James Samson is a partner in Samson, Fink & Dubow.
Would you let your treasurer take your co-op or condo’s reserve funds to Atlantic City or to Las Vegas? Of course not – yet all too often boards allow their reserves to be put at risk by imprudent speculations, improper management, and the absence of oversight.
Two simple examples illustrate the problem.
One of our clients received a $2.5 million settlement, which was meant to be used to satisfy the capital needs of the client for the foreseeable future. Instead of investing the proceeds in treasury bills (T-Bills) or certificates of deposit (CDs), both of which are insured by the Federal Deposit Insurance Corporation (FDIC), the treasurer bought shares in a mutual fund that traded in government obligations. The directors quickly learned the difference between a T-Bill and a mutual fund that trades in T-Bills. Before stopping the treasurer’s practice and liquidating the mutual fund investment, they lost 25 percent of their precious new reserves in less than four months.
Another client contemplated bankruptcy and liquidation. This co-op was able to devise a complicated workout that resulted in the property paying off its debts, selling several unneeded assets, cutting operating expenses, and establishing a very healthy reserve fund of over $3 million. The board had spent hundreds of hours crafting and negotiating the workout and was justifiably proud of the results. Three years later, without one capital improvement project being implemented or one emergency requiring their use, the money was all gone and the client was insolvent again.
What happened? Greed, that’s what. Some of the reserve funds were used for operating expenses because the board members did not want to raise the members’ monthly expenses. Worse – much worse – the board allowed the treasurer to embark on a series of complex option transactions with a goal of tripling the reserve in a short period. The strategy was an utter failure, the money vanished, and the building was in trouble again.
How can your board avoid such a catastrophe? How do you protect your reserves? How do you create an adequate reserve fund? There are a few simple rules and they do not have exceptions or exemptions.
Never Risk the Principal
Reserve funds are too important and too hard to replace. They should be treated like trust fund money. Never invest or speculate with them in a manner where the principal is at risk in any way. The reserves should be invested directly into T-Bills or FDIC-insured CDs (one CD per bank and no more than $100,000 in any one institution). Mutual funds which invest in treasury obligations or in fixed-rate bank obligations place your money at risk. Do not invest in such funds. Likewise, but more obviously, the purchase of stocks, no matter their quality, should be avoided.
Even worse are the practices of board members who treat the reserve fund as though it were a day-trading account. One well-respected accountant was appalled when the treasurer at one of her buildings gave her a large stack of trade confirmations as part of the audit. Day-trading is gambling; it can open a treasurer to personal liability. Do not do it!
Options, commodity trading, and “rare metal” trading are also forms of gambling that can result in the loss of principal. No matter how attractive the return promised, the investment is inappropriate and should be avoided. Make sure all reserve funds are FDIC-insured or are U.S. government general obligations. It takes a little more work to keep track of several CDs or T-Bills, but banks do go out of business (as do brokerage firms), so keeping track is necessary.
Segregate Reserve Funds
Keep reserves in separate accounts maintained in separate financial institutions. Do not commingle your reserves with operating funds. It is harder to keep track of commingled funds and to know when the reserves are being improperly used.
Never Permit Wire Transfers
We actually restrict wire transfers in our management contracts. First, there is never an emergency that is so great that a bank or certified check cannot be used. The need to wire money almost always is the result of bad planning – a self-induced emergency. Second, wire transfers do not create adequate paper trails. Third, transfers can be initiated by unauthorized people. One management company caused 26 of its cooperative clients to lose over $2.6 million because an unauthorized employee secured access to the account numbers and passwords and then proceeded to wire transfer funds back and forth among the 26 cooperatives to cover his embezzlement activities.
No Access for the Agent
This rule is a corollary to Rule 2. Permitting a managing agent direct access to reserve funds is never wise and often risky. Large pools of money that are not needed for current expenses are attractive targets for employees of the managing agent who want to “borrow” (i.e., embezzle) the funds.
Almost as bad is the situation where the managing agent “lends” your reserves to another building that is short of cash. It happens a lot more often than you’d think. One of our cooperatives discovered that its managing agent had lent $200,000 of its reserve fund to an affiliated condominium without its consent.
Keeping the reserve fund totally segregated and out of the reach of management also insures that the agent cannot use the funds for ordinary operating expenses when he runs short of cash or exceeds a budget. Maintenance or common charges should cover monthly operating costs. If the maintenance is insufficient, the board should be notified and allowed to analyze the problem. Is it a collection or arrears problem? Have expenses exceeded expectations? Did the managing agent fail to set aside enough money each month to pay insurance premiums, water and sewer taxes, or real estate taxes?
If the agent is required to come to the board when there is an operating cash flow problem, the board gets an early opportunity to analyze the problem and correct it quickly. If the agent can simply transfer funds from the reserve fund, the problem can be camouflaged indefinitely until reserves are depleted.
Reserves Are Item No. 2
Your reserve fund is the second most important item on your monthly board agenda. Generally, financial matters should be the first item on every board’s agenda. They should be discussed before the heated arguments about the lobby redecoration, gossip about the new purchasers, or a discussion about repairs.
After analyzing income and expense issues, the treasurer should present a short report on the reserve fund. Every board member should know how much is in the fund, what is currently available, where the money is invested and how, and what can be spent in the next 90 days and why.
The Reserve Funds Are for
Emergency or Capital Use Only
Reserves are for emergencies and long-term, building-wide capital improvements. If a property is using its reserve funds for operating expenses, the board has a problem that it has not addressed.
Two years ago, an Upper East Side cooperative corporation had a catastrophic flood that damaged 44 apartments. After 18 months of hard negotiations with the insurance carrier, it recovered over $610,000. If it had not had a healthy reserve fund to pay for the repairs, it would have been forced to settle early for the insurance company’s offer of $535,000, and the shareholders would have faced an assessment for the difference.
For years, my building’s board carefully set aside funds for capital improvements and for the long-term goal of paying off the mortgage. Then a new board took control. Most of its members had no intention of staying in the building long-term, so they raided the reserves, subsidized operating income with periodic withdrawals, and in a few short years wiped out the reserve fund. After doing that, all of the board members sold their apartments and left the problem to their ex-neighbors. As a result, maintenance was raised 35 percent in one year, capital improvement projects were deferred, and the hard job of rebuilding reserves began again.
Enough Is Never Enough
How big should your reserve fund be? The answer depends upon the age of your building, how many basic systems you must replace in the next decade, whether your organization can easily borrow money, and how tolerant your tenant-owners are to large, unexpected assessments.
Generally, condominiums encounter greater difficulty than co-ops do in borrowing for capital improvements. Many condo bylaws contain organizational restrictions that require unit-owner votes for major renovation projects or special assessments. Worse, most condominium buildings in New York are less than 30 years old. Therefore, during the early years of their existence, repair costs were low and major system replacements were not needed. The boards and their unit-owners became addicted to the low common charges and lack of problems. Now the luxury high-rise buildings that were constructed in the mid-1980s need a new roof, a new boiler, and a major Local Law 11 façade renovation.
Conversely, while most cooperatives are able to borrow money easily, they face the problems of much older systems. Most cooperatives were conversions from rental buildings. The previous landlords often failed to address capital improvements adequately and solved their problem of deferred property maintenance by conversion to co-ops. Although many buildings received a Local Law 70 reserve fund contribution from the original sponsor, that money had been spent years ago.
Since most buildings must address one major system rehabilitation at least once every five years and the high-rise buildings must also deal with a Local Law 11 repair project every five years, the capital needs in many buildings require setting aside $100,000 to $200,00 annually. Few cooperatives or condominium associations have the self-discipline for such forced savings.
Develop a Strategy
There are many ways to create or augment a reserve fund. All require planning and many have negative consequences. Some are very creative. The two most common methods are:
(1) Small periodic assessments. Many buildings assess the shareholders or unit-owners either one extra month common charges or maintenance each year or assess an amount equal to the shareholder’s co-op/condo tax rebate and/or STAR refunds.
(2) Borrowing. Cooperative corporations are able to take advantage of low-interest rates and borrow extra money when their mortgage is refinanced. For example, if the mortgage interest rate is 5.1 percent and the co-op can invest the excess funds in CDs earning 5.5 percent, the cost of the excess money for the reserve fund is only 0.4 percent, which is tax deductible for the shareholders. Actually, some tax planners argue that, effectively, the entire 5.5 percent is deductible and that the entire 5.1 percent interest income can be sheltered by depreciation or operating losses on the building. But watch out for Regulation T. Do not get greedy! Condominium associations find borrowing much more difficult.
Creative solutions require a board to take advantage of opportunities as they present themselves. Here are some examples:
(1) Right of first refusal. Most condominium associations have a right of first refusal to buy units when they are offered for sale. Cooperative corporations should consider adopting an amendment to their proprietary lease to acquire one. Several of our buildings earn significant income from buying and flipping apartments that are offered for sale at a below-market prices. One Riverdale co-op made enough profit off of a single flip to pay for its façade project. Properly done, the profits are tax free. One of our cooperative clients actually purchased the sponsor’s remaining unsold apartments and funded $6 million in capital projects out of the profits from their resale.
(2) Selling assets. Currently, six of our buildings are allocating ownership interest to a variety of spaces in their buildings. These spaces include unneeded hallway dead ends, rear yards, rooftops, garage/parking spaces, and professional or superintendent apartments. In each case, the sales proceeds of each are earmarked for the reserve fund. That, in turn, is money dedicated to future capital improvements.
(3) Flip fees. An apartment-transfer fee is one of the most controversial, yet most common, ways to fund a reserve account.
(4) Tax refunds. The periodic settlement of tax certiorari proceedings offers the opportunity to dedicate the refund to future capital expenses.
(5) J-51 Benefits. When reserves are spent for capital improvements, many cooperatives are able to secure J-51 tax-abatement benefits from the city. A lot of discipline is required, but the savings can be dedicated to future capital improvements rather than to reduce monthly maintenance costs.
Get Fidelity Insurance
Many cooperatives and condominiums rely on the manager’s fidelity bond or insurance policy to protect their reserves from theft. This is not adequate.
First, even if your managing agent maintains your reserve accounts (which it should not), your loss from theft by an employee of the managing agent may not be covered. You should insist upon a special endorsement confirming that theft of your association’s money by an employee of your agent is covered.
Second, what insurance company covers a loss caused by a theft from an officer or director of your housing company? While such losses are rare, they can involve millions of dollars. Your board should insist on its own fidelity policy.
Review the Bank Statements
More than one board member should receive the monthly reserve fund statements directly from the bank or investment firm. A copy should be sent to all board members and the managing agent and accountant.
Trust, but Verify
Two or more signatures should be required to withdraw reserve funds. Both signatories should be board members. Questions about expenditures and investments should not be viewed as testing the integrity of the treasurer. All board members have both the right and the obligation to understand fully the expenditures and investments. Questions should be encouraged. They help protect this valuable asset.