If the property you’re looking to buy has home owners association (HOA) fees, it’s essential that you understand where those fees are coming from, as well as their risk of increasing every year before you buy.
Formulation of the Fees
Every year, a home owners association (HOA) board of directors (BOD) prepares a community budget. That budget includes what the BOD will set as the current year total HOA fee per month, per unit. The composition of that fee is the first thing you’ll need to comprehend before you better understand fees increasing each year as well as the much loathed “special assessment.”
The monthly HOA fee has two parts to it, so for the sake of this exercise, let’s assume the total HOA fee is $300 per month per unit for a 100-unit community. Here are the calculations:
Current Year Operations Portion – $200 per month
The HOA collects fees from each of its units to pay for all the current year operations such as gardening, water, insurance, property management. The BOD forecasts forward that this year it will cost $240,000 to pay for all current year operating expenses. Since there are 100 units, we divide the $240,000 by 100 units to get $2,400 per year per unit or $200 per unit per month for operations.
Current Year Reserves Portion for Long Capital Items – $100 per month
The HOA also has to save money over time for long-term repairs and replacements, such as roofs, roads and parking lots. To understand how much they have to save, they have, or should have, an outside expert do a “reserve study.” The reserve study expert makes a 20-year +/- schedule of when HOA assets will need to be repaired and how much they will cost.
The reserve expert calculates an annual amount needed for those long-term repairs. Therefore, through the HOA fee, owners are putting money away each year to pay for those repairs. This money accumulates into “reserves” so that the HOA can pay cash for large-item repairs when they come due. This helps avoid special assessments because the HOA has the money on hand to pay for these capital items.
In our example, the reserve study specialist determined that owners should be putting away an additional $120,000 per year going forward or $1,200 per unit per year or $100 per month per unit owner.
Thus, $200 for current year operations and $100 to put away additional funds, totaling the $300 HOA fee per month, per unit.
As long as the HOA board makes perfect predictions, and the reserve study expert’s estimates are 100 percent accurate, the HOA will pay all the current year bills and be in great shape for paying for long term capital item repairs. However, this rarely happens.
Not an exact science
Calculating unfortunate budgeting expenses, long-term reserves, and unanticipated repairs is not an exact science. Usually, operating expenses are higher than budgeted, or some people do not pay their HOA fees, and the HOA gets drained of cash covering expense overruns. If the BOD spends extra on operations, they won’t be able to save the recommended cash for long-term repairs. Thus, the BOD increases HOA fees next year to catch up the amount they should have saved this year for their reserves.
If they don’t increase fees to make up for that balance, perhaps because owners protested higher HOA fees, when they need $240,000 to paint the building, the BOD uses a special assessment — an additional fee levied at homeowners— so the HOA can pay for the needed repairs.
The main takeaway…
At the end of the day, all the bills — current year, capital repairs and replacements — will have to be paid by you and the other owners in the community one way or another.
The BOD usually does their best to financially manage the community well, but due to a number of factors above, it is a challenging assignment. All the owners have to live within the HOA finances, but note, it’s better to increase fees as you go to avoid special assessments.
Leonard Baron, MBA, CPA, is a San Diego State University Lecturer, a guest blogger on Zillow.com, the author of “Real Estate Ownership, Investment and Due Diligence 101 – A Smarter Way to Buy Real Estate”, and loves kicking the tires of a good piece of dirt! See more at ProfessorBaron.com.