenses pertaining to that condominium unit or otherwise, shall, for the time the same become due and payable, constitute a lien in favor of the association of the condominium unit ... The recording of the declaration pursuant to this article shall constitute record notice of the existence of the lien, and no further recordation of any claim of lien for assessments shall be required.
- To the extent that the condominium instruments provide, the lien for assessments shall also include:
- A late or delinquency charge not in excess of the greater of $10.00 or 10% of the amount of each assessment or installment thereof not paid when due:
- At a rate not in excess of 8% per annum, interest on each assessment or installment thereof and any delinquency or late charge pertaining thereto from the date the same was first due and payable:
- The costs of collection, including court costs, the expenses of sale, any expenses required for the protection and preservation of the unit, and reasonable attorney's fees actually incurred: and
The fair rental value of the condominium unit from the time of the institution of an action until the sale of the condominium at foreclosure or until the judgment rendered in the action is otherwise satisfied.
FIGURE 3. Assessment Obligation of Owners/Rights of Association
Section 1. Purpose of Assessment. The assessments for common expenses provided for herein shall be used for the general purposes of promoting the recreation, health, safety, welfare, common benefit, and enjoyment of the owners and occupants of units in the Condominium as may be more specifically authorized from time to time by the Board. Assessments may be used to compensate officers and directors, only if approved by a majority vote of the Association.
Section 2. Creation of the Lien and Personal Obligation for Assessments. Each owner of any unit, by acceptance of a deed therefor, whether or not it shall be so expressed in such deed, is deemed to covenant and agree to pay to the Association: (a) annual assessments or charges; (b) special assessments, to be established and collected as hereinafter provided; and (c) specific assessments against any particular unit which are established pursuant to the terms of these By-Laws. All such assessments, together with late charges, interest, costs, and reasonable attorney's fees, as provided in the Declaration and in the maximum amount permitted by the Act, shall be a charge on the unit and shall be a continuing lien upon the unit against which each assessment is made. Such amounts shall also be the personal obligation of the person who was the owner of such unit at the time when the assessment fell due. Each owner shall be liable for his portion of each assessment coming due while he is the owner of a unit, and his grantee shall be jointly and severally liable for such portion thereof as may be due and payable at the time of conveyance. Assessments shall be paid in such manner and on such dates as may be fixed by the Board of Directors; unless otherwise provided, the annual assessments shall be paid in monthly installments due on the first day of a month.
Section 3. Acceleration. If a unit owner shall be in default in payment of an assessment, including, but not limited to, the monthly Installments based on the annual budget, the Board of Directors may accelerate the remaining assessments, including monthly installments based on the anneal budget, special assessments, and specific assessments, upon ten (10) days' written notice to such unit owner, whereupon the entire unpaid balance shall become due and payable upon the date stated in such notice.
LOAN STRUCTURE AND SECURITY
Loan Size, Interest Rates, and Terms
Keeping in mind this revenue-raising power as the basis of an association's ability to repay a loan, the lender could consider the terms and conditions of a typical loan request. The loan amount could range from $100,000 for installation of aluminum siding at a 50-unit garden-style condominium complex to $1 million for systems renovation in a large metropolitan high-rise condominium.
The term of the loan will usually be no less than three years but no more than five years. However, I am aware of a lender who was willing to make a seven-year loan that had an interest- rate adjustment based on the prime rate after five years. While the interest rate on such a loan obviously will vary depending on market conditions, a lender can set the interest rate at two to three points above the designated prime rate.
Also, a lender can often require that the community association purchase a certificate of deposit (CD) from the lender in an amount representing a certain percentage of the principal of the loan. This CD then will be pledged to the tender to secure a percentage of the loan principal. Obviously, such a transaction facilitates the loan decision and enhances the attractiveness of the loan because the purchase of a CD as security provides some of the funds that are lent to the borrower. Lenders sometimes have added a condition to the loan that the community association move all its bank accounts to the lending institution to obtain the loan and that such accounts remain with the institution during the term of the loan.
As stated earlier, the community association usually does not own any real property on which a second mortgage position can be taken to collateralize a capital improvement loan. While some loan officers have chosen to ignore the community association as a borrower because of the absence of such collateral, a loan officer who thoroughly understands the structure of the community association should nevertheless be able to obtain adequate security for the loan. Financing capital improvements that involve large investments in equipment, such as the replacement of a heating and air conditioning system, provides the lender with security if the lender takes a security position in the equipment and files a Uniform Commercial Code (UCC) secured transaction financing statement.
For loans not involving equipment, the lender can take a security interest in the assessments to be paid by the owners of units. This security interest may also be perfected by filing a financing statement in accordance with Article 9 of the UCC. While lenders might seek a pledge or security interest in all assessments to be received by the association for the term of the loan, lenders should be aware that certain expenditures such as insurance will be required of the association by state law.
Therefore, it would not be fair or perhaps even possible for an association board of directors to pledge all the assessment income. The lender, however, can easily require that an association's budget have a line item equal to the debt service on the loan and have it pledged. As has also been mentioned, many lenders have required associations to conduct all their banking with the lender during the term of the loan, and the lender obtains a perfected security interest in such association's bank accounts.
The documents required in a capital improvement loan request by a community association will be substantially the same documents that a lender requires from any commercial enterprise. Loan officers should receive:
- A description of the capital improvement involved or the repair work envisioned.
- Engineering reports or analysis regarding such work, if applicable.
- Bids or estimates for the work to be done.
- Financial statements of the association for at least two years. (A sample income statement for a resort-area condominium is shown in Figure 4.)
Necessary documentation particular to the community association borrower includes an asset collection analysis to show what percentage of the association's monthly assessment is collected in a timely manner. The association should also provide a statement of its collection policy. The loan officer should request that the association provide a ratio of outstanding/ late assessments to budgeted assessments receivable. A percentage to show the amount of timely collected assessments will also be indicative of evenness in the association's cash flow. The lender should inquire whether the association has a standard policy for treating delinquent unit owners.
The association must provide the lender with copies of the association's documents that outline assessment and collection powers. Also, the association should provide documentation to verify its statutory or corporate power to enter into the loan transaction. The board of directors for the association should provide a corporate resolution of its approval of the loan in which the purpose of the loan is set out. Finally, loan officers should require an opinion of the association's legal counsel to include a confirmation of the power to borrow and a brief analysis of the statutory and documentary bases for assessment and collection power.
FIGURE 4. Income Statement for 95-Unit Condominium in Southern Coastal Resort*
For the month ending December 31, 19XX
Regime Fees (Condominium Fees)
Common Area Electricity
Hot Water Electricity
Landscape - Labor
Landscape - Supplies
Pool - Labor & Supplies
Payroll Taxes & Benefits
Bank Service Charges
Net Operating Revenue
Transfer to Reserves
Hot Water Heaters
Stain Wood Rails
Paint - Corridor, Ceilings
Tennis Court Surface
Total Transfer to Reserves
Net after Other Expenses
Excess (Deficit) after Reserves
*Lenders must remember that the needs of a resort community will be different from those of an urban high-rise condominium. For example, the expense for lagoon treatment is regional, and therefore not likely to be encountered in other situation. Also, in a resort area, there may be many vacation renters who will jack up utility use and, hence, expense, simply because they may be more careless about using utilities.
Loan documentation will include a loan agreement, a promissory note, a security agreement and financing statement, and a collateral assignment or conditional assignment of assessments. In addition to the terms of the loan, the agreement should carefully state and describe the security for the loan in terms of all condominium association assessments or the line item in the budget for the loan service. The security as stated above can also include the security interest in bank accounts placed at the lending institution.
The loan agreement also should include a statement that debt service shall be included as a separate line item in each annual budget of the association beginning with the first annual budget after the loan is made and all budgets thereafter during the term of the loan. The borrower should agree that the amount of the annual budget and the amount of the annual assessments and carrying charges levied against the condominium owners shall at all times be in an amount sufficient to service the loan and to meet all annual expenses of maintaining and operating the condominium or home-owners association.
The lender also may wish to include in the agreement a requirement that the association furnish on a regular basis a list of the owners who are delinquent in paying their assessments. In this way, the lender may discover potential problems in collection and forestall such problems. Finally, the lender should require a submission of the borrower's annual budget during the term of the loan.
The security agreement and financing statement should be drawn to satisfy the requirements of Article 9 of the UCC. The statement will include a security interest in all bank accounts of the debtor (borrower) and all of the debtor's rights, title, and interest in all present and future condominium assessments payable to the debtor from all unit owners. A conditional assignment of the assessment can be drafted so that it becomes operative on any default made by the association. It will remain in full force and effect as long as any default of payment of the loan continues. Through this instrument, the borrower will have conditionally assigned, transferred, and set over unto the lender all its rights, title, and interest in present and future assessments that are due to the borrowing association from each unit owner.
In reaching decisions about lending to the community association, loan officers should pay special attention to the assessment collection records provided by the association. Study of such records will show how the association has been able to manage its cash flow and thus will give a true indication of its ability to service the debt through a line item in the budget. Since the association budget would include a line item for debt service, the loan officer must determine from the association's documents how the budget is formulated and whether unit owners have the power to vote down a budget proposed by the board of directors.
Properties and Their Owners
Of a more fundamental nature, but nonetheless important, is the lender's knowledge of the homes and homeowners being represented by the borrowing community association. Specifically, the loan officer should survey past and present selling prices for the homes. This will give an indication of the values of the homes to see if they are rising or falling, and also it will indicate to a certain extent the income level of homeowners. Such analysis will give a clear picture as to whether owners are keeping up the property and whether they have the earning power to pay assessments in a timely fashion. The lender must keep in mind that while the borrowing entity is a nonprofit corporation, the ultimate benefactors of the capital improvements will be the homeowners.
A careful examination by a loan officer of the above loan application documentation should minimize the risk in lending to a community association. The pledge of an assessment when the assessment collection and cash flow history of the association have been carefully studied should provide the lender with ample security.
In case of default, the lender can look to the monthly cash flow. Only in dire economic circumstances would this cash flow be imperiled.
Although the lender can minimize the risk, the tender must always ask itself the question, what if the association declared bankruptcy? Instances of community association bankruptcy are few, but there is some precedent. In the recent case of In re Condominium Association of Plaza Towers South Inc., 43 Br. 18 (S.D. Fla., Aug. 30, 1984), a U.S. Bankruptcy Court held that a condominium association may indeed file a Chapter 11 bankruptcy for reorganization.
However, almost no foreseeable circumstances would a condominium association be able to file a Chapter 7 for liquidation. The association must continue its statutory requirements to maintain the property. Furthermore, the record owners will continue to be legally responsible for the assessment whether or not units are inhabited. In fact, the lender should consider the association more in terms of a governmental unit, such as a city or county, that declares bankruptcy. A government has taxing power and that taxing power can be used to raise revenue to settle debts. There is also indication from other case law involving community associations that a court would order the association to look to its unit owners in the form of increased assessments to settle its debts. I conclude, therefore, that the chances of a community association filing for bankruptcy are very small. Even if a bankruptcy did occur, it would be a Chapter 11 reorganization which would be resolved in a relatively short time because a court would look to the assessment or taxing power of the association to place the association back on a sound financial footing.
Lending to community associations will offer more and more opportunities to financial institutions in the coming years as this form of owner- ship increases not only in numbers but also in variety. In coming years, borrowers will consist of not only the high-rise condominium seeking to renovate or replace a heating and air conditioning system but also community associations representing office condominiums, medical condominiums, and warehouse condominiums. It is, in fact, difficult to envision all the forms of shared ownership that may spring from the condominium concept. Lenders should acquaint themselves with this type of loan and should seriously consider it because of the attractive rate of return and because of the relative security with which loans can be made to a community association.
For additional information, readers are referred to the manual, "Financial Management of Condominium and Homeowners Associations," published jointly by the Urban Land Institute and the Community Association Institute (CAI). Copies may be ordered from CAI, 3000 South Eads St., Arlington, VA 22202. Price as of publication of this article is $18 for members and $27 for nonmembers.
AUTHOR'S UPDATE, SECOND EDITION
Prjcher dans le desert, as the French would Say, "to Preach in the desert"; and Preaching in the desert is the feeling that I have often had over the past six or seven years when discussing lending to community associations with loan officers. The message, however, must finally be getting through. Some bankers are now at least expressing interest in making medium term loans to community associations.
For instance, I was recently involved in the request by a large planned community in Florida to obtain a $7.5-million loan commitment for capital improvements to the community, including a new and larger clubhouse and new swimming pool. The association's loan request elicited strong interest from several banks, and the association succeeded in receiving a commitment for funding its $7.5-million project from a Florida bank.
The terms and conditions of the loan Were quite favorable to the association, reflecting the bank's analysis as to the low risk in making such a loan. The association was given a two-year period in which to draw down the commitment during the construction phase of the project and pay a fixed interest rate on the amounts drawn down. At the close of the two-year construction phase, the association would have eight years to pay back the principal borrowed and the interest accrued. The eight-year loan was also at a fixed interest rate.
Five years ago when I wrote the original article, I spoke of three- to five-year loans to community associations with limited interest by lenders in a seven-year term. The ten-year term of the above- described loan and the fixed interest rate are very encouraging indicators as to bankers' new receptivity and recognition of the value of these loans.
For those lending institutions interested in community associations, the demand for such loans will continue because of unabated growth of community associations in the U.S. over the past five years. My original article reported some 85,000 community associations. More recent statistics published by the Community Association Institute (CAI) showed that by 1988 there were a total of 130,000 community associations. The CAI has projected that by 2000, the number will have grown to 225,000.
While the above loan example indicates that banks are beginning to make loans to community associations, I still encounter the same question from bankers with whom I have spoken over the past five years: "What is the security?" The answer lies in an analysis of an association's right to collect assessments owed by its individual members and of its right to file a lien and ultimately foreclose against an individual unit. The association is nothing more than a group of owners against each of whom there is a mutual right to foreclose a lien for failure to pay assessments.
I believe that the "search" for real estate as security in these loans is the reason that more of them are not made. These loans must be viewed in the context of commercial accounts receivable loan based entirely on the cash flow of the association. An association's cash flow comes from the assessments imposed on its members. Therefore, the collection mechanisms are in the hands of the association and can be exercised at the direction of the lender as set forth in the loan documents should any payment problems arise.
In the final analysis, the loan must be based on an understanding of the underlying development and its viability. There would have to be a drastic drop in real estate values to make owners "walk away from" their individual units en masse and thus cause a potential default in a community association loan. The drastic drop in real estate values in Alaska over the past several years is an example of such precipitous loss of value that might bring on a default for one of these loans. Otherwise, lenders should be able to make safe and profitable loans to community associations.
This article has been published with the express written permission of the publisher, Robert Morris Associates, and was originally published in The Journal of Commercial Bank Lending and in "Lending to Different Industries," Volume 2, Second Edition.