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How to Spot Red Flags when Reviewing Association Financial Information
How to Spot Red Flags when Reviewing Association Financial Information
Part 1 of a 2-part series – By Perry C. Rohan, MBA, LCAM, CPM®
Many of today’s real estate investors are finding their opportunities inside of condominium or homeowner association-controlled communities. It is important to understand that these communities are directed by volunteer residents, many of whom no prior experience applicable to their roles as board members. Consequently, the financial stability of these associations are inconsistent at best, so it is important to closely review the books and records of an association before making an investment in that community. This article intends to help you, the residential real estate investor, understand and evaluate the financial health of condominium and homeowner associations, from the perspective of running a rental business inside one of these association-controlled communities.
ANALYZE THE FINANCIAL HEALTH OF THE ASSOCIATION
A community association is a business. It generates income, pays its bill and hopefully has a little money left over at the end of the year to help fund special projects or make emergency repairs. Just like an investor would probably do extensive research before buying stock in a public company, real estate investors should be fully informed about the financial health of a community association, before purchasing a property within it. Here are some financial documents to review and what to look for:
Operating Budget: Represents projected income and expenses for each year. You will probably want to review the last 3 to 5 years if possible as well as the current (or upcoming) year.
- Look for changes in assessments. A healthy association has small, regular increases in assessments every few years. An association with large jumps in assessments each year may indicate issues with emergency repairs or deferred maintenance that finally caught up with the board. Associations without any recent changes in assessments could indicate an under-funded maintenance and repair budget which could require a “special assessment” that you will be on the hook for if you buy into this community.
Large year-over-year increases in assessment fees or no increases in assessment fees for many years.
- Review the line items in the budget. You will probably see things like legal & collection fees, allowances for bad debt and/or contingency. If the amounts budgeted in these categories are high, for example, greater than 10% of the total assessment income, then this association is probably having a difficult time collecting assessment fees from its owners, or is not able to properly anticipate future events. This situation could create a short-fall in the budget which would spell trouble for you and the rest of the paying owners in the community.
Large budget allocations for uncollected assessments, legal collections and/or contingencies.
- Analyze Reserve Transfers.A healthy and well-run association will transfer money regularly into a separate bank account called a “Reserve Bank Account”. The reserve account is money set-aside to make repairs to, or replacement of, major items such as roads, gate entry systems, pool & clubhouse, roofs, landscaping overhauls, etc. Some homeowner associations do not have reserve accounts so in these situations, you have to dig a little deeper. Does the association need a reserve account or is there is nothing in that community that requires major repair or replacement by the association? Some condominium associations have specifically opted to “waive reserves” and therefore, are not putting any funds aside for major repairs. Communities without proper reserve funds will ultimately require residents to pay for repairs and or improvements via a special assessment at some point in the future.
No reserve fund when there should be a reserve fund, or there is an under-funded reserve fund.
- You should see a large allocation for insurance on the budget. You may not know what type of insurance is in place by looking only at the budget, so you will want to review a current insurance certificate so you can see exactly what insurance policies are in place and what level of $ coverage for policies are specified. An adequately protected community association should have insurance coverage in place for commercial general liability, directors and officers, workers compensation, crime or a fidelity bond, and an umbrella policy. Depending on where the association is located, additional insurance for unforeseen disaster events (i.e., hurricane, flood, tornado, etc.) should also be in place with limits that adequately protect the association.
No funding for insurance. Insurance coverage is limited, policies expired or not adequate to properly protect the association in the event of a loss.
Balance Sheet: Represents the list of assets and liabilities of the association. Just like any business enterprise, there is also an Owners Equity section which collectively represents the group of homeowners in this community. Again, you want to review the current data but also try to go back a few years so you can understand what has happened in the past. Look for the following:
- Cash on hand.This line item should be separated in to multiple accounts. You should see an Operating Account(s) and a Reserve Account(s). Review the operating account and see if there is enough money in that account to cover three (3) months of operating expenses in that bank account. If there is less than 3-months of “back-up” cash, then this could become an area of concern. What would happen if a hurricane hit the area or a fire or flood, or the major employer for the area suddenly closed and half the community stopped paying their assessments? Associations are not allowed to dip into reserves to pay regular bills. Healthy associations have cash-on-hand to see them through emergencies.
Less than 3-months of cash on hand to cover operating expenses.
- Accounts Receivable.This is the amount of money owed by homeowners to the association by residents. What is the % of the annual assessment income that this accounts receivable amount represents? Is it 5% or is it 25%? A healthy association will usually carry no more than 5% to 8% of its annual assessment amount in an accounts receivable balance. However, high accounts receivables do not always tell the entire story. Some associations may have high accounts receivables as a percentage of assessment income, but it may be only one or two residents that account for most of the delinquencies. You will have to make a judgement call here.
High accounts receivable balance relative to the annual assessment income.
- Liabilities Section. A liability on a balance sheet is simply a “snapshot” of what bills may be outstanding at that moment in time. However, you should review this closely to be sure that the amount is reasonable. Also, and we have seen this in many cases, an association may have borrowed money in the past to make some kind of large repair or improvement. This debt would appear on the balance sheet and should also be reflected on a subsequent schedule outlining the original amount of the loan, hopefully with an amortization schedule showing when the loan will be paid off.
Liabilities too high relative to the annual assessment income.
Income & Expense Statement: This may be a single year statement or month-by-month report showing what happened in each month as the year progressed. Either way, you want to closely review a report that shows columns for “Actual”, “Budget” and “Variance” so you can see a true picture of what is happening. Look for the following:
- Large Variances.Healthy associations budget accurately and are usually paying their bills within a reasonable range from their budgeted amounts. Associations in trouble are frequently going over budget on many of their line items and some of these expenditures represent major issues to be concerned with. For example, frequent overages in legal fees and collection write-offs indicate trouble collecting fees from homeowners. It could also represent liens and foreclosure issues with the properties. Regular overages in maintenance and repair items is cause for concern that there has been a trend in deferring maintenance and there is no telling if or when that situation might end.
Large negative variances between budgeted and actual expenditures.
Reserve Schedule: A detailed review of individual association components, including their life expectancy and anticipated replacement costs. The Reserve Schedule also shows how reserve funds are allocated to those specific association components. Note: Not all reserve schedules are the same. Look for the following when reviewing reserve schedules:
- Is reserve funding straight line or is it pooled?Straight line reserve funding is when there is a specific amount of reserve funds tied to specific items. For example, there is $15,000 set aside for the gate, $10,000 for a clubhouse roof and $60,000 to repave the roads in the community. Straight line set-asides cannot be changed, so you cannot take the $10,000 from the clubhouse account and use it for something else. Pooled funding is just one big dollar amount that can be used for whatever item needs to be repaired or replaced. Pooled reserves are much easier for the board to manage, however, it can lead to short falls in funding necessary projects, unless a proper reserve schedule is followed.
- When was the last official reserve study performed?Prices for repair and replacement change all the time. Additionally, life expectancy of association components (i.e., roofs, roads, etc.) can change over time or as a result of damage. Healthy associations fund a reserve study on a regular basis, and in some states, Florida for example, condominium associations are required to fund a study every three years. Check the reserve study of your target association. See if it makes sense to you. You will probably want to drive through the community to review things, like if the reserve study says the roads have 10 years left on their life, but you see pot holes and cracks all over the place could spell trouble for a real estate investor.
Pooled reserve funding in when there are many components requiring reserve funds; No reserve study; reserve study not being followed or not realistic.
The business of investing in residential income properties can be challenging. Property must be purchased, mortgaged, insured and maintained, all within a cost structure that falls below income received from rents. Add to this the complexity of operating a rental business inside an association-controlled community where the investor is not in control of the association’s finances, but can be negatively impacted by them. Therefore, it is important to understand the financial environment before you make an investment in any association-controlled community.
About the Author:
Perry C. Rohan, MBA, REALTOR, CPM is the Managing Broker/Owner of Rohan Realty Associates and can be reached at email@example.com
On March 19, the Internal Revenue Service released Revenue Procedure 2002-22, which addresses the use of real property fractional ownership interests as replacement property in Internal Revenue Code Section 1031 tax-deferred exchanges. Commercial real estate professionals commonly refer to these fractional ownership opportunities as tenancy-in-common interests.
The potential advantages of using fractional ownership interests to complete a 1031 exchange are significant for both investors and their advisers. Tenancy-in-common interests offer increased opportunities to identify a replacement property within 45 days, the option to buy into institutional-grade product for less money, and the potential to diversify into multiple properties with fewer dollars.
Like-Kind Exchange Primer Under Section 1031, property owners may defer gain recognition on a sale by exchanging for like-kind property; however, they must meet numerous requirements to complete a successful exchange.
In order to achieve 100 percent tax deferral, the cost of the replacement property must be equal to or greater than the net sales price of the property being sold, and all the proceeds must be used. Further, the seller must identify a suitable replacement property within 45 days of the relinquished property sale. Finally, the seller must take title to the property he ultimately buys in the same manner in which he gives title to the property he sells.
In the past, tax professionals and other investment advisers were wary of recommending fractional interests as replacement properties because the IRS often considered the investor’s interest in the new property to be a partnership, thereby invalidating the exchange. Along with partnerships, Section 1031 prohibits owners from exchanging out of real estate and into a corporation or limited liability company.
This concern often prevented investors from buying shares of larger and potentially more attractive properties. In response to the need for high-quality replacement property in a range of prices, a niche group of companies began offering tenancy-in-common interests to complete 1031 exchanges. To meet the title requirements, investors receive a deed for a portion of the property, rather than a share of a partnership. To encourage referrals, many tenancy-in-common program sponsors offer referral fees ranging from 1 percent to 6 percent of the equity value placed in the product.
Fundamentals of the New Guidelines Rev. Proc. 2002-22 provides guidance on the use of fractional interests as replacement properties in 1031 exchanges. Although the IRS did not provide the ultimate safe harbor blessing for these investments, it outlined 15 minimum standards tenancy-in-common interests must meet to be considered as potential replacement property. A few of the key criteria are:
- the number of tenants-in-common cannot exceed 35;
- the sponsor of the interests may own the property (or an interest therein) for only six months before 100 percent of the interests are sold;
- any decision that has material or economic impact on the property or its owners must be approved unanimously by the owners; and
- the management agreement must be renewable annually and must provide for market rate compensation.
For the complete listing of requirements, visit the IRS Web site at http://www.irs.gov/. Investors should seek private-letter rulings on specific offerings for more concrete assurance that their fractional interest meets the specified qualifications.
Some investment advisers have found that recommending properly structured tenancy-in-common programs can result in a win-win situation for all parties. For example, one of your clients owns a small apartment building that requires an inordinate amount of time to manage. As he nears retirement, your client receives a $750,000 offer on the building and wants to exchange into an institutional-grade investment. With the amount he will be able to invest from the sale, your client doesn’t think he can afford a high-quality investment offering a strong yield and greater appreciation potential. However, in this scenario, your client should consider a tenancy-in-common program that complies with the recent IRS ruling. With his sale proceeds, your client feasibly could exchange into a 15 percent interest in a class A office building worth $5 million.
The new guidelines also open the door for investors who want to structure fractional interests in a desirable replacement property on their own. For instance, Jennifer Reed owns a high-quality rental property in suburban Atlanta worth $500,000. She notices a small strip shopping center for sale in the area and, after some due diligence, discovers the center can be purchased for $1.5 million. Though individually she cannot afford the center, she has two friends who would like to invest a portion of their portfolio in real estate. The three decide to purchase the property together. When Jennifer sells the rental property, she exchanges all of the debt and equity from the sale for a one-third interest in the shopping center as a tenant-in-common. The other two investors provide the balance of the funds necessary to close the deal.
Proceed With Caution As tenancy-in-common programs are in their infancy, commercial real estate professionals should review them carefully before advising clients to consider them as viable replacement property options. Because all programs are not created equal and may have been structured prior to the release of Rev. Proc. 2002-22, careful due diligence is essential. As more sponsors modify their programs to seek and receive private-letter rulings certifying compliance, less due diligence will be necessary.
Whether for groups sponsoring fractional interests or creative investors looking to pool resources into a larger property, the new IRS guidelines are good news for the commercial real estate industry. For investment advisers, this guidance provides exciting new options for clients who don’t want to forego the benefits of a Section 1031 tax-deferred exchange.
Consult a tax professional for further information on individual cases.
Like-Kind Exchanges – Real Estate Tax Tips
Generally, if you exchange business or investment property solely for business or investment property of a like-kind, no gain or loss is recognized under Internal Revenue Code Section 1031. If, as part of the exchange, you also receive other (not like-kind) property or money, gain is recognized to the extent of the other property and money received, but a loss is not recognized.
Section 1031 does not apply to exchanges of inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets.
Properties are of like-kind, if they are of the same nature or character, even if they differ in grade or quality. Personal properties of a like class are like-kind properties. However, livestock of different sexes are not like-kind properties. Also, personal property used predominantly in the United States and personal property used predominantly outside the United States are not like-kind properties.
Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties.
Note: This page contains one or more references to the Internal Revenue Code (IRC), Treasury Regulations, court cases, or other official tax guidance. References to these legal authorities are included for the convenience of those who would like to read the technical reference material. To access the applicable IRC sections, Treasury Regulations, or other official tax guidance, visit the Tax Code, Regulations, and Official Guidance page. To access any Tax Court case opinions issued after September 24, 1995, visit the Opinions Search page of the United States Tax Court.
1031 Exchange Explained
<:figure>A 1031 exchange helps defer gains taxes on the sale of a property.
For real estate speculators and families who live in areas with an expensive real estate market, capital gains can pose a significant tax burden, particularly if real estate was held for a long time or through a volatile time in the market. Although it’s impossible to completely avoid capital gains assessments, a 1031 like-kind exchange allows property owners to sell one property and purchase another with the proceeds, and, if handled correctly, shields investors from immediate gains taxes.
The Internal Revenue Service allows investors to liquidate one property and exchange it for one of a similar kind — all domestic real estate qualifies as like-kind — and postpone gains taxes from the original sale. To qualify for a 1031 exchange, taxpayers may not take possession of the money generated by the sale of the property. To do this, investors must simultaneously sell the old property and purchase the new one, or route their funds to a qualified intermediary so they don’t take possession of the money, even if it’s reinvested in the new property. Any personal acquisition of the funds, even if it’s momentary, incurs gains taxes.
A 1031 exchange is only valid if the property owner’s equity in the new property is equal to or greater than that of the old property. Because of this, investors may not cash in equity on their old property during the exchange, though they can invest more into the new property.
If property owners don’t simultaneously sell and purchase the properties involved in the 1031 exchange, a qualified intermediary — a real estate broker — must serve as a go-between for the sale and purchase of the properties. Money gained through the sale of the original property is placed into an exchange account managed by the intermediary, so taxpayers never come in direct contact with the funds.
Property owners must identify one to three potential properties to purchase within 45 days of the original sale if a qualifying intermediary holds the funds. The exchange must be completed, with a new property purchased, within 180 days of the sale of the original property or by the date the taxpayer’s taxes must be filed.
In the case that a taxpayer purchases a replacement property before the original one is sold, a reverse exchange may be engineered. Amendments to 1031 rules were introduced in 2000 to allow a safe harbor for reverse exchanges in this situation.
Tax Basis and Gains
A successfully executed 1031 exchange allows a taxpayer to avoid paying gains on the sale of the original property, but those gains are only deferred to a later date. When a property purchased as part of a 1031 exchange is sold, its tax basis is calculated as the gains between the original property and the final one’s sale price. For example, an investor purchases a property for $100,000, and sells it as part of a 1031 exchange for $150,000, and purchases another property for $200,000. When that property is sold for $220,000, the investor’s tax basis is the difference between the purchase price of the original property and the sale of the second one. This investor faces gains taxes on $120,000 ($220,000 – $100,000) in this situation.
Wilhelm Schnotz has worked as a freelance writer since 1998, covering arts and entertainment, culture and financial stories for a variety of consumer publications. His work has appeared in dozens of print titles, including “TV Guide” and “The Dallas Observer.” Schnotz holds a Bachelor of Arts in journalism from Colorado State University.