For community associations contemplating large-scale capital projects, an alternative to funding with cash reserves, is to contract a loan with a bank that specializes in association lending. Utilizing financing is a good way to spread the cost of common area improvements out over time, and is a way to equitably distribute the cost of improvements to those who are actually benefiting from them. For those communities considering utilizing a financing program, the following overview provides a basic game plan for undertaking such a task.
When contemplating a loan, the first step an association will want to take will be to contact their management company and attorney to assess what steps need to be taken in order to obtain the necessary approval to enter into a loan. The bank’s primary security for these loans will be an assignment of the association’s assessments, and therefore it will be necessary that the governing documents of the association permit them to enter into a loan as well as pledge their assessments as security.
Once the association’s ability to enter into a loan is confirmed, the association needs to determine what means will be used to repay the loan. For smaller loans, an increase to regular monthly assessments may be a feasible way to make loan payments. Another option could be to implement a special assessment wherein each unit owner would pay up front or participate in the loan program. In either case board or homeowner approval(s) necessary to implement the desired repayment structure must be considered. It is not necessary to have the assessment increase implemented prior to executing the loan, but in most cases it will have to be approved before closing the loan. That being said, implementing an increased regular assessment or a special assessment, prior to obtaining a loan, can be a good way to demonstrate to a bank that the association has both community support and the ability to repay the loan.
When applying for a loan the bank will want to know the type of loan and term being sought. For large lengthy projects there will most likely be the option of entering into a non-revolving line of credit during the construction period. These lines of credit are typically six to twenty-four months, and during that time interest only payments will be made on the amount drawn. Upon expiration or at construction end, the line will be converted to a fully amortizing term loan. A typical term loan will be from five to fifteen years in length. It is important that the loan length not exceed the useful life of the improvements being financed. Alternatively, if the project is short-term or small in size, it may make sense to forego the draw period and enter into a term loan immediately.
When a bank evaluates a loan request, there are some key metrics that may be used to gauge the credit risk of the association. The following are some factors that a bank may consider during the underwriting process.
- Delinquency
- Number of accounts and total amount of delinquencies.
- Many banks have a maximum rate of 10% for number of units aged 60+ days.
- Strong credit – Delinquency rate less than 5%.
- Liquidity
- Amount of cash as a percentage of annual assessments and annual debt service.
- Many banks have a minimum liquidity requirement of 20% of the association’s annual assessments.
- Strong credit – Liquidity levels greater than 50% and at least one year of debt service payments.
- Size
- More units/homes provide a diversified cash flow stream.
- Assessment Increase
- Large increases may cause delinquencies to rise.
- Strong credit – Increase of less than 25%.
- If a large increase is necessary, implementing it before applying for the loan can mitigate risk.
- Large increases may cause delinquencies to rise.
- Annual Assessments/Market Value
- Annual assessments should not be greater than 10% of the unit value.
- Strong credit – Annual assessments less than 2% of market value.
- Annual assessments should not be greater than 10% of the unit value.
- Owner Occupancy and Concentration
- A high % of investors not living in their respective units poses more risk.
- Strong credit – Over 80% owner-occupied; multiple unit owners control less than 10% of the units.
- Weak credit – Less than 60% owner-occupied; multiple unit owners control greater than 20% of the units.
- A high % of investors not living in their respective units poses more risk.
- Management and Capital Planning
- Strong external professional management company with experience in managing similar projects is desirable.
- Professional reserve study that is at least partially funded indicates prudent financial planning.
Ratings of fair to strong in most of the factors above by an association improve their chances of being approved for a loan.
This article was contributed by Josh Ormiston, Vice President | Association Lending department at Alliance Association Bank – a division of Western Alliance Bank. If you have any questions, please contact Josh at [email protected] .
