Bank Loan? Reserves? Special Assessment?  

Published on: March 1, 2010

By Stephen Marcus, Esq. 

A decade ago, most condominium associations would not have considered applying for a bank loan, and a good thing – because they would have been hard-pressed to find a bank willing to make one.  Today, associations will find that banks are not only willing to lend them money, but anxious to do so.

From the lender’s perspective, the loan collateral (common area fees) and the priority “super lien,” (ensuring the association’s ability to collect those fees) make association loans as close to risk-free as any loan could be.  Bankers will tell you that making loans on which the loss rate historically has been virtually nil is close to a no-brainer.  “In 30 years of originating these loans,” one area banker told me, “I’ve never had to write one off.” 

The decision-making for community associations will be a bit more complicated as they weigh the pros and cons of using bank loans, special assessments or reserves to meet their financing needs.    There are two schools of thought on this.  Some industry experts say associations should make reserves the first choice and special assessments the second for financing major capital projects, turning to bank loans only for unanticipated or emergency expenditures they can’t finance otherwise.   Others suggest precisely the opposite:  Use loans for planned repair and replacement projects and rely on reserves   (or assessments) for emergencies.

No Blueprint for All

In fact, no single approach will apply in all circumstances to all communities. Boards will answer the loan vs. reserve question differently, depending on their financial management strategies and on whether they have sufficient reserves in place to make using them an option.  For communities with relatively affluent owners who are able and willing to write large checks for association expenditures whenever the funding is needed, a special assessment that can be collected quickly is the obvious choice – avoiding both the costs of a bank loan and the need to tap association reserves or even, possibly, the need to have them

But for most communities, special assessments will be the least desirable of the financing options, for two reasons: 

  • “Unlike common area fees, special assessments aren’t covered by the priority lien and so may not be collectable from owners who default on their association payments or lose their homes to the lender through a foreclosure. 
  • Fannie Mae and Freddie Mac, which set the underwriting standards most mortgage lenders follow, are scrutinizing special assessments more closely as a possible indicator of financial problems in a condominium community.  Lenders won’t necessarily reject loans on that basis, but assessments may create complications for condominium owners seeking to sell their units or refinance an existing loan. 

One of the strongest arguments in favor of assessments over loans has been the tax advantage for owners who finance their share of an assessment through a home equity loan. While interest payments on the equity loan are deductible, the owner’s share of the association’s loan probably is not.  But that argument has become less persuasive in a battered economy that has left many condominium owners without much or any equity in their units and made it difficult for owners who have equity to obtain financing.  Association loans have become more appealing for many communities as a result.

The Basics Apply

Boards that are planning to seek bank financing should begin that process as they would begin the search for an individual loan, by shopping for the best rates and terms.  Most banks will require the association to deposit its reserves with the institution (if it hasn’t already done so) as a condition of providing the loan.  A bank with which the association has an existing relationship might be willing to offer a lower rate, reduced closing costs or other incentives to keep the community’s business.  This is a good place to start your shopping, if the bank has experience making association loans and has originated a large number of them. 

Association loans are fairly straightforward; there is nothing terribly complicated about the requirements lenders will impose or the underwriting standards they will apply.  One thing lenders will not typically require is a personal guarantee from board members.  This is often the major concern expressed by trustees and it is easy to allay. In a very small (fewer than 10 units) association, some lenders may want all the owners to guarantee their share of the loan.  But they will seek this guarantee (if at all) from all the owners, not just from members of the board. 

In considering an association’s loan request, the lender’s main concerns will be the community’s finances and its management.  In the latter category (finances) lenders will want to see adequate reserves, or a good explanation for the failure to have them. So while obtaining a loan may be preferable to tapping association reserves, it is not an alternative to having them. 

Lenders will also look closely at the association’s budget.  Operating losses, if they are large and repeated, will be a definite red flag, so be prepared to explain any budget gaps and the board’s plan for dealing with them. 

High delinquency rates will be another obvious concern for lenders; they will want to see that the board has a sound collection policy in place and adheres to it. 

Under the management category, lenders want the association to be in the hands of owners and not still under developer control. They are also generally more comfortable if the community is professionally managed, although most will provide loans to self-managed associations if they have a history of good management.  

Owner occupancy will be another box on the lender’s checklist.  Most banks will shy away from communities with a large percentage of renters.

Lenders will also consider the purpose of the loan.  You’ll have trouble finding lenders willing to finance budget gaps caused by operating losses.  Loans for construction defect litigation – or any litigation or that mater – won’t get a warm reception either, because lenders can’t be certain (nor can you) that the association will win the suit.  Banks willing to consider these loans will want boards to have a back-up plan for repaying the litigation loan and for financing the repairs if the association loses the suit or get less of an award than it was seeking. 

Documentation Requirements

Loan documentation requirements for association loans are fairly standard.  Most lenders will want to see, at a minimum:

  • The association’s budget and its annual and year-to-date financial statements.
  • The minutes of board meetings – to verify that the board has approved the loan and authorized an increase in fees or some other means of making the loan payments; and
  • The contract with the vendor the board has selected for the project being financed.

Lenders will also want to review the condominium documents to determine whether owners must approve the loan; if so, the lender will want to verify that the board has obtained the necessary vote. 

Most documents give boards the authority to obtain a loan, so it is unlikely that owners will have to vote on it.  But bear in mind:  Owner approval is usually required for an “improvement” – the addition of a swimming pool, clubhouse or other feature that was not already in place – as distinguished from the repair of an existing component, which boards can undertake on their own. Boards should make sure they get any required owner approvals before beginning the loan application. If you have to withdraw the application, because owners subsequently refuse to approve the loan or the project, lenders won’t refund the up-front application and loan commitment fees the association has paid.

Even if owner approval isn’t required, the board should inform owners of the plan to borrow money and communicate the loan costs and repayment terms.  It is also a good idea to poll owners at the outset to get their input on financing options.  If all the owners or most of them prefer an assessment and are able and willing to make their payments quickly, there is no need for the association to incur the loan costs.  If the community is divided on the question, you can collect the assessment from those who prefer that option, borrow the balance of the funds required and allocate payments among the owners who want to pay their share of the project costs over a longer term.  If only a few owners want the loan option, it may still make sense for the association to let them pay their share in installments with interest over a specified period of time, avoiding both the loan and the risk that owners unable to afford the lump-sum payment might have to sell their units. 

No Release

Owners who prefer to pay their share of a bank loan up-front often request a release indicating that they have met their obligation ¾ a request that lenders always refuse.  Should the association default on the loan, lenders want to retain the right to levying a special assessment or collect common area payments from all owners.  Many owners view the prospect that they could be dunned again as an argument against pre-paying their share of a loan, which it may be.  But if you think about it, this is really no different than what happens if some owners fail to make their common area payments; all the other owners must make up the difference to ensure that the association’s expenses are paid. 

The small risk of association defaults  ¾ as far as I know, there haven’t been any in Massachusetts ¾ should also reduce owner’s concerns on this point.  Defaults are so rare, in fact, that there are no   examples to illustrate how lenders deal with them.  Presumably, the lender would exercise its right to use association common fees to repay the loan.  Obviously, this is not a situation in which any association wants to find itself. The standard advice to individuals applies to association boards: If you anticipate problems, contact your lender well in advance, preferably before you have missed a payment.  Explain the difficulty and try to negotiate a mutually acceptable solution.  It is unlikely that lenders will be willing to “modify” the loan by reducing the payments; but they may be willing to give the association time (probably not much) to get back on track and avoid a default.  It is best for boards to enter this discussion with a good explanation for the financial problems the association has encountered, along with an equally good (and preferably short-term) plan for solving them. 

A decade ago, most condominium associations would not have considered applying for a bank loan, and a good thing – because they would have been hard-pressed to find a bank willing to make one.  Today, associations will find that banks are not only willing to lend them money, but anxious to do so.

From the lender’s perspective, the loan collateral (common area fees) and the priority “super lien,” (ensuring the association’s ability to collect those fees) make association loans as close to risk-free as any loan could be.  Bankers will tell you that making loans on which the loss rate historically has been virtually nil is close to a no-brainer.  “In 30 years of originating these loans,” one area banker told me, “I’ve never had to write one off.” 

The decision-making for community associations will be a bit more complicated as they weigh the pros and cons of using bank loans, special assessments or reserves to meet their financing needs.    There are two schools of thought on this.  Some industry experts say associations should make reserves the first choice and special assessments the second for financing major capital projects, turning to bank loans only for unanticipated or emergency expenditures they can’t finance otherwise.   Others suggest precisely the opposite:  Use loans for planned repair and replacement projects and rely on reserves   (or assessments) for emergencies.

No Blueprint for All

In fact, no single approach will apply in all circumstances to all communities. Boards will answer the loan vs. reserve question differently, depending on their financial management strategies and on whether they have sufficient reserves in place to make using them an option.  For communities with relatively affluent owners who are able and willing to write large checks for association expenditures whenever the funding is needed, a special assessment that can be collected quickly is the obvious choice – avoiding both the costs of a bank loan and the need to tap association reserves or even, possibly, the need to have them

But for most communities, special assessments will be the least desirable of the financing options, for two reasons: 

  • “Unlike common area fees, special assessments aren’t covered by the priority lien and so may not be collectable from owners who default on their association payments or lose their homes to the lender through a foreclosure. 
  • Fannie Mae and Freddie Mac, which set the underwriting standards most mortgage lenders follow, are scrutinizing special assessments more closely as a possible indicator of financial problems in a condominium community.  Lenders won’t necessarily reject loans on that basis, but assessments may create complications for condominium owners seeking to sell their units or refinance an existing loan. 

One of the strongest arguments in favor of assessments over loans has been the tax advantage for owners who finance their share of an assessment through a home equity loan. While interest payments on the equity loan are deductible, the owner’s share of the association’s loan probably is not.  But that argument has become less persuasive in a battered economy that has left many condominium owners without much or any equity in their units and made it difficult for owners who have equity to obtain financing.  Association loans have become more appealing for many communities as a result.

The Basics Apply

Boards that are planning to seek bank financing should begin that process as they would begin the search for an individual loan, by shopping for the best rates and terms.  Most banks will require the association to deposit its reserves with the institution (if it hasn’t already done so) as a condition of providing the loan.  A bank with which the association has an existing relationship might be willing to offer a lower rate, reduced closing costs or other incentives to keep the community’s business.  This is a good place to start your shopping, if the bank has experience making association loans and has originated a large number of them. 

Association loans are fairly straightforward; there is nothing terribly complicated about the requirements lenders will impose or the underwriting standards they will apply.  One thing lenders will not typically require is a personal guarantee from board members.  This is often the major concern expressed by trustees and it is easy to allay. In a very small (fewer than 10 units) association, some lenders may want all the owners to guarantee their share of the loan.  But they will seek this guarantee (if at all) from all the owners, not just from members of the board. 

In considering an association’s loan request, the lender’s main concerns will be the community’s finances and its management.  In the latter category (finances) lenders will want to see adequate reserves, or a good explanation for the failure to have them. So while obtaining a loan may be preferable to tapping association reserves, it is not an alternative to having them. 

Lenders will also look closely at the association’s budget.  Operating losses, if they are large and repeated, will be a definite red flag, so be prepared to explain any budget gaps and the board’s plan for dealing with them. 

High delinquency rates will be another obvious concern for lenders; they will want to see that the board has a sound collection policy in place and adheres to it. 

Under the management category, lenders want the association to be in the hands of owners and not still under developer control. They are also generally more comfortable if the community is professionally managed, although most will provide loans to self-managed associations if they have a history of good management.  

Owner occupancy will be another box on the lender’s checklist.  Most banks will shy away from communities with a large percentage of renters.

Lenders will also consider the purpose of the loan.  You’ll have trouble finding lenders willing to finance budget gaps caused by operating losses.  Loans for construction defect litigation – or any litigation or that mater – won’t get a warm reception either, because lenders can’t be certain (nor can you) that the association will win the suit.  Banks willing to consider these loans will want boards to have a back-up plan for repaying the litigation loan and for financing the repairs if the association loses the suit or get less of an award than it was seeking. 

Documentation Requirements

Loan documentation requirements for association loans are fairly standard.  Most lenders will want to see, at a minimum:

  • The association’s budget and its annual and year-to-date financial statements.
  • The minutes of board meetings – to verify that the board has approved the loan and authorized an increase in fees or some other means of making the loan payments; and
  • The contract with the vendor the board has selected for the project being financed.

Lenders will also want to review the condominium documents to determine whether owners must approve the loan; if so, the lender will want to verify that the board has obtained the necessary vote. 

Most documents give boards the authority to obtain a loan, so it is unlikely that owners will have to vote on it.  But bear in mind:  Owner approval is usually required for an “improvement” – the addition of a swimming pool, clubhouse or other feature that was not already in place – as distinguished from the repair of an existing component, which boards can undertake on their own. Boards should make sure they get any required owner approvals before beginning the loan application. If you have to withdraw the application, because owners subsequently refuse to approve the loan or the project, lenders won’t refund the up-front application and loan commitment fees the association has paid.

Even if owner approval isn’t required, the board should inform owners of the plan to borrow money and communicate the loan costs and repayment terms.  It is also a good idea to poll owners at the outset to get their input on financing options.  If all the owners or most of them prefer an assessment and are able and willing to make their payments quickly, there is no need for the association to incur the loan costs.  If the community is divided on the question, you can collect the assessment from those who prefer that option, borrow the balance of the funds required and allocate payments among the owners who want to pay their share of the project costs over a longer term.  If only a few owners want the loan option, it may still make sense for the association to let them pay their share in installments with interest over a specified period of time, avoiding both the loan and the risk that owners unable to afford the lump-sum payment might have to sell their units. 

No Release

Owners who prefer to pay their share of a bank loan up-front often request a release indicating that they have met their obligation ¾ a request that lenders always refuse.  Should the association default on the loan, lenders want to retain the right to levying a special assessment or collect common area payments from all owners.  Many owners view the prospect that they could be dunned again as an argument against pre-paying their share of a loan, which it may be.  But if you think about it, this is really no different than what happens if some owners fail to make their common area payments; all the other owners must make up the difference to ensure that the association’s expenses are paid. 

The small risk of association defaults  ¾ as far as I know, there haven’t been any in Massachusetts ¾ should also reduce owner’s concerns on this point.  Defaults are so rare, in fact, that there are no   examples to illustrate how lenders deal with them.  Presumably, the lender would exercise its right to use association common fees to repay the loan.  Obviously, this is not a situation in which any association wants to find itself. The standard advice to individuals applies to association boards: If you anticipate problems, contact your lender well in advance, preferably before you have missed a payment.  Explain the difficulty and try to negotiate a mutually acceptable solution.  It is unlikely that lenders will be willing to “modify” the loan by reducing the payments; but they may be willing to give the association time (probably not much) to get back on track and avoid a default.  It is best for boards to enter this discussion with a good explanation for the financial problems the association has encountered, along with an equally good (and preferably short-term) plan for solving them.