Building to last: What are capital improvements?
What are capital improvements and how do they keep your community relevant and maximize property values? Capital improvements are essential for maintaining the relevance of your community and enhancing the value of properties. However, navigating the challenges and expenses associated with significant upgrades, renovations, replacements, and repairs can be daunting for many associations. Discover how to effectively handle a capital improvement project, reserve studies, and funding strategies to ensure a successful management process.
What are capital improvements?
A major replacement or repair can be considered a capital improvement if it increases a component’s market value beyond its original or current state. In general, it is intended to lower future operational costs (such as maintenance or utility costs) or enhance residents’ quality of life.
Capital improvement projects might appear challenging at first glance, yet they are crucial for enriching the quality of life in your community. These endeavors are directed towards boosting the quality of services for inhabitants and minimizing long-term operational expenses. Such projects encompass a variety of upgrades, including the adoption of energy-saving heating and cooling systems, roof renovations, and the integration of LED lighting solutions. Essentially, these capital improvements are key to preserving and enhancing both the value of properties and the satisfaction of residents.
The best way to know how a capital improvement needs to be defined and, if necessary, approved for is to check your community’s governing documents and involve your association’s attorney. For reference, here is a common definition that applies to many associations:
Capital improvements are meant to last more than a year and usually cost over $10,000. However, they can save your association money in the long run by keeping your property relevant and in tip-top shape, resulting in better resident experiences and property values.
Preventive maintenance: capital improvement’s close cousin.
In contrast to capital improvements, preventive maintenance is generally less costly and performed more frequently. They are funded from your association’s operational budget under the line item “Repairs and Maintenance (R&M),” and they are meant to restore your major components (or “assets”) to their original condition or prevent them from deteriorating further.
Adhering to the manufacturer's or contractor's recommended preventive maintenance schedule for a component significantly enhances its chances of achieving or surpassing its anticipated lifespan—that is, the duration it is expected to function as intended. By extending the useful life of a component, the period before it necessitates replacement or major repair is prolonged, resulting in cost savings for your association.
However, there are caveats. “Sometimes, repairs to an older component can get very expensive; in fact, it may be more cost less to replace the component altogether,” said Christopher L. Pappas, senior vice president at FirstService Residential. “If the repairs cost about the same or are more than a replacement, you should replace the component. The new component may even be tax deductible, or you may get a tax incentive.” New equipment may also come with a manufacturer’s warranty, be more energy efficient, and have a longer life expectancy.
In some instances, maintenance jobs can turn into capital improvement projects unexpectedly. For example, roof damage could appear to require a simple repair, but further inspection might reveal that the entire roof needs to be replaced.
The role of reserve studies.
A reserve study allows you to plan and budget for capital improvement projects over the next 20 to 30 years. A specialist from a reserve study firm (preferably an engineer) should conduct the study, which consists of:
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A physical analysis. The reserve specialist performs a site inspection to assess the condition of common-area assets within your community, such as clubhouses, lobbies and pool areas. Based on this assessment, they estimate the remaining useful life and make recommendations for their repair or replacement.
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A financial analysis. After the site inspection, the reserve specialist estimates the cost for each repair or replacement as well as any additional improvements (like adding a playground or expanding the fitness center). Based on these costs and your current reserves, the reserve specialist recommends a funding plan and calculates the monthly contribution required from each homeowner.
In most areas, the developer would have provided your association with an initial reserve study at the time the property was transitioned to a residential board, but you should get the study updated regularly. “Keep in mind that some states have laws in place that mandate the frequency,” said Karla Chung, vice president of FirstService Financial. “Whether your state does or doesn’t, you should still plan to update your reserve study every 3 to 5 years and after you complete a capital improvement project.”
It’s also important to have your study reviewed annually to make sure the recommended funding is still accurate. Factors such as increases in labor or material costs, unexpected events, such as natural disasters, and increases in delinquencies, can alter your funding needs.
Given that a reserve study does not offer an exhaustive project outline, it is advisable to seek out a detailed "conditions assessment" or "conditions study" approximately one to two years prior to a component's anticipated lifespan conclusion. This in-depth analysis will furnish a clearer estimate of the necessary work and associated expenses. For such assessments, local professionals, including contractors, engineers, and architects, can offer their expertise.
Paying for a community project.
Once you’re ready to start a project, you need to determine how your association will pay for it. You have several options:
Your reserve fund. The first source you should tap into is your association’s reserve fund. Hopefully, you’ve been following your reserve study’s recommendations and putting the appropriate amount of money aside. Choosing the right type of account for your reserve fund is important, too. Since your board has a fiduciary duty to your homeowners, it’s imperative that you protect the money they are entrusting you with. However, that doesn’t mean putting it in a checking account that yields no interest. With an integrated approach to long-term reserve fund management, FirstService Financial provides multiple products through various financial institutions to ensure that liquidity needs are met while maximizing interest yield and principal protection. “Over the years, we’ve helped multiple associations increase their returns on their reserve funds by moving their funds to safe, high yield accounts like CDs,” said Chung.
What if you don’t have enough in your reserves to cover the cost? Unfortunately, many associations don’t adequately fund their reserves. Boards are often reluctant to increase assessments in response to rising costs because of the reaction homeowners are likely to have. Since funding day-to-day operations is a more immediate need, they attempt to reduce expenses by decreasing the amount they set aside to fund future projects.
Besides leaving you with an inadequate amount of money for needed repairs and upgrades, underfunding your reserves can have other serious consequences. For one thing, it can negatively affect property values. Not being able to replace items like roofs, major equipment, and sidewalks will lower property values. In addition, it can dissuade prospective homebuyers from moving into your community or building, especially those who plan to pay for their home with a Federal Housing Authority (FHA) loan. A buyer won’t qualify for an FHA loan if the association isn’t allocating at least 10% of its operating budget for its reserve fund. Even if your association has been diligent in funding your reserves, an unforeseen event or long-term crisis, such as a pandemic, can have a big impact — especially if it is not covered by insurance. Lastly, your association may realize that enhancing amenities is the only way to compete with communities or condos being built in your area. Whatever the reasons for your shortfall, you do have other funding options, which you can use individually or in combination.
Loans. Loans have become increasingly common for funding capital improvements in recent years, a trend that has been mirrored at FirstService Financial. “From 2012 to 2018, the number of loans we helped associations obtain rose from 2 to 78.” said Chung. “And over the past 20 years, FirstService Financial has facilitated more than $2 billion in loans, overseeing the entire lending process – from negotiation to closing.”
One of the advantages of taking out a loan is that you have the money immediately. A loan can also help you fill a gap in your reserve fund or in the amount you’re able to collect up front when homeowners pay a special assessment in installments. You can even take out a loan for the full amount of the project and then use a special assessment to pay it back.
Before determining if a loan is the right option for your community, make sure to consult with your association attorney as some governing documents require a membership vote before securing a loan.
Increased dues. Typically, increasing dues or levying a special assessment are two additional ways to cover the cost of a capital improvement project. Even under the best circumstances, both options tend to be the least popular among homeowners.
Some communities have managed to remain financially stable despite economic upheavals or other emergencies. In such fortunate areas, raising fees or implementing a special levy could be an effective strategy for financial planning. On the contrary, communities in regions more affected by economic downturns may find their residents struggling to meet current financial obligations, rendering any additional financial demands particularly burdensome. Thus, when confronted with any form of economic adversity, the decision to increase fees or impose a special assessment should be approached with careful consideration and empathy.
Remember that for an association to operate effectively and manage ongoing capital projects and maintenance costs, it is critical that you make regular and incremental dues increases. When raising dues, communicate why these increases must occur, so that residents expect them. Work with your management company to draft appropriate and effective communications around any dues increases.
For special assessments, offsetting the financial burden by allowing residents to pay it in installments can make a special assessment more manageable. Keep in mind, however, that since you won’t have the entire balance of the special assessment right away, you may have to either delay work until you do or align installments with the contractor’s payment schedule.
Insurance. Although insurance can’t pay for a planned capital improvement, inadequate coverage can result in unanticipated capital expenses. Make sure you are properly covering assets that may be susceptible to damage from weather or other mishaps.
Capital improvements not only affect your community or building’s health and reputation, but also homeowners’ wallets. That’s why you need to prioritize projects appropriately and communicate with association members from the beginning. It’s also crucial to create a plan prior to starting each capital improvement project, to have a professional managing the project and to communicate with residents about the project’s status as work progresses.
Conclusion.
Capital improvements play a fundamental role in both preserving and increasing the value of community properties. While these enhancements come with their own set of challenges and expenses, it's crucial for board members to fully understand the details of these crucial improvements. Exploring preventive maintenance strategies, undertaking comprehensive reserve studies, and creating solid financial plans empowers communities to confidently manage these complex capital projects. Through forward-thinking management and strategic foresight, such initiatives not only safeguard the future of your property but also drive its continuous development and flourishing over time.