There is an ongoing debate in community associations about how much cash an association should set aside to adequately fund its operations and reserve accounts, and at what level contributions should be set to obtain that cash from members. Boards of directors are often faced with the dilemma of increasing monthly dues in the face of resistance from members or deferring funding of certain budget items, usually reserve funds, until later.

California has a mandatory funding statute for community associations. Section 1366 of the Civil Code says: “Except as provided in this section, the association will collect regular and special contributions sufficient to fulfill its obligations under the governing documents and this title.”[1] You use the term “shall” and that means that the proper evaluations to do the job are required up to the limits of the authority of the board. In California, the board has the authority to increase regular evaluations up to 20% over the previous year and can impose a special evaluation of up to 5% of the gross budget, all without a vote of the members.[2]So the authority is there. But does the board have to use it?

Legislators use the word “shall” when they want to eliminate options. Thus, as used in Civil Code Section 1366 (a), the intent of the legislature is that the boards of community associations are legally obligated to assess as necessary to fully comply with the association’s “obligations”. . But what exactly are those obligations? In terms of association operating expenses, it is a fairly easy decision. Expenses such as water, garbage, administration, pool maintenance, and insurance bills are current running costs. If you want the service, you must pay the bill, usually monthly. Discussion of those obligations begins and ends during each year’s budget committee meetings, and once those expenditures have been projected, there may be little argument, but they must be paid now, from monthly installments. If the board does not want to increase the amount of contributions during the previous year, its only legal option is to make sure that the expenses in the budget match the projected income. Obviously, managers can decide to cut certain expenses and make other adjustments designed to keep the total cost of ownership low if they so choose. But once they agree on a budget, the obligations are clear and the law requires them to evaluate as necessary to meet those monthly obligations.

Reserve funding is another matter. Until it is time to put a new roof or paint the buildings, no reserve fund expenses are required, so the question that often arises is: “Why is it necessary to finance these obligations now?“This question fuels the discussions mentioned above: should appraisals be considered today to save enough for future reserve obligations, or should we just wait until needed and then seek out homeowners for a special appraisal, or apply for a bank loan?

Recent surveys indicate that most associations are doing something of each: They save some money but rely on a special appraisal or a loan to finance the balance. We say “trust” as if that’s part of a conscious plan because these surveys also reveal that the average association has only 50% of the cash in reserves that their reserve study requires. So if now is the time to replace the roof and the association only has 50% of the cash it needs, then some alternative sources of funding will need to be tapped, or the project will need to be deferred until the cash is available. It is unknown if that is really the plan or not.

The most widely used alternatives are special evaluations, bank loans or deferral. Special appraisals can work to finance a large construction project if homeowners have the means to pay for them. It also depends on state law. In some states, there are no restrictions on the amount that an association can specially assess. The only limitation is political resistance, but the basic authority is there if the association chooses to use it. In California, however, special assessments that exceed 5% of the “gross budgeted expenses for that fiscal year”[3] require the approval of the members of the association. This has the effect of taking control from the hands of the board of directors and placing it in the hands of the members. And while this may be the populist’s choice, it greatly complicates matters because self-interest, and not community interest, often influences the vote. If the board and management do an excellent job of explaining the need, if the members can afford the evaluation, if all their long-term interests are reasonably similar, and if they have been adequately advised over the years that this It was really the plan, it could happen. But what if not? Given all the above obstacles, that is always a different possibility.

Seeking a loan from a bank to finance a major repair project is a common alternative chosen by boards. In some states, this is the preferred alternative to regular and special evaluations. One argument for using borrowed funds is that the homeowners who will most enjoy the upgrade are the ones who will pay for it, as the repayment will extend over the life of the new roof. In most years, these loans would be readily available, but we have to question whether they would be the best option in a recessionary economy when lending is tighter. In addition, the cost of the project will increase with the use of borrowed funds, not only because of the interest paid on the borrowed money, but also because of the interest lost on the appraisal savings that would otherwise be earned. Finally, the long-term debt burden assumed by the association will limit the association’s access to capital for other purposes.

The last alternative would be to postpone the necessary work for a later time. This has the obvious drawbacks of increasing short-term repair costs, lowering property value, and causing homeowner inconvenience due to an increased incidence of leaks or other damage. Also, in an inflationary economy, the cost of labor increases with each deferred year. This can cause a downward spiral: the association lacks the cash to do the work because the reserves have not been adequately funded over time; a special assessment to close the gap will add significantly to the monthly assessment payments and therefore owners will not pass the special assessment to finance the work or to make payments on a bank loan; work is postponed; the price of labor goes up and becomes less affordable; the deterioration of the conditions causes a loss of market value; owners perceive a loss of investment and are even more reluctant to approve the injection of new capital; condition and market value continue to decline, and so on.

So do the provisions of Section 1366 (a), that a board of directors “will collect periodic and special fees sufficient to meet its obligations … “ specifically include the obligation to at the moment fund reserves? Unlike other states, such as Hawaii, there is no express mandate in California law, but there are strong arguments that the legislature is seeking funding for assessments. The only evidence of a contrary intention is Section 1365 (3) (C) of the Civil Code, which requires a board to notify owners: “The mechanism or mechanisms by which the board of directors will fund reserves to repair or replace major components, including appraisals, loans, use of other assets, deferral of selected replacements or repairs, or alternative mechanism.. “[4] The argument is that since these alternates are recognized, they must be authorized. However, it is important to note that the obligation to disclose the use of an alternative financing scheme does not amount to an endorsement or authority for the use of the alternative.

Section 1365 (C) (3) also disagrees with the reserve study section of the code that requires a board to adopt a funding plan and mentions only the use of regular or special evaluations for that purpose. It states: “The plan will include a timeline of the date and amount of any changes to regular or special evaluations that would be necessary to sufficiently fund the reserve fund plan.“[5] You also disagree with Section 1366 (a) itself which requires the board to impose regular and special evaluations, but it does not say anything about the use of other alternative sources of financing.

We also have to consider the board’s fiduciary responsibility to the association, and given the political and economic vagaries, pitfalls, and additional expenses that would accompany reliance on special evaluations, bank loans, or deferrals, a board that chooses to evaluate at a level below the funding requirements established by the reserve study could very well face a future legal challenge to that decision. We are aware of at least one issue where that has already happened. Most likely, the association or its members cannot avoid a judgment obtained on such a claim, and it is questionable whether the association’s liability insurance would indemnify the association against such loss.

Our recommendation is what you’ve probably come to expect from our treatment of these issues in the past: a board’s prudence, fiscal responsibility, and fiduciary obligations to its members require more than just waiting until the roof needs to be repaired. before searching. money. Meeting the funding levels in the association’s reserve study through gradual accumulation through regular evaluations, coupled with periodic inspections, is the safest and most predictable method yet devised to meet future repair obligations.

[1] California Civil Code Section 1366 (a)

[2] California Civil Code Section 1366 (b)

[3] California Civil Code Section 1366 (b)

[4] California Civil Code Section 1365 (3) (C)

[5] California Civil Code Section 1365.5 (e) (5)