There are many ways to look at a line of credit. Some co-op boards see it, correctly, as a a safety net, a rainy-day fund, a pot of money that can soften the sting if the building gets hit with an unforeseeable expense. Other boards see it, unwisely, as a way to plug gaps when operating expenses outrun the budget. And some boards see it the way Linus, of “Peanuts” fame, sees his security blanket: it may not do any good, but it sure does feel good to know it’s there. Before acquiring a line of credit from a lending institution, a co-op board should know exactly what it is and how much it costs, the right ways and wrong ways to use it, the smart way to pay it back, and, in the end, how to make sure it doesn’t morph from savior to scourge.
A Good Tool – If Used Right
“Lines of credit became very popular in the ’80s and ’90s, when accountants, lawyers, and property managers advised boards to get one,” says Patrick Niland, president of the mortgage brokerage First Funding of New York. “It’s a convenience, like an overdraft fund on a checking account, or a back-up to the reserve fund. It’s a loan subordinate to the co-op’s underlying mortgage. It can be secured, or it can be unsecured, backed only by the good faith of the co-op. If it’s unsecured, the board avoids the mortgage recording tax – which is 2.05 percent for a line of credit up to $500,000, and 2.8 percent for a line of credit larger than that.” (New York City’s mortgage recording tax is among the highest in the nation.)
Niland points out other drawbacks. While proponents of credit lines note that they have to be repaid only if they’re used, Niland counters that some banks impose a small fee – usually a quarter of a percent – on the unused portion of the fund. “If you’re not going to use the line of credit,” he asks, “why pay fees every year?”
Beyond that, banks charge a variable interest rate on all money that’s drawn from a line of credit. While interest rates are still relatively low, this breaks one of Niland’s cardinal rules. “A basic tenet of finance,” he says, “is that you never use variable-interest debt to pay for a long-term asset, like a new roof or windows. You want a fixed-rate loan – either by taking out a second mortgage, or by borrowing enough on your first mortgage.”
Consulting with an engineer on the condition of the building’s systems can help boards determine how much they need to borrow to cover such foreseeable repairs. It’s the unforeseeable repairs – a boiler that fails in mid-January, surprise violations from city inspectors – that make a line of credit attractive to many boards.
“It’s a good tactical tool, but it needs to be used judiciously,” says Gregg Winter, president of the mortgage brokerage Winter & Company. If a board dips into its line of credit to pay for an unexpected expense, Winter stresses that there must be a plan for paying back the debt. This can be done through an assessment, or with funds from a flip tax, or simply by building the debt into the new loan the next time the board refinances its mortgage.
“Each board will have to have that discussion,” Winter says. He adds that lines of credit, once commonplace, have become rarer because of tightened banking regulations in the wake of the 2008 financial crisis. Banking regulators require that banks must now maintain greater capital reserves to back a line of credit, even if the borrower doesn’t tap into it, which makes the loans less profitable to lenders and accounts for the “non-use fees” that some lenders now charge. The fees apply to the untapped portion of an available line of credit. Some lenders, however, offer unsecured credit lines without imposing non-use fees.
Jeffrey Weber, president of Weber-Farhat Realty Management, says each board’s discussion about how to repay the line of credit needs to take into account the resources of shareholders. “If a board uses its line of credit and decides to pay it back with an assessment,” Weber says, “they may want to spread the assessment over two or three years so it doesn’t hurt people on fixed incomes. But remember, it’s for emergencies. It is absolutely not for operating costs.”
A Sure Way To Hit the Floor
The board at a 37-unit co-op on the Upper West Side fell into that trap. Eager to keep maintenance low, the board took out a $250,000 line of credit instead of replenishing its reserve fund. The board drew $50,000 from the line of credit to do a major sidewalk paving job, then another $50,000 (in addition to a $50,000 assessment) to renovate the super’s apartment and turn it into a rental unit. After drawing again from the line of credit for elevator repairs, the board had spent about half of the original loan. When the board tried to refinance its underlying mortgage, it was told the line of credit had to be paid off before a new mortgage could be issued. Without a reserve fund to fall back on, and with shareholders unable to bear an assessment that would pay off borrowed money, the board had no choice but to build the line-of-credit repayment into the new loan.
“The board felt like it was okay to operate this way because the value of the building was increasing,” says John Viesta, who joined the co-op board in 2014. “But now the chickens were coming home to roost. Nobody would run their household this way. It’s pretty simple: you shouldn’t spend more than you make. Using a line of credit as an emergency fund is fine, but if you use it to cover operating costs, you’re going to hit the floor.”
A far happier scenario played out at Birchwood at Spring Lake, a 733-unit homeowners’ association (HOA) in Middle Island, Long Island, where the seven-member board has spent the past dozen years working to avoid assessments and minimize jumps in monthly common charges. That philosophy was put to the test recently when the board set out to tackle a major capital project.
To gain access to the 150-acre property, you pass under an arch, along a quarter-mile blacktop road to a security checkpoint. That quarter-mile entry road plus another half-mile past the security gate had become an eyesore. “It was embarrassing,” says board treasurer Mike Habich of the road, which was paved when the complex opened in 1990. “There were patches in the pavement every 100 feet. We decided to beautify the entrance and give it some curb appeal.”
So Habich, a retired insurance broker, got to work with his fellow board members and the HOA’s management to arrive at a rough cost of $800,000. How to pay for it? The board last levied an assessment in 2006, and common charges remain flat or rise by just 2 to 3 percent a year. The road project would swamp the $500,000 capital projects budget. So, barring an assessment or a hike in common charges, the board needed money from a different source. Management began investigating a line of credit and recommended three potential lenders: two local banks and the Alliance Association Bank in Las Vegas, which specializes in loans to co-ops, condos, and homeowners’ associations. The board settled on a $1 million, seven-year line of credit from Alliance.
The paving job took about a year, and the board drew down a little more than $800,000 from the line of credit. When the work was complete, the board closed down the line of credit and converted its debt into a term loan with a 5.3 interest rate. It began paying off the principal and interest last January and will pay off the loan over the course of seven years, through a small line item in the annual budget – “payment of capital improvements loan” – but no assessment or increase in common charges. A far-sighted, relatively painless solution.
Josh Ormiston, vice president at Alliance Association Bank, a division of the Western Alliance Bank, oversaw Birchwood’s line of credit loan. He says most of the bank’s borrowers wind up using about three-fourths of an available line of credit, then pay off the debt with a fixed-rate term loan like Birchwood’s. That 5.3 percent rate reflected the rises in interest rates while the paving work was under way. If the payback stretches longer than 10 years, Ormiston says, variable interest rates apply.
“The advantage of a line of credit is that you’re not paying interest on money you didn’t use,” Ormiston says. “The downside is that you’re subjecting yourself to some interest-rate risk.” Habich, Birchwood board’s secretary, has no regrets. “I don’t know any way we could have done this other than a line of credit,” he says.