Building to last: Mastering capital improvements
Capital improvements are a necessity to keep your community relevant and maximize property values. Yet as crucial as these major upgrades, renovations, replacements and repairs are, many board members struggle with the complexities (and costs) they present. Read on to better understand and successfully manage capital improvements, including the roles of preventive maintenance, reserve studies, and funding strategies.
So, what defines a capital improvement?
If you find capital improvements confusing, you’re not alone. One reason is that some associations distinguish between “improvements” that require a homeowner vote — such as adding a tennis court — and “repairs and replacements” that do not — like replacing a roof. In addition, some states have their own definition that associations must use.
The best way to know how a capital improvement needs to be defined and approved for your association is to check your association’s governing documents and involve your association attorney. Here is a general definition that applies to many associations:
A capital improvement is a major replacement or repair that will increase a component’s market value beyond its original or current state. In general, it is intended to lower future operational costs (such as maintenance or utility costs) or enhance residents’ quality of life.
Capital improvements are meant to last more than a year and usually cost over $10,000. However, they can also save your association money in the long run by keeping your property relevant and in tip-top shape, resulting in a better resident experience and property values.
Preventive maintenance: capital improvement’s close cousin
In contrast to capital improvements, preventive maintenance jobs are generally less costly and are performed more frequently. They are funded from your association’s operational budget under the line item “Repairs and Maintenance (R&M),” and they are meant to restore your major components (or “assets”) to their original condition or prevent them from deteriorating further.
Following a component’s preventive maintenance schedule as recommended by the manufacturer or contractor increases its likelihood of reaching or exceeding its expected useful life — that is, the estimated amount of time it will serve its intended purpose. The more you can stretch a component’s useful life, the longer you can go before it needs to be replaced or requires a major repair, which translates into more savings for your association.
However, there are caveats. “In some cases, repairs to an older component can get very expensive; in fact, it may be more cost-effective to replace the component altogether,” said Christopher L. Pappas, senior vice president of FirstService Residential. “If the repairs cost about the same or are more than a replacement, you should replace the component. The new component may even be tax deductible, or you may get a tax incentive.” Sometimes it’s better to replace an asset than repair it. New equipment may also come with a manufacturer’s warranty, be more energy efficient and have a longer life expectancy. Some maintenance jobs can turn into capital improvement projects unexpectedly. For example, roof damage could appear to require a simple repair, but further inspection might reveal that the entire roof needs to be replaced.
The role of reserve studies
A reserve study allows you to plan and budget for capital improvement projects over the next 20 to 30 years. A specialist from a reserve study firm (preferably an engineer) should conduct the study, which consists of:
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A physical analysis. The reserve specialist performs a site inspection to assess the condition of common-area assets within your community, such as clubhouses, lobbies and pool areas. Based on this assessment, they estimate the remaining useful life and make recommendations for their repair or replacement.
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A financial analysis. After the site inspection, the reserve specialist estimates the cost for each repair or replacement as well as any additional improvements (like adding a playground or expanding your fitness center). Based on these costs and your current reserves, the reserve specialist recommends a funding plan and calculates the monthly contribution required from each homeowner.
In most areas, the developer would have provided your association with an initial reserve study at the time the property was transitioned to a residential board, but you should get the study updated regularly. “Keep in mind that some states have laws in place that mandate the frequency,” said John Lee, vice president of FirstService Financial. “Whether your state does or doesn’t, you should still plan to update your reserve study every 3 to 5 years and after you complete a capital improvement project.”
It’s also important to have your study reviewed annually to make sure the recommended funding is still accurate. Factors such as increases in labor or material costs, unexpected events, such as natural disasters, and increases in delinquencies, can alter your funding needs.
Since a reserve study isn’t a detailed scope of work, you should also plan to get a more comprehensive “conditions study” or “conditions assessment” about 1 to 2 years before a component is expected to reach the end of its useful life. The level of detail it provides will give you a more accurate picture of the work and cost involved. Local experts, such as contractors, engineers and architects, can provide this.
Paying for a community project
Once you’re ready to start a project, you need to determine how your association will pay for it. You have several options:
Your reserve fund. The first source you should tap into is your association’s reserve fund. Hopefully, you’ve been following your reserve study’s recommendations and putting the appropriate amount of money aside. Choosing the right type of account for your reserve fund is important, too. Since your board has a fiduciary duty to your homeowners, it’s imperative that you protect the money they are entrusting you with. However, that doesn’t mean putting it in a checking account that yields no interest. With an integrated approach to long-term reserve fund management, FirstService Financial provides multiple products through various financial institutions to ensure that liquidity needs are met while maximizing interest yield and principal protection. “Over the years, we’ve helped multiple associations increase their returns on their reserve funds by moving their funds to safe, high yield accounts like CDs,” said Lee.
What if you don’t have enough in your reserves to cover the cost? Unfortunately, many associations don’t adequately fund their reserves. In fact, a study conducted by a major reserve study firm found that up to 72% of associations in the United States fail to do so. Boards are often reluctant to increase assessments in response to rising costs because of the reaction homeowners are likely to have. Since funding day-to-day operations is a more immediate need, they attempt to reduce expenses by decreasing the amount they set aside to fund future projects.
Besides leaving you with an inadequate amount of money for needed repairs and upgrades, underfunding your reserves can have other serious consequences. For one thing, it can negatively affect property values. Not being able to replace items like roofs, major equipment and sidewalks will lower property values. In addition, it can dissuade prospective homebuyers from moving into your community or building, especially those who plan to pay for their home with a Federal Housing Authority (FHA) loan. A buyer won’t qualify for an FHA loan if the association isn’t allocating at least 10% of its operating budget for its reserve fund. Even if your association has been diligent in funding your reserves, an unforeseen event or long-term crisis, such as a pandemic, can have a big impact — especially if it is not covered by insurance. Or your association may realize that enhancing amenities is the only way to compete with communities or condos being built in your area. Whatever the reasons for your shortfall, you do have other funding options, which you can use individually or in combination.
Loans. Loans have become increasingly common for funding capital improvements in recent years, a trend that has been mirrored at FirstService Financial. “From 2012 to 2018, the number of loans we helped associations obtain rose from 2 to 78.” said Lee. “And over the past 20 years, FirstService Financial has facilitated more than $2 billion in loans, overseeing the entire lending process – from negotiation to closing.”
One of the advantages of taking out a loan is that you have the money immediately. A loan can also help you fill a gap in your reserve fund or in the amount you’re able to collect up front when homeowners pay a special assessment in installments. You can even take out a loan for the full amount of the project and then use a special assessment to pay it back.
Before determining if a loan is the right option for your community, make sure to consult with your association attorney as some governing documents require a membership vote before securing a loan.
Increased dues. Typically, increasing dues or levying a special assessment are two additional ways to cover the cost of a capital improvement project. Even under the best circumstances, both options tend to be the least popular among homeowners.
Some communities have been fortunate enough to not experience financial shortfalls, even in the midst of economic turbulence or other crises. For those communities, increasing dues and even collecting a special assessment may be a viable funding option. However, for communities in locations that have been hit harder by economic difficulties, residents may struggle to pay dues, which can make any increase feel unmanageable. When facing a crisis or any economic challenge, any consideration to raise dues or levy a special assessment must be done with prudence and sensitivity.
Remember that for an association to operate effectively and manage ongoing capital projects and maintenance costs, it is critical that you make regular and incremental dues increases. When raising dues, communicate why these increases must occur, so that residents expect them. Work with your management company to draft appropriate and effective communications around any dues increases.
For special assessments, offsetting the financial burden by allowing residents to pay it in installments can make a special assessment more acceptable. Keep in mind, however, that since you won’t have the entire balance of the special assessment right away, you may have to either delay work until you do or align installments with the contractor’s payment schedule.
Insurance. Although insurance can’t pay for a planned capital improvement, inadequate coverage can result in unanticipated capital expenses. Make sure you are properly covering assets that may be susceptible to damage from weather or other mishaps.
Capital improvements not only affect your community or building’s health and reputation but also homeowners’ wallets. That’s why you need to prioritize projects appropriately and communicate with association members from the beginning. It’s also crucial to create a plan prior to starting each capital improvement project, to have a professional managing the project and to communicate with residents about the project’s status as work progresses.