The Importance of Including HOAs in Your Due Diligence
Your real estate due diligence checklist isn’t complete if it doesn’t include homeowners’ associations.
The need for due diligence in real estate transactions should go without saying, but many buyers fast-track through some important areas of the process. Whether you’re a first-time homebuyer or an investment institution, ensuring your due diligence stage is thorough and complete is nonnegotiable.
Most, if not all, real estate transactions have similar pathways to closing day. General due diligence items include inspections, appraisals, insurance verification and title searches. These items are essential to making appropriate homebuying decisions, and they often must be carried out within 10-17 days from acceptance of the offer.
Homeowner Association Due Diligence
For most transactions, the process can seem straightforward, but for the more than 53% of properties belonging to a homeowner association, the task list can grow long quickly. According to HOA USA, there are more than 351,000 homeowner associations governing homes across America. Buyers purchasing in a condominium, cooperative or planned community must look at several aspects of that association before signing on the dotted line. Homeowner associations can affect several aspects of your investment, including your resale value, rental cash flow and overall marketability.
So, what must you do during the due diligence stage to make a sound investment?
Homeowner associations are governing bodies, controlled by a homeowner-elected board of directors, to carry out the daily business of the community. Whether for a townhome, condominium or single-family home, homeowner associations are in place to create a standard, maintain communities and enforce rules. Directors can use their governing documents to carry out those functions and establish the standard each new member must abide by. These documents are referred to as CC&Rs—covenants, conditions and restrictions.
Covenants, Conditions and Restrictions
Requesting the governing documents and reviewing them is vital in the due diligence efforts, particularly for investors evaluating a property’s ROI. The CC&Rs will dictate whether a property has:
1) Rental restrictions
2) Pet restrictions
3) Resident Behavior standards
- Visitor hours
- Community access
- Common area manners
- Vehicle registration
- Exterior storage
- Noise-level compliance
- Holiday decoration
- Architectural modification requirements
While most of the information needed will be in the governing documents, it is not the only set of documents that should be evaluated. Other documents that can provide a better sense of how the association is run, what repairs or projects are upcoming and an overall sense of the community are the board meeting minutes and community newsletter.
Financial Statements and Budgets
Homeowner associations run like businesses. As such, they have financial components that need to be reviewed to ensure financial stability. Assess-ment of the association’s financial statements and budgets can provide better insight as to how effective the association is running the community and the impact it could have on the property’s value.
Items represented as bad debts and misallocation of capital expenses should be of utmost interest. These are indications of the association’s financial distress or mismanagement.
Ensure the association has sufficient reserves. A reserve study provides insight into the association’s ability to use assessment funds for both operating expenses and long-term repairs. Insufficient assessment dues collection and lean budgets can often lead to HOA-imposed special assessments, leaving owners to cover a portion of large repairs. According to an article in Investopedia, “a good standing association will have 25% gross income in reserves for emergencies and repairs.”
Insurance Master Policy
It is important that the association’s master policy has coverage that can extend to the individual unit or home. Review the policy carefully, noting what is or is not covered and whether additional insurance for the property is required. It is important to understand what insurance coverage is available and provided through your assessment dues.
Statement of Account
Known throughout the U.S. as a demand letter, paid assessment letter, resale document, etc., the statement of account gives you the breakdown of all the association’s fees and charges to the homeowner. Additionally, it will provide you with an overview of where the account currently stands and an opportunity to review any violations that should be corrected before closing. This includes potential fees for nonpayment and violations.
Board Litigation History
Homeowner associations can find themselves in various litigation matters. These matters can affect both the seller and the buyer. While disclosure laws exist for each state, requesting information regarding any litigation issues is important when determining if a property is a good investment. Some common litigation issues for associations can be tax issues, contractor liens and owner unpaid dues. An article on Investopedia states that “some condo and homeowner associations have been forced
into bankruptcy for unpaid HOA dues.” This can have implications on the property’s earning potential, resale value and rental property return.
Purchasing Property Within an HOA
Regardless of where the property you may purchase is located or how the property is governed (homeowner association or not), due diligence is a key component in real estate transactions. When purchasing a property, it is important to ask yourself questions that will shape your decision. For investors, it is important to ask:
1) How can the HOA’s rules be modified or amended?
2) How is the HOA board elected (or removed)?
3) What ownership does the HOA board hold?
4) How are HOA meetings called?
5) What are the consequences of any violations of the HOA’s rules?
6) What is the renter’s application and approval process? Buying a home is a major decision, and due diligence should always be part of the equation. For those purchasing to live in a property, you want to know your property is free of any major issues or damages and that there will not be any surprises. If you are purchasing as an investment, ensuring it will make money even before buying it is crucial. And, while due diligence may look different for individual homebuyers and investors, ensuring proper time and effort is allocated remains the same.
