Loans are a Many Splendored Thing

COMMUNITY ASSOCIATIONS AND FINANCIAL INSTITUTIONS ARE INCREASINGLY WOOING EACH OTHER. HERE'S WHAT YOU NEED TO KNOW TO MAKE A BEAUTIFUL FRIENDSHIP.

Most boards of directors don't like to borrow. They're one-fund associations--they see reserves as their only source of funds and they'll use those reserves until they're depleted. Borrowing is a last resort.

As for financial institutions, some don't even know that community associations are alive.

But that relationship is changing. Institutions are increasingly taking notice of community associations and increasingly offering loans. Community associations, many of which are facing large-scale repair or restoration projects--without the reserves to pay for them--are viewing loans as a reasonable alternative to special assessments.

Are there downsides to loans? Of course. The biggest downside is that you have to pay it back. If an association defaults on its loan, a financial institution typically claims association assets. Rising inflation could cause rates on a loan to increase.

Inflation, however, is currently stable. With interest rates expected to be lower in 1996 than in past years, associations should be able to find reasonable credit without high up-front fees or points. The time for pursuing a credit relationship could be now.

HOW DO I LOAN THEE?

The time to take out a loan or establish a line of credit is when you least need it. When you need it, it is much more difficult to obtain. A modest credit facility--any type of borrowing or credit option--may be relatively cheap insurance for unexpected situations, such as natural disasters. The options include:

Line of credit. A line of credit allows an association to borrow funds by accessing a credit account, similar to a credit card. Usually the cost or fees are based on the total amount of the loan and the amount of money drawn against the credit line. In some cases, interest rates may be higher than for term loans, but rates and fees generally vary depending on the institution.

If a repair or restoration project may take a long time to finish, and the contract requires progress payments, a line of credit may be beneficial. Why? Because you don't pay interest on funds that aren't used. The Freddie Mac earthquake regulations in California also show the benefits of a line of credit. In July 1995, the Federal Home Loan Mortgage Corporation--known as Freddie Mac--began requiring condominium associations in high-risk areas to have earthquake insurance before it will buy mortgages for those units. Although Freddie Mac recently announced two alternative plans, associations in those areas will need either reserves or other funds to pay for the high-priced insurance. So if you have a $12 million policy with a 10 percent deductible, you'll need $1.2 million in reserves, or a credit line available at a moment's notice. This is one more reason to consider a credit facility.

Term loans. With a term loan, an institution lends a sum of money and interest accrues immediately. The term loan allows an association to make repairs and pay the money back over time--usually over three, five, or seven years. This is much more attractive than a special assessment, since the payments are spread out over a multiyear period.

Hybrid loan. Some institutions offer a hybrid facility whereby an association draws funds on a fixed time frame and pays interest only during that time. Once the project is completed, the credit facility is transformed into a term loan paid off in monthly installments. The association pays interest only on the funds utilized, and then has additional time to pay off the loan.

Borrow from the homeowners. Some associations--typically largescale or upscale communities--can borrow from the homeowners. A Pasadena, California association developed a plan whereby 15-20 homeowners loaned the association $100,000 each. Since the association offered above average rates, the homeowners loaned the association $1.5 million. Everyone won.

MAKE YOURSELF ATTRACTIVE

In any relationship, people want an attractive partner. The same principle applies to financial institutions and community associations:

What are lenders looking for? Most institutions expect a complete package of information that spells out the reasons for the loan and how the board intends to pay it back. They want a board that has followed through on all proper procedures and requirements--state corporate requirements, for example--as if the association were a multi-national corporation.

They will also look for warning signs. These include inadequate reserve funds, high delinquency rates, high lien or foreclosure rates, and a large rental versus owner percentage. They will consider the community's physical appearance, too--if the community looks untidy and unkempt, the institution may view the association unfavorably.

In some cases, this creates a predicament. The association may need the loan because of poor finances, yet the poor finances may prevent it from receiving the loan. In these situations, an association must clearly show why it is worthy. If a board is running the association like a business, and can show that it is putting its financial house in order, an institution may take this into consideration. But no institution will hand out money to an unprepared, disorganized board. Look and act professional.

What should boards look for?

Work with financial institutions that specialize in community associations. Some financial institutions have community association specialists who understand the legal or fiduciary requirements faced by board members.

Fees, costs, and interest rates are also important to consider. Average fees and costs vary depending on the loan amount, the complexity of the project, and the community's location. There may also be legal and accounting costs, application fees, and fees for environmental reports, engineering studies, commitment fees, and closing costs. Rates will vary depending on the institution--whether it's loaning its depositors' funds or its own capital--and the time frame of the loan.

Just as the lowest bid isn't always the best bid, the lowest rate may not be most beneficial to community. Low rates may mean there are hidden expenses that make up the difference. Some institutions, for example, require impound accounts--these are funds set aside for contingencies, such as a missed payment. Others may require board members to personally guarantee the loan (though most institutions do not).

A HEALTHY RELATIONSHIP

Loans provide several benefits. By borrowing, an association can maintain and enhance the community without completely depleting liquid reserves. The board has access to reserves for other repairs. In addition, many states require associations to provide full disclosure of their financial condition to prospective buyers. When prospective buyers review the finances and see healthy reserves--as opposed to a zero balance or a special assessment--they are more apt to buy into the community.

In some situations, borrowing may result in tax benefits for associations. The interest paid on a loan or a line of credit may be deductible against the interest earned on reserve investments. Talk with your association's accountant or tax preparer about these potential benefits.

A loan may also provide contracting advantages. Instead of having the contractor return over weeks and months, the board can get the whole job done at once. Because of this, you may be able to obtain bulk discounts on time and materials.

Obviously there are other options--if you can cover expenses through a minor special assessment or by increasing dues, do so. It's the simplest way and doesn't add costs. But while raising monthly dues may be a necessity, if you need a large amount of cash--fast--it may not be the answer. And while special assessments are often a necessary evil, they may inflict financial hardships on homeowners with fixed incomes or second mortgages, and those living on limited retirement funds. Paying a special assessment could result in a financial catastrophe.

Like any business, associations must carefully calculate their debt to assets ratios. They must maintain cash flow to service the loan and must not overextend themselves. Yet they must also establish a game plan. Just as you plan for your children's education, you must plan for your association's future. Loans and credit facilities are one more tool to ensure you get there.

Loans & Legalities--Do We Need Permission?

Before investigating loans or credit facilities, ask your legal counsel to review the association's CC&Rs and other corporate documents. Most documents allow associations to incur debt; some, however, do not. Others require members to approve a loan. Some preclude borrowing unless a majority of homeowners and mortgage lenders approve the pledge of common area assets as collateral. Obtaining a loan may require a revision of the CC&Rs and governing documents.

The attorney will need to prepare specific items for the financial institution. This may include the articles of incorporation, CC&Rs, bylaws, financial statements, and past budgets and reserve studies. Count on spending a considerable amount of time compiling the information required by the financial institution.