Determining Long-Term Financial Soundness

finance_era_increase_320

 

As much as everyday Americans buy condominiums and community-based houses (HOAs), one suspects that very few have a clue how to assess the financial soundness of the association they are about to join. Every buyer receives a hefty package of governing documents and financial statements. How many people do you guess read them? How many attempt to read but don’t understand them? How many buyers accept on faith that their new community is well governed and financially sound because it looks well kept up? Considering that they are investing hundreds of thousands of dollars, that approach doesn’t really seem very sound, does it? Here’s a better one.

It’s not very practical to try to teach people to be more financially sophisticated, and waiting forPinching Pennys the state legislature to mandate easy-to-understand, self-revelatory financial statements is going to be a very long wait indeed, so what approach can we use immediately that will work for anyone?

What you need to do is make two determinations about a potential new community. How well is it managed today, and how well is it prepared for the future? The best way to answer the first question is the way everyone already does—look around for yourself. If it looks clean, neat, and orderly, it probably is reasonably well managed today. Everyone has their own standards, of course, but that’s all you need to do to answer the question for yourself. If you’re comfortable, and happy with the community as you see it first hand, then that’s all you need to know. That’s the easy part.

Now it gets a little trickier attempting to tell what the long-term financial soundness of a community might be. Here’s a crude, but effective, simple, quick, and fool proof way to do just that. First, determine the number of units in the community. It’s stated in the governing documents and probably in the marketing literature provided by your real estate agent. Next guess what the average cost of a unit is. You don’t have to be terribly accurate as long as you’re not wildly inaccurate. Now multiply the two to get the total asset value of the community.

Don’t worry about the precisely accurate number as long as you are within $10 million of the right number. For example, you are considering buying into a community of 75 units and your best guess is the average unit cost is $325,000. The total community asset value, therefore, is 75 x $325,000 = $24,375,000. Let’s make this very simple and just round off to an even $24 million.

A general rule of thumb is that the community’s reserve fund should be 10% of the total real estate asset value which in this case would be $2.4 million. Now look at the financial statements and especially the independent audit and see what the reserve fund balance actually is.

In the overwhelming majority of communities, it will not be remotely close to this 10% threshold figure. Most communities underfund their reserves. The reasons are many and varied, and some of them are much more reasonable than others. Some communities might have just paid for a large capital improvement and the fund is temporarily low. Other communities just never adequately funded their reserve in the dangerous belief that low monthly fees will increase the value of their property. This is a disaster in the making, but it might take many years before they learn that the very opposite has occurred. Whatever the reason, it’s never very comforting to know that the reserve is significantly underfunded. This calculation is just as valid, and probably even more important, to current owners who want to know if they are likely to face crippling special assessments sometime in the future. What’s an owner or buyer to do?

That’s a complicated question, actually a multitude of questions rolled into one, which we will need to address in future blog postings.