Financial Pitfalls Following Developer Transition

By Maria C. Kao & Matt Meadors  Note: This article first appeared in the Summer 2024 Edition of The Communicator Magazine.

EVERY DEVELOPMENT GOES through a transition where the original developers hand over the management and operations to the homeowners. Such a transition will include the finances of the association. Here, we focus on an association’s legal obligations, but also offer real-life advice from a professional manager experienced in turning over a community.

The finances should not be overlooked during the transition phase, and it is of utmost importance to make sure the basics are set up correctly. They should include assessment calculations, reserve studies, a thorough investigation into the operating budget and many, more discreet issues. Let’s synthesize the legal obligation information together with operational know-how for those interested in setting up the future of financial stability for a transitioning project.

OPERATING

Pursuant to the Department of Real Estate’s (DRE) regulations, developers are obligated to provide various documents to the governing body of the association, and financials (i.e., pro forma operating budget) are included (See Cal. Code Regs. tit. 10, §2792.23). Oftentimes, the budget set up by the original developer is known as the DRE budget. The budget worksheet by the DRE states as follows for the formula on operations:

This budget is a good faith estimate from plans prior to construction and/or completion (for new projects) or from a combination of plans and/or site inspections (for existing projects).

The association may increase or decrease its budget. It is typical for costs to increase as the project ages. The association should conduct a reserve study after its first year of operation to adjust the reserve funding plan for any changes which may have taken place during construction.

Since the DRE Budget is only a good faith estimate, there is plenty of room for improvement once it is turned over to a homeowner board. This is where a professional management company can help you navigate what to investigate and look for. We have included some starting points here. 

Cost Analysis

As far as the association’s costs go, Civil Code §5600(a) states: "Except as provided in Section 5605, the association shall levy regular and special assessments sufficient to perform its obligations under the governing documents and this act." The DRE breaks down its requisite worksheet into these categories:

100s – Fixed Costs (taxes, insurance, etc.)

200s – Operating Costs (utilities, goods and services)

300s – Reserves (for replacement and major maintenance)

400s – Administration (legal, accounting, etc.)

500s – Contingency

Since there is only a short history prior to the developer turnover to homeowner control, the transition period serves as a critical time to investigate the various categories that make up the association’s costs.

There are often contracts that were entered into by the developer because they knew the provider beforehand, because the provider was cheap, or because they believed that the service would add something that buyers would want. These three things often don’t align with what the membership, and its new member-led board, wants and needs.

For instance, the association may be paying a good sum of money to have cable service provided for TVs in the common area. However, the new board may see fit to use the TVs to showcase information pertinent to the members and the community, and forgo the expense.

Other times, developers are not paying close attention to cost creep, or indeed even what expenses may be necessary. As an example, we took over management of a new build community that had six phone lines tied to their fire system. Upon some simple investigation, and clarification with the fire protection vendor and the local fire department, it was determined that a line of communication was already active, and that the phone lines were unnecessary, thus saving the association thousands of dollars per month.

Reserves

Along with managing the association’s income and operating costs is the responsibility to perform a reserve study. Civil Code §5550 mandates that there be a "reasonably competent and diligent visual inspection of the accessible areas of the major components that the association is obligated to repair, replace, restore, or maintain as part of a study" at least once every three years. The reserve study minimum requirements are also set forth in the same code section.

It would be valuable to perform a more in-depth reserve study at the transition period. It is also worth looking at the reserve study to ensure it encompasses all major physical components. It is often the case that components may have been overlooked. Reserve study companies generally have three levels of studies they perform, with the most intensive being starting from scratch and walking the site with the reserve specialist. It costs a bit more up front, but will make sure the community is protected.

Income

An association is obligated to collect assessments. That income is limited by statute. Civil Code §5600(b) states: "An association shall not impose or collect an assessment or fee that exceeds the amount necessary to defray the costs for which it is levied." Given this legal requirement, associations have to balance income against costs. There is a limit to how much you can levy and that assessment levy is anchored against the association’s costs.

This transition period is also a good time to review the association’s sources of income and assure that those are being properly accounted for, billed for, and collected. It is not uncommon for a homeowner board to walk into unpaid assessments (sometimes even from the developer). The onus is on this board to investigate and use the tools available to bring it current. 

Cost centers and utility billings are another place where money can get lost if not properly accounted for. A real life example is where after assuming management of a community whose CC&Rs indicated that homeowners would be billed back for certain utilities, it was discovered that the submetering service was never completed by the developer. The association had been paying for its members water and electricity for over a year, costing it tens of thousands of dollars. A brief look at the income statement showed where the income leak was so it could be fixed.

PRACTICAL TAKEAWAYS

If you are a new board member, here are a few action items to help get you started: 

Thoroughly Review and Adjust the Budget: The initial DRE budget is a starting point, but requires adjustments based on real costs. Conduct a detailed cost analysis to ensure that all expenses are necessary and beneficial for the association.

Conduct a Comprehensive Reserve Study: Schedule an in-depth reserve study during the transition phase. This should include a detailed inspection to ensure all major components are covered, providing a clear picture of future financial needs and avoiding potential oversights.

Assess and Update Contracts: Review all existing contracts inherited from the developer. Evaluate whether they align with the community’s needs and financial goals. Renegotiate or terminate contracts that do not serve the association’s best interests.

Investigate Income Sources: Ensure that all sources of income, including assessments and utility billings, are accurately accounted for and collected. Address any unpaid assessments promptly to avoid financial shortfalls.

Engage Professional Management: Consider hiring a professional management company to navigate the complexities of the transition. They can help you with the rest of these action items. Their expertise can help identify cost-saving opportunities, streamline operations, and ensure compliance with legal obligations. 

Regular Financial Reviews: Associations with income exceeding $75,000 are required to have a third-party financial review performed annually. If there is concern around financial theft, then a more costly financial audit may be necessary. Implement monthly financial reviews by the board to maintain transparency and accuracy. This will help in identifying any discrepancies early and ensure the association’s financial health.

Communicate with Homeowners: Keep the community informed about financial decisions and changes. Transparent communication builds trust and ensures that homeowners understand and support the financial strategies being implemented.

By focusing on these practical steps, transitioning associations can set a solid foundation for financial stability and long-term success. Don’t be scared! Be educated!

Maria Kao is a partner with Briscoe Ivester & Bazel, LLP and specializes in corporate governance and litigation. She is currently representing common interest developments, residential, commercial and mixed use developers, and apartment owners/holding groups. Matt Meadors, CMCA, AMS, PACM is the COO of HOA Organizers. He frequently presents and writes for CAI and served on the Greater Los Angeles Chapter Board of Directors from 2021-2023.