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Part 1 - To assess or not to assessAug 23, 2008

My opinion is that any co-op corporation or condo association without an annual assessment income stream is operating with fiscal recklessness and fiduciary irresponsibility. Why such strong words? As soon as the property is built, it begins to age; it depreciates and it is inevitable. Why not plan ahead and plan effectively?

But wait! Let’s do a special assessment! But, the shareholders are up in arms. How dare you promote a “special assessment”!

Let’s attack the stigma of special assessment another way. Is it not better to plan for a child’s college attendance at the time of birth rather than to awaken to the need for funding in the first year of college attendance? Yearly amounts placed into savings are certainly more palatable than funding the surprise tuition fee of $5,000 to $50,000 without the benefit of prior savings. Certainly capital improvements are as inevitable as or even more inevitable than college tuition payments.

So let’s see if this works for one’s building. Start today, or very soon, with a relatively low per share assessment and work up the amount year after year after year after year. Yes, one can stabilize the per share assessment at a plateau. This recognizes that aging starts slowly and then increases or accelerates over time, until capital replacements or improvements are made. In some cases, because of past failures to create a capital reserve funding program and to actually add capital, starting low may not be a suitable option.

Has everyone become aware of the AICPA capital replacement schedule that should accompany the annual report each year? And, by the way, this is not a recent phenomenon. Our co-op corporation publishes the report as required. We have checked other buildings in our immediate area and have found that many avoid the necessary engineering review and thus decline to publish the report. What are the boards hiding? Attentive auditors publish a footnote, but how many shareholders read the footnotes or understand the footnotes?

In our case, we hired an engineering firm many years ago, e.g.: upon conversion to co-op; well before the AICPA made its prescient pronouncement. In turn, our engineering firm updates the report every two years. Yes, the first analysis and report was a bit pricey, but as we have continued the engagement with the same firm, the recurring costs are substantially less. Essentially, the schedule defines the major mechanical and structural components of our site/building and postulates the useful life in years remaining and the estimated cost to replace the items at current costs. Inflation is not included. Our schedule, much should be similar for all buildings, contains line items such as heating boilers, hot water boilers, roof fans, lobby, hallways, emergency generator, emergency lighting, fire pump, sidewalks, garage decks, recreation deck, walls & fencing, pool, driveways, roof, terraces (owned by the co-op), windows, HVAC chillers, HVAC condensers, water pumps, elevator system, fire alarm system, security system, compactor system, etc.

Using the above schedule, we create a spreadsheet for each line such that the completed spreadsheet reflects how much capital reserve outflow we will encounter in each year based on the engineer’s life expectancy study. Now all should understand that these are engineering and cost estimates. In some cases, the useful life of a line item can be extended by judicious annual maintenance and repairs. Nevertheless, we have a fifteen year forecast. It’s very simple and can be updated quite easily with today’s spreadsheet programs. Using a spreadsheet where we can modify the life expectancy by a year or two is also very utile. Most importantly, it is very visual. And, a board member with some finesse has created a bar chart to display the life spans as estimated.

By example, the useful life of one’s vehicle can be extended by transmission overhauls, alternator replacements, shock absorber replacements, new belts, new writing and plugs, etc. But at some point, typically for economic reasons, one replaces the older vehicle with a new one. Unfortunately, one cannot sell a building and purchase a replacement, which is why the AICPA schedule wedded to a stable financial plan (with assessments every year; yes that is the mantra herein) is the safest, most prudent and fiscally responsible approach for all shareholders. In our building, there are never any surprises.

Thus, all boards are enjoined to build the capital asset reserve program and the underlying processes so there are no surprises and no overwhelming burden because of a surprise. And especially, all need to effectively plan to avoid the mortgage/loan market trap. Taxes on capital improvement (reserve) income one cries! Accumulated depreciation should offset any surplus until such time as the capital reserves are expended.

Why avoid loans in lieu of assessments? Loans are non-productive for the borrower e.g.: co-op and shareholders, and loans suck the financial underpinnings (interest expenses) from the co-op condo. And a decision today, e.g.: borrow, preempts other options in later years. Corporations which produce a product borrow to create more product or new products. A co-op has no way to produce more apartments, so why borrow and to what purpose? Oh, I know why! The knee jerk reaction is for the board to say no increase in maintenance costs this year or next year. Who is fooling whom? In my view, borrowing hides poor fiscal management and inhibits real nuts and bolts financial planning, e.g.: a long term strategy. All need to note that a loan does not yield more products, but erodes useful income (e.g.; interest). So in the parlance of the financial industry is one’s co-op or condo rated AAA or is one’s co-op rated as junk bonds. The board must think financially and fiscally.

Why have an assessment and not use ordinary maintenance income? The answer is in the tax treatment. Ya need to read the IRS rules and behave accordingly. Our assessment is imposed ten of the twelve calendar months to show the separation of income streams (maintenance vs. assessment) to avoid an IRS challenge. Assessments are added to the purchase price of the shareholders apartment when calculating the cost basis for sale purposes. Unless kept segmented, the IRS can challenge the calculation and the shareholder loses.

By the way in NJ, taxes are based on the assessed value of the building + the non-current principal of the underlying mortgage – capital reserves. For an example, a building with a $57,000,000 assessed value with $14,000,000 non current mortgage principal and no reserves is paying taxes based on the sum of $57,000,000 + $14,000,000, for a total tax basis of $71,000,000. Not only do the shareholders pay for useless interest, but they also pay more taxes. Cute! Do the shareholders know; does the board even know? Who cares, our maintenance is low. But interest expense and tax expense, means that other items are underfunded or not funded, thus less repairs are performed or less services and amenities are provided.

In our case, if a maintenance staff member is asked to replace a sink washer or the trap beneath a sink or the flushometer, the visit is free to the tenant for the first thirty minutes, save the cost of the parts. Other buildings charge the moment the maintenance worker enters the apartment. We can discuss this, but we feel our policy encourages shareholders to repair items rather than allow a small issue linger until it becomes catastrophic.

Our building started the assessment stream as soon as the building converted to co-op some twenty-seven years ago. Oh, by the way, we are a 500 unit coop in northern NJ. We retired (in the first twenty five years) an $8,000,000 original mortgage incurred at the time of conversion (without ever refinancing or expanding the principle). During the twenty five years, we expended $16,000,000 in capital expenditures; and we are one of the lowest cost upscale residences in the region for the quality of life, services and amenities. Our annual maintenance + assessment combined have risen an average 3.5% a year over the life of our co-op history. For comparison purposes, our area’s rent controlled apartments have risen 5.5% per year in the same period. Not bad, own an apartment and have it “rent controlled”!

We have never had a special assessment (e.g.: surprise, unplanned), but we do have a planned assessment every year. Yes, we started at 50 cents a share (40,000 shares) and have grown the assessment at 25 cents to 50 cents a share where now after retirement of the mortgage the assessment is $24 a share. It jumped from $12 a share in the last year of the mortgage to the new value, because we did not lower maintenance, but transferred the income that was in maintenance to retire the mortgage to the assessment stream. (Remember the tax treatment notes earlier.) Yes, we amended the amounts in our monthly statement to shareholders to reflect same.

Why no decrease? The building is aging and our outside engineering firm poses the need for another $15 to $20 million in the next fifteen plus years for capital improvements. Even so, we kept to our norm of about 3.5% increase in costs per year. Has anyone wondered what the long term cost of living index is for the same twenty-five years? It is closer to 3.9%. So our residents are benefitting from long term strategic planning.

And as we have had a long term plan, we don’t whipsaw our shareholders with a 10% increase one year and 2% the next. Our, long term plan and our yearly budget account for keeping the equivalent of nearly two month’s of maintenance in our cash reserve account as a cushion. In addition, we have a multi-million dollar line of credit. But, the line of credit is employed only to pay for capital improvements in anticipation of the yearly receipt of the “regular” capital assessment stream income over the ten months each year. The borrowings of the line of credit are typically paid down to zero by year end, or at most, the first month of the new year. Again, we have unwavering commitment to the “plan”. And, we don’t use the line of credit every year.

Regardless of what folks are recommending, avoid long term borrowing. Once a building borrows without a loan/mortgage retirement plan (long term); I would opine that the building has entered a death spiral. If the building has a loan today, immediately plan to start retiring it and start the annual assessment, if building has not begun so already. Why work for the banks? Work for your owners.

Remember, few building have anyone on the board for an extended period. Typically, boards turn over very quickly and each new regime promises to lower maintenance and avoid assessments; yeah, motherhood and apple pie. It’s fiscal doom. All costs are going up, e.g.: natural gas, salaries, insurance, consumables, services, repairs, water, electrical services, taxes, government fees, security, medical plans, etc. There are no schools for co-op/condo board members. Many writers offer the wrong advice. Most folks have never been in the board of a corporation and thus have no clue as to how to be a board member. But, the first words are always: “We’ll lower maintenance”.

Anyone can be fiscally irresponsible, even the CEO’s of major corporations as evidenced by the debacle in the financial industry over the years 2007 and 2008. Avoid putting one’s property into bankruptcy with good planning and a long term plan that does not change year to year. That’s right, develop a plan and stick to it. One long term plan works forever. But, ya gotta stick to it and not have every new board heave the plan through the window and work via myopic short term planning.

Doesn’t everyone realize that when one purchases an apartment in a co-op, the underlying burden of the mortgage in effect reduces the value of the apartment? Hmmmn one says! OK, let’s go to the blackboard. If a 400 unit building has an $18,000,000 mortgage outstanding, the average apartment has a burden of $45,000 in debt, not taking into account studios (much less, but lesser purchase price) and three bedroom units (analogous, larger and thus larger purchase price). So if one buys a unit for $500,000, one also assumes an additional $45,000 debt (the corporation’s). That’s what co-ops are all about! In effect, the unit is only worth $455,000), but who’s counting? Most shareholders do not.

And let’s see what can happen when a building has an underlying mortgage of $12,000,000 with $11,000,000 principal remaining that the previous boards of director regimes deemed useful in reducing the monthly maintenance burden to shareholders, e.g.: no assessments. So the building now encounters a major hurdle. Because previous regimes performed inadequate capital project replacements and improvements, the building needs another $12,000,000 and it needs it soon, within a few years, not fifteen years.

So the board goes to a friendly lender. In turn, the lender says sure, we can provide a new loan of $23,000,000. But, since there were a substantial number of years on the existing loan, there is a prepayment penalty of $3,000,000. So now, the building has a new mortgage of $23,000,000, but netted only $9,000,000. Why? Repay $11,000,000 principal and pay a penalty of $3,000,000; this equals $14,000,000 out of pocket. And the new lender required that the co-op put $8,000,000 into an escrow account to make sure that the building did not spend the funds on other than capital projects.

So now the co-op is “owned” by the lender, not by the shareholders. But wait! Its worse! The building has a capital forecast that it needs $19,000,000 in capital improvements over the next fifteen years, starting now. Well, they have $8,000,000 in escrow. Great! But where does the co-op obtain the other $11,000,000? The correct response should be via an assessment through a regular yearly program. But the board of directors has declined to impose any assessments. They are so happy that they have $8,000,000 in escrow and can complete the capital expenditures that have been long overdue, that anything beyond the next year or two is out of range. They are blinded by their ill conceived wealth.

Would all not agree that this is short term nearsighted planning at its best (e.g.: worst)? So in a few years, when the $8,000,000 in escrow is exhausted and the loan is not repaid, what’s next? It will be another refinancing, another prepayment penalty, and another escrow account, not to mention the non-productive expenditure of interest expense payments. By the way this vignette is not a fabrication but a true a true story that has emerged from several co-op buildings.

The mantra should be: “Never ever surprise the shareholders and always operate in a fiscally responsible manner”. To do otherwise, is to abrogate fiduciary responsibility, with dire consequences. But who cares? The current owners are happy today, but little do they know. As an aside, I sit on our building’s admissions committee and I am somewhat taken aback by the number, almost 100%, of the buyers who have little knowledge of the financial operation of a co-op. Yet for most, this is one of the biggest financial commitments,

By the way, forget any thought of deriving investment income from capital reserves. No board exercising its fiduciary responsibility properly should ever invest in any instrument other than first rate US government bonds. Yes, low interest, but safety not income is paramount.

Before our original mortgage (yes, never refinanced or expanded) was retired, our assessment program was equivalent to about 8% atop our regular maintenance income. Now with an older building, 40+ years and aging, our assessment is about 17% atop our yearly maintenance income. As asserted, there was no reduction in maintenance.
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Please continue to Part 2 below
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Part 2 - To assess or not to assess - NKT Aug 23, 2008

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Please begin with Part 1 above
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But let’s do the math. Our building and property have a value of about $120,000,000 as computed from the average share price of recent sales times the number of shares outstanding. We have and have had for a long period of time a recurring yearly assessment program, e.g.; no special assessments, no unplanned assessments) just regular assessments as part of the yearly financial program as noted elsewhere. Yes, again as noted, the assessment amount per share has increased slowly over the years. Today, at our current rate, the annual assessment is but 0.79% of the value of the building. What homeowner (shareholder) should be opposed to that level of spending?

So, the most viable recommendation is to assess each year such that all shareholders are attuned to the need for capital improvements, so that the board of directors can operate in a fiscally responsible manner, e.g.; improving the plant without resorting to surprise assessments or debilitating loans. It is a little like Pavlov’s dog; sorry don’t mean to insult anyone. Train the shareholders, e.g.; assessments are a recurring yearly activity, and they will come when the bell rings. Don’t overlook the fact that by posing the long term need for capital improvements and the need for the underlying funding via assessments, all residents can effectively plan their personal budgets years in advance. If we can do it in our co-op, so can others.

Finally, when the co-op is illiquid and the lending institutions decline to extend any more credit, what’s the draconian course of action? Any thoughts? It may be that the co-op converts to condo and during the course of the conversion each shareholder is then required to pay the underlying burden of the co-op’s loans outstanding and any prepayment penalties. This payoff (principal and penalties) can be made directly by the shareholder; it can be subsumed by the shareholder by adding it to the shareholder’s principal amount in converting from any existing co-op loan to a condo mortgage, or the shareholder can incur a new condo mortgage if the shareholder owned the co-op unit free and clear, save the underlying co-op mortgage burden. Oh and let’s not overlook the fact that in a conversion, there may be a need to create some liquidity for the condo association with cash reserves and a reserve fund (typically neglected).

Had the lenders declined to refinance or extend additional credit to the building with the $11,000,000 principal outstanding, the shareholders would have been faced with a condo conversion cost of $11,000,000 principal + $3,000,000 prepayment penalty + $8,000,000 for a reserve fund for failure to do capital improvements. The total, without legal fees, is $22,000,000. So now explain the shareholders that because they cannot obtain any financing, they need to convert to condo and oh by the way, the average shareholder (there are 450 units) must show up at the closing with $53,000 in cash.

So, one reads this and thinks it’s farfetched. Well, one needs to do some research about the Briarcliff co-op in Cliffside Park, NJ. They planned to convert but never did convert because of some litigious shareholders. But they were facing huge numbers for each shareholder, e.g.: underlying mortgage + purchase of garage space (to generate reserves) plus additional sums for the capital improvements never funded or performed.

These are some tough decisions. Remember emerging from fiscal irresponsibility is never easy; it is painful for all shareholders. The alternative is worse. It could mean the end of the co-op corporation.

Further, short term band aids and workarounds are only advisable if there is an accompanying long term solution. A one time special assessment is ludicrous. Capital improvements are not a one time event. Without a cohesive long term plan, it is doom and gloom.

To avoid the panic and the horror of a special assessment, the board should plan and impose a yearly assessment based on the engineer’s description of the viability of the capital plant along with the engineer’s proposed replacement program and costs. If the plant is aging and it is, the board cannot avoid an assessment if fiduciary responsibility is to be properly discharged.

By the way we have two major meetings a year and workshop meetings every other months. Why? Because we have a plan and we need not resort to firefighting and crisis management. Did I reveal, we are self managed with our own management and superintendent team and work force (porters, maintenance and doormen), though we outsource security and pool operations, along with other technical specialties, e.g.: HVAC maintenance, boiler maintenance, plumbing, electrical work, elevator repairs?

If one heeds some of the thoughts herein and embarks on a new course, Bon Voyage!

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