FOLW Advisory Team
Owners, especially those on fixed incomes, have limited resources. They may not be able to afford the large special assessments that would be required if reserves are insufficient to cover a major replacement. Special assessments have the reputation of being indicative of poor management.
Community Associations Institute, Replacement Policy
It’s been just over three years since the Clubhouse was shuttered and closed by the Board. The new Clubhouse is open, the food is good, the views are lovely, and it’s being well-attended. With the plan now realized, it is good business practice to conduct a post-completion project review to identify which elements of the project were successful and which were not so successful.
At the request of the Friends of Lake Wildwood (FOLW) Coordinator, this document summarizes financial events related to the cost of constructing a replacement for the Clubhouse, Clubhouse funding sources and methods, the accuracy and understandability of financial reporting to the membership. It also extends an invitation to FOLW and other members of Lake Wildwood Association to participate in a conversation about the future of our community prior to the coming Board election.
CLUBHOUSE CLOSURE: The Board closed the Clubhouse on January 1, 2014 due to “extensive unsafe building conditions” and “life safety issues.” That severe level of disrepair did not develop over night.
In a courageous mea culpa article two months later, the Board President admitted that the Association had, for 15 years, excluded about 75% of all common facilities and common elements from the Reserve Study and funding to keep assessments low. That resulted in substantial deferred maintenance and the transfer of costs to a future generation of owners.
About a month after the Clubhouse closed, the Board amended Association Finance Rules, adding all previously excluded assets to the Replacement Reserve Study. As a result, estimated reserve obligations increased $10 million in FY 2014/15 and another $5 million the following year.
CLUBHOUSE COSTS: The Board shuttered and closed the old Clubhouse on January 1, 2014. It then proposed building a larger, upscale Clubhouse at cost of $5.5 million. The special assessment prospectus for the new Clubhouse expressed a high degree of confidence in cost estimates.
With only a 5% cost overrun allowance, the project was $1.2 million over budget (24%) prior to the start of construction. Many costs were underestimated (furniture/fixtures/equipment, professional fees, loan points), some were not included (landscaping, an estimate for code changes), and some costs were added when special interest groups asked for changes to the original plan
While Association Declaration Article IX requires the Board to obtain competitive bids from licensed contractors, that did not happen. Instead, the architect preferred a specific contractor whose profit margins were substantially higher than other builders under consideration. The Board adopted that recommendation by a 4 to 3 vote.
CLUBHOUSE FUNDING: The $5.5 million in Clubhouse replacement costs were to be financed by a $4 million loan, the sale of four Association-owned lots for about $1.25 million, and the balance of about $250,000 from replacement reserves. The Board proposed to assess each membership interest $1,500 to repay the $4 million construction loan. That assessment was approved by the members in September 2014.
Sale of the four lots netted $943,000, leaving a shortage of $367,000. That, plus the $1.2 million cost overruns compelled the Board to raise another $1,567,000. The Board funded most of that shortfall by improperly spending $1,511,826 from Replacement Reserves.
Here’s the problem with that expenditure. The Association maintains two reserve funds: a Replacement Reserve Fund for capitalized assets and a Non-capitalized (Maintenance) Reserve Fund for assets that have not been capitalized. Finance RULE R-4.10.10 defines capitalized assets as those that have been “booked” or added to the Association’s balance sheet.
The Association never capitalized the old Clubhouse, as required by Finance RULE R-4.20.80. That’s why the 2014 Audit reported no reduction in asset values due to Clubhouse closure. It’s also one reason why spending $1.5 million from the Replacement Reserve Fund for capitalized assets may have been improper.
To keep assessments low, Association reserve policy had long excluded structural components of the Clubhouse and all common facilities, along with the golf course, lake, dam, 5 parks, culverts, etc.. Consequently, the 2014 Audit reported only $374,300 in replacement costs for the Clubhouse, comprised almost entirely of furniture, fixtures, and equipment. NO reserves were targeted for replacement of the Clubhouse structure at the time it was closed.
We have been advised that the Board’s $1.5 million reserve expenditure on replacement of the old Clubhouse was likely improper because: (1) Exclusion of the Clubhouse structure for so many years confirms that it was not a purpose for which the Replacement Reserve Fund was established; and (2) When the Board decides to replace a destroyed or no longer usable asset such as the Clubhouse, its replacement must be funded out of the operating account unless it involves a like-for-like replacement. The new Clubhouse certainly does not constitute a like-for-like replacement for the old building.
FINANCIAL REPORTING: At a time when many people wanted to know about reserve liabilities before voting on the clubhouse assessment, the 2014 Audit improperly reported reserve obligations based on the prior year’s Replacement Reserve Study. That caused estimated replacement costs for all major common elements to be understated by $10 million. With no oversight, only a single manager signed the Management Representations letter to the Auditor, thus failing to comply with the two-signature requirement for an audited statement.
In 2015, the Board hired a credentialed reserve specialist to produce the reserve study and funding plans. Although a major step in the right direction, the new Reserve Study does not provide a complete and understandable picture of the cost of replacing major common facilities and common elements. Instead, the Member Summary reports only the cost of replacing sub-component parts of common facilities like concrete, decking and balconies, roofing, lighting, etc., but does not aggregate those sub-component parts under major common facilities or even the major component categories listed in the full Reserve Study. That makes it very difficult for members — or Board Members — to assess the reasonableness of reserve obligations and funding.
The Reserve Study Member Summary reports available funds from only a single “Reserve Fund” and does not disclose the respective funding status of the Association’s two restricted reserve funds. Consolidation of the two reserve funds into a single Reserve Fund, as has been done the past two years, makes it impossible to see if money is being spent from the proper source or if funds are being improperly co-mingled.
The Association has repeatedly asserted that $1.5 million was available in the reserves to replace the Clubhouse and, has in fact, spent that sum on the Clubhouse project. However, as previously noted, NO reserves were targeted for replacement of the Clubhouse structure prior to its closure. By law, the Board may not expend reserve funds for any purpose other that the repairs, restoration, replacement, or maintenance of major components for which the reserve fund was established.
Replacement Reserve Fund expenditures are also restricted to the renovation or replacement of capitalized assets that have been booked to the balance sheet. Since the Association never capitalized the old Clubhouse, the expenditure of $1.5 million on the Clubhouse from the Replacement Reserve Fund for capitalized assets may have been improper.
LET’S FIX THE SYSTEM This article has presented a troubling list of inadequate construction cost controls, false or misleading financial reports, and improper use of replacement reserve funds. However, it is not our intent to fault the actions of our well-intentioned Board Members.
The volunteer Board members who have served Lake Wildwood Association over the years have generally acted with intelligence and in good faith, but sometimes without a clear understanding of what was required of them. Recent results have made clear that we are outgrowing the system of governance and financial management created nearly a half century ago by the developer.
As a starting point for a change conversation, we ask you to think about the following factors as possible contributors to the concerns we’ve presented:
- The Board is restructured by elections every year, thus interrupting the continuity of Board planning and actions and leading to inconsistent decision making.
- Long-term memory regarding Association policies and practice resides in our standing committees. The Board has recently circumvented those committees by appointing ad hoc committees that report directly to the Board to serve specific purposes. Previously, it was Board policy to appoint sub-committees under the standing committees.
- The Board eliminated the audit function of the Finance Audit Committee last year, transferring that responsibility to a new Audit Committee populated and controlled primarily by Board Members. The Audit Committee, which will be restructured annually along with the Board, is not independent and cannot objectively audit Board financial planning and actions.
- Volunteer Board Members often have no prior corporate management or Board experience and do not receive adequate training on the highly specialized statutory requirements that apply to homeowner associations in California. Perhaps all new Board members should be provided with more complete training such as the Leadership Training Course for Board Members that’s offered by the Community Associations Institute?
We ask each of you to respond to the five-question survey we’ve prepared. Simply click on the following link, and you’ll be taken to the Survey. We intend to present a summary of the results to the Board, but your answers will remain unattributed and confidential.
YOU CAN MAKE A DIFFERENCE!