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Do not buy into a real estate sinkhole!

Are you buying real estate?  Then avoid sinkholes, I say!

The sinkhole I am referring to may reside in the very property or homeowners’ association that you may become a member of upon closing your real estate transaction, and this applies to residential and commercial real estate.  While a POA and HOA are basically the same, the descriptive terms do tend to vary by region.  POA refers to a Property Owners’ Association while an HOA refers to a Homeowners’ Association.  For purposes of this posting, I will use the term Property Owners’ Association, or POA.  If you purchase real estate in an area that happens to have an association, you immediately become a member upon closing the transaction and become legally obligated to fulfill your duties as outlined in the POA bylaws.

POAs can drastically vary in size and “power,” but overall you can view them as a partnership.  However, this partnership will ask for monetary contributions from you without ever offering a profit split.  In a well run association, your “profit split” may come as increased real estate values.

Keep in mind, however, that like any partnership, a POA that loses money or otherwise experiences cash shortages will ask each of its members to cough up their relevant share of necessary funds.  Yes, the bylaws may include percentage or dollar limitations on how much the POA can increase the dues, but there are also many exceptions by which they can overcome such limitations.

WARNING: The first sign that your POA is financially stressed is when its board members begin reviewing the maximum increase they can demand in POA dues.

By far the riskiest POA to invest into is one of a condominium or townhouse complex where significant expenses are covered by POA dues, including utilities and insurances.

The current economic climate has created rather troubling times for a number of POAs.  Some states provide POAs significant protection in their claims against property owners.  However, other states do not provide any real protection, further stressing the finances of POAs.  South Carolina, for example, does little to protect a POA’s interests.

The real issue of POA finances comes into play when you purchase into a POA, and only a limited number of property owners actually pay their allotted POA dues.  Imagine the following scenario:

It is 2008 and you have purchased a single condominium in a 100-unit complex for $250,000; each condo is identical in size, features, and location.  Thus, each condo owner is assigned equal dues of say, $6,000 per year.  As part of these dues, the POA will pay all building insurances, common area landscape maintenance, utilities such as water and electric, and association management fees.  Overall, each condo owner is responsible for 1% of the total POA operating costs.

Now imagine during 2009, ten condo owners were unable to pay their share of POA dues.  During 2010, an additional ten owners stopped paying their dues.  Now only 80% of owners are paying their dues, but those 80% must cover 100% of all POA costs if they are unwilling to sacrifice services provided by the POA.  Assuming there are no reserve funds, which is surprisingly common among POAs, and the bylaws prohibit raising individual owners’ dues by an amount sufficient to cover the cash shortages, then services must be reduced.

The above scenario is absolutely a sinkhole because a number of POAs operate on very tight budgets to begin with.

To protect its interests, the POA may file liens against the twenty property owners that are not paying their dues.  Surely this truly protects the POA?  Wrong…in a number of states, the legal system gives priority based on the date of the liens rather than who initiates foreclosure proceedings.  If there is a mortgage attached to a unit, then the bank has priority, even if the mortgage is still being paid by the condo owner.  Furthermore, in most circumstances tax agencies are given top priority, even over first mortgages.  What is the net result?  The POA’s liens on properties become virtually worthless because upon foreclosure, which is the inevitable result of filing a lien if the lien itself does not prompt owners to pay their dues, there will not likely be any funds for the POA to recover upon foreclosure.

Now imagine the condo complex’s POA has insufficient funds to pay building insurance.  If you have a mortgage, your mortgage company will notify you that they will, per your contractual agreement, purchase a policy to protect their interest (your condo).  However, a small problem exists.  Condominium complexes are generally insured by the building, not by the unit, so individual policies cannot be purchased.  Additionally, you may find out that that to purchase an insurance policy for your building will cost $25,000 or more.  If the POA has insufficient funds to pay the insurance premiums, who will?

The same scenario occurs if common utilities are not paid for.  It is not uncommon for condominium complexes to have common water and electrical meters.  If the POA cannot pay for the utilities and they are shut off, then either a single owner or a small group of owners would need to pay to have service restored to the building.

Now back to the topic of liens and foreclosures.  After filing a lien, foreclosure proceedings need to be started as soon as possible.  The POA must pay for this and if mortgages exist on the foreclosed properties, then the foreclosure proceedings simply force the mortgage companies to acquire the properties.  As far as the POA is concerned, this may be good as it can turn a “non-performing” asset into a “performing” asset.  In other words, the new owner (the mortgage company) will, in theory, begin paying their dues from the date of foreclosure forward.

Do keep in mind that a number of POAs are well managed and funded.  It is the financially sound POAs you must seek out.  Before you buy into any owners’ association, do the following:

  • Ask for the names of the Board of Director’s president, secretary, and treasurer.  Talk to them.
  • Request the most recent financial statements.  Discuss them with your own accountant.
  • Inquire with the Board president, secretary, and treasurer regarding pending special assessments and unpaid special assessments.  Special assessments could take thousands of dollars out of your pocket.
  • Discuss your findings with your attorney.

Your willingness to complete your purchase should be absolutely dependent upon your complete satisfaction of being able to easily obtain the necessary information regarding your potential owners’ association.  Let this information requirement be a contingency in your purchase agreement.

You might be amazed at the extreme difficulty in obtaining such information.  If obstacles prove to be numerous and frustrating, then simply cancel your purchase contract (because it should be contingent on receiving said information) and be thankful for your due diligence.  Whatever you do, stay away from real estate sinkholes.  Your wallet will thank you!