In practically every discussion of topics related to HOA governance, it is important to remember that one size does not fit all. Association type, size and complexity all contribute to the application of best practices. Consider how the following factors can define the simplicity or complexity of budget preparation.
- Even a small single family association with less than 50 homes and no amenities can easily have a budget of $25,000. It is not unusual for many associations to have budgets in the hundreds of thousands of dollars, and most large scale associations have annual operating budgets that exceed a million dollars.
- Condominium and townhome associations with greater responsibility for common areas or exterior maintenance will typically have far more contracts for services.
- Many associations have complexities associated with foreclosures, absentee owners, aging infrastructure and high assessment delinquency rates.
- Over seventy percent of associations are self-managed and many struggle with board turnover or expertise. Contrast this with associations that benefit from expertise from a management company, reserve specialist, accountant, and attorney.
Most Associations Will Have Two Budgets
The “operating budget” includes line items for annually recurring expenses such as landscaping, management, insurance, utilities, and other services. The”reserve fund”is money collected as part of each lot owner’s assessment for the repair and replacement of major capital items. Examples include new signage, re-paving, clubhouse renovations, exterior painting and roofing of townhomes, replacement of carpet in condominiums
Start with a Review of State Statutes and Governing Documents
The board should start early and give itself enough time to develop the budget as well as meeting critical deadlines associated with providing notice and obtaining approval. Having a budget calendar is helpful. Look to state statutes and the governing documents for requirements regarding dates and timeframes related to board adoption of a proposed budget, notice and review periods by members, actual adoption, fixing of annual assessments, and notice of annual assessments. Some states and governing documents require member approval and specific quorums while others utilize a ratification process that the budget is approved unless a majority or more of the membership attends a ratification meeting and rejects the budget. Governing documents often include language that the annual assessment cannot exceed the previous year by more than ten percent.
After completing this review, it only takes a little extra effort to develop a written budget policy that defines the process, key dates, quorum requirements, and necessary votes. This document will prove helpful when presenting the budget to the membership for approval.
Signing Contracts for the Next Fiscal Year
Most associations have contracts with multiple vendors. These may include management, landscaping, stormwater and pond maintenance, accounting and tax returns, pool maintenance, insurance, snow removal and the list goes on. Focus first on the largest contracts. The objective is to agree on expectations of service to be provided, negotiate price and then conclude the process with signed contracts. This avoids spending surprises that exceed budgeted amounts in the next fiscal year.
Budgeting for Reserves
Most associations have responsibility for common area elements that require maintenance or replacement costs that exceed $10,000. This includes major capital projects such as roofs, paving, pools, painting, clubhouse renovations, irrigation and security system upgrades. With large condominiums the list expands to include HVAC systems, boilers, elevators, windows, balconies, etc. The solution is that the association should have a reserve study performed that takes into account useful life, repair or replacement costs and a long range funding plan. For a small association with only an entrance sign, simple spreadsheet calculations may be sufficient. For medium size associations, there are HOA software applications that get the job done. At the higher end of the spectrum, large associations are advised to have a reserve study conducted by a certified reserve specialist every three to five years. Some states as well as mortgage companies now require associations to have a current reserve study and even a reserve fund that equals a specified percentage of the operating budget.
Associations that do not adequately plan and budget for reserves often end up with deteriorating infrastructure that adversely affects property values. Percentage of homes for sale and rental properties will increase. As a means of holding assessments constant, boards may defer adequately funding the reserves and pass the buck to the next elected board. This is a dangerous practice that usually results in extreme special assessments for which the members are not prepared. It is also particularly unfair to new residents that learn that they may be required to pay for the failure of previous boards to exercise their fiduciary responsibility. Efforts to sue in court only result in attorney fees that must then be then shared by all members. It cannot be stressed enough that the budget process takes into account adequate funding of reserves.
Budgeting for Noncash Items
Imagine that the budget has been approved and assessments calculated based on the number of lots/owners. But what happens if ten percent or more of the lot owners are delinquent. If the budget does not include a line item for noncash items such as bad debts, then the difference will have to be made up by reducing expenses or increased income from paying members with a special assessment or with a loan. The noncash expense for bad debts is often even worst when the costs of legal fees are included. What about an unbudgeted large deductible expense for an insurance claim? Another example is the legal costs associated with a lawsuit that is brought during the fiscal year but which was not anticipated in the budget. The board should give careful consideration to including noncash items in the budget.
After working on the expense side of the ledger, consideration must be given to revenues. Many associations will not have any non-assessment revenues other than interest expense. However, the following are some examples that should not be overlooked.
- Fees from clubhouse rental, non-member pool fees, marina fees and similar types of income.
- Timber leases and harvests
- Cell tower leases
Prior Year Actuals
At some point in time the board should review prior year actual expenses and revenues. Watch for potential increases in utility fees. Some items will be difficult to project such as costs for irrigation or snow removal.
The “Miscellaneous” Line Item
Industry professionals are often divided over the need for a miscellaneous line item. This budget category needs to have a list of possible uses so the board has some guidance on how to proceed in spending the funds. If an association doesn’t use the full amount budgeted during the year, it should consider reducing the amount for the next year.
Current Year Carryovers
As nonprofit corporations and consistent with IRS rules, most associations will adopt an annual resolution carrying any year end surpluses forward into the next year’s operating budget. Any spending of year end surplus funds should benefit all members. While ‘blowing it’ on a yearend party might seem like a fun idea, it is widely discouraged.
Developing the Proposed Budget
By now, most of the necessary research is complete and it is time to develop and finalize the proposed budget.
Boards that are developing their first budget after going through transition from developer control to a resident elected board should be prepared for “assessment shock”. As a fairly common practice, developers will often subsidize or absorb expenses so as to realize artificially low HOA assessments and therefore improve the marketability of the community. The wake-up usually occurs when the first board realizes the need to disproportionally increase assessments. Unfortunately residents will often place blame with the newly elected board unless special efforts are made to inform and educate. For associations that have survived the first budget year, remember it is easier to gain member support for a two to three percent budget increases each year rather than face a ten percent increase every three years.
Since most boards do not want to become a lightning rod for disgruntled members, there is a strong temptation to maintain the budget status quo. As a result, reserves are often underfunded, noncash items are overlooked and risks taken that will hopefully get the association through until board members resign or terms expire. If this practice continues over several years the association may find itself under significant financial stress. This typically also leads to challenges in finding strong leadership to serve in the future. It is critical that the board perform its fiduciary duty in preparing a realistic proposed budget.
The Budget Approval Process
As was pointed out earlier, there are wide variations in state statutes and governing documents regarding the budget approval process. This includes procedures regarding providing notice, board authority versus member authority to approve, ratification, and notice of assessment. Associations contracting with management companies will benefit from professional knowledge and experience as well as expertise from accountants and attorneys. Boards of self-managed associations are encouraged to consult with industry professionals when necessary.
The Consequences of a Budget that is Rejected by the Membership
In some associations the authority to approve or reject the budget rests with the membership at a properly called meeting. In other associations, the authority to approve or reject the budget rest solely with the board or in many cases is considered ratified at a separate meeting unless a percentage of the membership votes to reject the budget. Given the challenges of obtaining voting quorums at annual meetings, it is not unusual that few if any members attend the budget ratification meeting and consequently few board proposed budgets are rejected. In the circumstance that the budget is rejected, most state statutes and/or governing documents provide that the association continue in the next fiscal year on the basis of the existing budget.