News and Resources

Weathering the Storm of Foreclosures and Shrinking Capital

By: Anthony Dister, Assistant Vice President, COMMUNITY ADVANTAGE of Barrington Bank and Trust

Weathering the Storm of Foreclosures and Shrinking Capital

How can Associations protect themselves in an economy that just seems to keep getting worse? The tightening credit market has affected every aspect of the economy in Chicago from large corporations to small businesses to community associations, as easy credit is not so easy to come by anymore. Historically many corporations and Associations would rely on debt to finance operating shortfalls, big ticket item acquisitions, and capital improvement projects; however these borrowers are finding that either rising interest rates have made it non-cost effective to borrow or credit is no longer available.  This has led many people to think that the credit crunch has reached a critical level in Chicago. 

A credit crunch is a period of time in which credit and loans become more difficult and costly to obtain. There are individuals and companies who invest in debt and these investors make money when loans are repaid; they do not make money when they are not. When credit card, loan delinquencies, and foreclosures rise, debt investments become unattractive, leading investors to pull their funding. As a result, banks become stricter with lending as capital becomes scarce.

Community Associations have not been immune and are feeling the effects of the crunch. As foreclosures continue to rise Associations have felt it where it hurts and that is in the operating budget.  Assessments are going uncollected as units in foreclosure are taking months to merely recoup a portion of the funds owed or in many case none at all. The large increase in the volume of foreclosed units on the market has caused them to sit on the market vacant for months. The average condominium unit in Chicago now takes almost nine months to sell and the foreclosure process time has more than doubled from start to finish. Third Quarter 2008 saw a record number of foreclosure filings in Chicago as there were over 15,752 new foreclosed properties in the Chicagoland area. This is the first time there have ever been over 15,000 quarterly foreclosures in Chicago and represents a 7% increase over the 2nd Quarter of 2008.  To put this in perspective, in the 3rd Quarter of 2006 there were only 8400 total foreclosure filings in the Chicagoland Area. 

The following are steps that virtually any Community Association can take to ensure they remain credit worthy and have sufficient funds to meet all their financial obligations. Associations must protect themselves against shrinking assessments due to foreclosures as cash becomes tight in the winter months and the economy continues to falter. 

Create an operating contingency account. Many Associations are under the assumption that an operating contingency fund and a reserve account are one in the same; however this is not the case. Reserve funds are to be used for the purpose of replacing or improving the common elements of the Association; Operating funds are to be used for daily expenses and maintenance of the Association. Any funds “borrowed” from reserves to fund operating shortfalls are to be paid back and noted in the financial statements as funds due to operating. Associations may create and fund the operating contingency account from excess operating funds at year-end, interest earned on reserve investments, or splitting the contributions to reserves between the two funds. The operating contingency account aids Associations in forecasting their future capital needs for larger projects that are strictly maintenance. This account helps to insure against an associations worst enemy - deferred maintenance which can be a very large operational expense leading to a shortfall.     

Associations must face reality and come to terms that they will most likely not collect 100% of the amount budgeted for assessments. In many cases Associations never have collected 100% of the funds yet every year assessments are not increased and everyone wonders why there is an operating shortfall. Association Boards should work together or with their managers to create a bad debt reserve or contingency for bad debt and incorporate it into their operating budget. This line item does not condone non-payment of assessments however it does help to allow the Association to have sufficient cash flow to run its’ operations.

Raise assessments on an annual basis at least 3-5% or the current inflation rate. Expenses typically go up every year so assessments should too. Until all vendors, suppliers, and utility companies agree to take a year off of price increases this money must come from somewhere.      

Establish a delinquency collection policy and stick to it. Association boards must be diligent in the monthly collection of assessments and turn over accounts to the Association’s attorney as soon as your policy allows for it. If the Association does not follow its own procedure and turn accounts over to collection they may be forfeiting the right to collect past due assessments if the unit goes into foreclosure. Timely filing of claims against owners is critical to the collection process. Associations with high delinquency ratios will have a more difficult time securing loans and establishing credit with vendors. The Association’s assessment income is the greatest source of cash flow and must be protected by its Board.

Obtain FHA approval. Unlike Federal Housing Administration insured mortgages for single-family homes, FHA loans for condos are more complicated. The condo unit itself or the entire building must be FHA approved. As bank mortgage underwriting requirements have tightened up, lenders, borrowers and developers have started to investigate FHA loans again as a means for selling or purchasing units. FHA loans require a smaller down payment and are guaranteed by the U.S. Government but require much more paperwork than conventional mortgage products. FHA loan requests as of 6/30/08 total 4,066, up from 1,347 as of 6/30/07. FHA has a list of requirements condominiums must adhere to for FHA approval (for a complete list please consult an FHA mortgage representative). While these loans take much longer to process (average closing time of 10 weeks) they can make your Association more attractive to perspective buyers. Bringing more potential buyers to your Association to spark dwindling sales and even could be considered as a marketing technique.

Associations may wish to consider taking out a line of credit for incidental charges and non-budgeted expenses. Association lending requirements have become more stringent however the collective borrowing power of a well run Associations are still able to secure financing in this turbulent market. This will allow Associations to borrow funds as needed and fill in the gaps left by foreclosures and delinquent assessments. The interest due on these lines of credit should not become an annual line item on the budget rather the principal should be paid back as quickly as possible. Many times lenders will require that the line is rested at least once a year to ensure this takes place. 
       
Many Community Associations are wondering if they should scrap or postpone improvement or capital repair projects; however if projects are planned for accordingly they may be completed as needed or required. Many Associations have had a reserve study completed however few follow them. Planning ahead and reserving for future capital expenses reduces the need for special assessments and loans. While many capital projects are extremely expensive, being able to self- fund a portion of the project eases the burden on unit owners and helps the Association obtain the financing necessary to complete the remainder of the project. Banks are looking for Associations to have reasonable reserves on hand or the ability to pledge a portion of the funds as additional collateral for the loan if needed. This requirement may be a fixed percentage of the operating budget or a pre-determined dollar amount to be maintained on deposit with the Bank. Associations should use their reserve study as a guideline to determine what the acceptable levels of reserves to be maintained is and have it updated at least every five years.

Many believe that the Federal Government’s bailout plan will stimulate the economy and help to ease the credit crunch, however only time will tell. Until the tidal wave of foreclosures ends and home values stop plummeting the economy will not improve so Associations need to be prepared to weather the storm and be proactive in taking measures to protect themselves.  Associations who prepare and take the steps listed above will return faster to increasing values, over-all profitability, and unit owner satisfaction.