The Ins and Outs of Homeowners Associations

The Ins and Outs of Homeowners Associations-Professor-BaronAbout 20 to 30 percent of home buyers purchase properties within common-interest developments, commonly referred to as homeowners associations (HOAs).

Before weighing the pros and cons of owning a property in an HOA community it’s important to understand what HOAs are, how they are governed and how they affect a homeowner’s bottom line.

Here are some basic facts home buyers should know.

What is a common-interest development?

In a common-interest development individual owners typically share some parcel and the buildings on that parcel as co-owners. A common-interest development would generally be a condominium building, a town home community or lofts, or could be a single-family home community, private neighborhood or other similar arrangement. Buyers in the development or building agree to live by the community rules and regulations.

These regulations mean that as an owner you have certain rights and restrictions as outlined by development documents commonly called CC&Rs (covenants, conditions and restrictions). The CC&Rs govern your allowed ownership, use and behavior at the property — everything from use of your unit to parking restrictions, insurance, architectural rules, paint colors, storage of RVs or boats, pets, allowed inhabitants and more. These rules and regulations can be changed, subject to approval by a majority of the owners.

How are HOAs governed?

To interpret and enforce the rules and regulations, most HOAs elect a board of directors who follow the regulations of the community and make prudent financial and operational decisions. As an owner, you get to vote for the board members (this process is usually outlined in the community bylaws).

However, most owners in a typical community don’t go to board meetings and don’t get involved in the operations of the community. And that’s fine, as there’s no requirement for an owner to vote or otherwise be involved. Most owners only show up to meetings when HOA fees are raised or if they are affected by a particular issue. Keep in mind though, if you have an issue or disagree with a restriction in your community, you should attend the board meetings and work with the HOA toward finding a solution that the majority of owners can agree with.

Are there financial risks with HOAs?

HOAs are nonprofit organizations, but their complex financial and legal operations can sometimes cause owners significant financial pain in the form of unexpected dues increases and special assessments. Unfortunately, few buyers know how to evaluate HOA documents ahead of time, which could help mitigate the considerable risks.

Many people don’t like having to follow rules and decide to avoid living in an HOA-governed community altogether. But don’t forget, the HOA makes sure your neighbors don’t park cars in their front yards and/or that a neighbor doesn’t paint a house pink or carry out other nuisance behaviors — any of which could easily occur in an area not governed by an HOA.
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Risks of Buying into an HOA Community – Buyer Beware!

Zillow blogger Brendon DeSimone wrote an article called “Three Ways an HOA Can Screw Up the Sale of a Condo” which discussed some of the red flags a seller should learn and items they should clear to help get their property ready for sale. In addition, it’s necessary for a buyer to do an in-depth analysis of the HOA to better protect themselves when purchasing a property.

Researching an HOA is a time consuming process and very few buyers have any idea what they should be looking into when purchasing. Yet your time and effort is worth it as it is your money at risk!

risks-of-buying-into-an-hoa-communityEach one of these items is a significant risk issue and should be reviewed and understood, no matter how difficult it is to get the proper documentation. Some states are not helpful with requiring things like reserve studies, and some communities don’t even have or prepare what is needed. But if you understand the issues, that will help you reduce your real estate risk.

While you may be familiar with basic due diligence for HOAs, there are additional risks a buyer needs to understand to protect themselves when purchasing a home for sale in a common interest development community:

Unfunded or seriously underfunded reserve and replacement accounts: In this case, there are long-term repairs and replacements that will be needed in the future, like roofs, private streets, mechanical equipment, but the HOA has not saved anywhere near enough money to pay for these.

HOA in litigation: The HOA could spend a lot of money filing or fighting litigation and most lenders will not lend money on a project that is in litigation. This also means that you may have trouble selling your unit until the litigation is ended – which could be years – and possibly beyond that date.

Water and mold issues: Potential large dollar uninsured repairs that were not anticipated – so potential regular or emergency special assessments in large amounts.

Too many rental units: You many have trouble obtaining a mortgage or it may be more expensive (i.e. a higher interest rate) and the project may not be as well taken care of, thus making it harder to sell.

New project, few owners:  Less than a majority percentage of the units are sold and the developer is in financial trouble. You need to determine who will be paying the HOA fees on the unsold units to cover the property expenses to keep the lights on, elevators working, maintenance, etc.

Insurance: This involves not being properly insured for the inherent risks you potentially incur on the interior part of the unit you own, or the exterior. Cash buyers be especially aware here.

Is the building on a ground lease? Or does the HOA own the pool, parking lots, clubhouse, streets? This may seem extreme but in some rare instances the HOA may be leasing common areas because the original developer made them separate and kept ownership. You better know for sure before you invest.

One owner controls multiple units: If the original developer or a subsequent owner has control over more than 10.0% of the units this may be an issue with financing and other issues.

CC&Rs (Covenants, Conditions and Restrictions): CC&Rs are the governing documents or rules that the HOA’s abide by. It is necessary to read them, and the bylaws, as well as the Board of Directors meetings minutes and notes. If you don’t, you run the risk of being in the dark about a possible special assessment and could be charged the week after you close escrow. I know one incidence in which a woman closed three days before a $7,500 special assessment that had been noted in the BOD minutes that she got via escrow but did not read.

Lender Condo Certification (Condo Cert) – Did your lender do one? Did you ask for it and get a copy? Did you read it and made sure you understood the items on it? If you are paying cash, you don’t have the lender watching out for you, how are you going to mitigate that risk?

Banks will not finance it, just pay cash! If a bank will not finance a unit, they are telling you something! I often hear investors say, “well, I’ll just pay cash.” What you must consider however, is that the bank, with decades of experience losing money on loans in these communities, is signifying a problem by not approving the loan. Don’t just pay cash because you have it; I suggest that you listen to the banker.

Those are the issues, and if you plan to buy into an HOA-governed community, you need to fully understand these items and how to mitigate these risks.

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Demystifying HOA Fees and Special Assessments

If the property you’re looking to buy has home owners association (HOA) fees, it’s essential that you understand where those fees are coming from, as well as their risk of increasing every year before you buy.

Formulation of the Fees

HOA-fees-and-special-assessmentsEvery year, a home owners association (HOA) board of directors (BOD) prepares a community budget. That budget includes what the BOD will set as the current year total HOA fee per month, per unit. The composition of that fee is the first thing you’ll need to comprehend before you better understand fees increasing each year as well as the much loathed “special assessment.”

The monthly HOA fee has two parts to it, so for the sake of this exercise, let’s assume the total HOA fee is $300 per month per unit for a 100-unit community. Here are the calculations:

Current Year Operations Portion – $200 per month

The HOA collects fees from each of its units to pay for all the current year operations such as gardening, water, insurance, property management. The BOD forecasts forward that this year it will cost $240,000 to pay for all current year operating expenses. Since there are 100 units, we divide the $240,000 by 100 units to get $2,400 per year per unit or $200 per unit per month for operations.

Current Year Reserves Portion for Long Capital Items – $100 per month

The HOA also has to save money over time for long-term repairs and replacements, such as roofs, roads and parking lots. To understand how much they have to save, they have, or should have, an outside expert do a “reserve study.” The reserve study expert makes a 20-year +/- schedule of when HOA assets will need to be repaired and how much they will cost.

The reserve expert calculates an annual amount needed for those long-term repairs. Therefore, through the HOA fee, owners are putting money away each year to pay for those repairs. This money accumulates into “reserves” so that the HOA can pay cash for large-item repairs when they come due. This helps avoid special assessments because the HOA has the money on hand to pay for these capital items.

In our example, the reserve study specialist determined that owners should be putting away an additional $120,000 per year going forward or $1,200 per unit per year or $100 per month per unit owner.

Thus, $200 for current year operations and $100 to put away additional funds, totaling the $300 HOA fee per month, per unit.

As long as the HOA board makes perfect predictions, and the reserve study expert’s estimates are 100 percent accurate, the HOA will pay all the current year bills and be in great shape for paying for long term capital item repairs. However, this rarely happens.

Not an exact science

Calculating unfortunate budgeting expenses, long-term reserves, and unanticipated repairs is not an exact science. Usually, operating expenses are higher than budgeted, or some people do not pay their HOA fees, and the HOA gets drained of cash covering expense overruns. If the BOD spends extra on operations, they won’t be able to save the recommended cash for long-term repairs. Thus, the BOD increases HOA fees next year to catch up the amount they should have saved this year for their reserves.

If they don’t increase fees to make up for that balance, perhaps because owners protested higher HOA fees, when they need $240,000 to paint the building, the BOD uses a special assessment — an additional fee levied at homeowners— so the HOA can pay for the needed repairs.

The main takeaway…

At the end of the day, all the bills — current year, capital repairs and replacements — will have to be paid by you and the other owners in the community one way or another.

The BOD usually does their best to financially manage the community well, but due to a number of factors above, it is a challenging assignment. All the owners have to live within the HOA finances, but note, it’s better to increase fees as you go to avoid special assessments.

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