Reserve Fund Check-Up

As interest rates begin a slow climb upward from their historically low levels, the refinancings that have brought fiscal health to many cooperatives and condominiums are beginning to look less and less attractive. Another way must be found to strengthen reserve funds – and many boards are turning to the transfer fee, or flip tax, as their best option, with a bank line of credit held at the ready for emergencies. But it’s often not that easy to sell the concept to shareholders.

At 2 Grace Court, a 104-unit co-op in Brooklyn Heights, treasurer Gary Broder tallied the numbers from a shareholder vote on a transfer fee of one percent hoping that, when the tally was done, a two-thirds majority would have voted “yes.”

“But we may fall short,” he says, noting that Grace Court has spent its way through much of a half-million-dollar reserve fund on a series of much-needed capital improvements and is now sitting on about $100,000 in cash. “Our budget is $1.2 million, and we need a two-month cushion.” The amount of that is based on a five-year capital plan which the board settled on, working with accountant Stephen Beer, a partner in the firm of Czarnowski & Beer.

“There are two main arguments for the flip tax,” Broder says. “First, everyone is doing it – it’s an accepted practice – and most people are building it into their selling price. Someone selling a co-op for $500,000 will price it up a little bit to $505,000. The other argument is that for those who don’t want to sell, the money is coming out of someone else’s pocket. But the people who want to sell soon are basically against it.” As an inducement to shareholders who currently have their units on the market, 2 Grace Court’s shareholder resolution postpones the one percent transfer fee until January of next year.

Some advocates of the flip tax/transfer fee would replace both terms with “working capital contribution,” a name which now generally applies to the modest assessment required of many condo purchasers that goes into the general fund. The thinking is that “working capital contribution” helps the shareholder recognize that any building needs a capital funding plan, and that any investor or homeowner should be willing to contribute to such a long-term plan. It’s also true that a contribution into a capital fund puts money onto the equity side of the balance sheet, rather than the income side – which can be beneficial at tax time. But, by whatever name you call it, the question for most shareholders is when are they going to have to pay?

Signs of Health

Originally, flip or transfer taxes were a way to discourage purchasers from buying at an insider’s price and then cashing in with a quick sale. Today, such fees typically run from one to three percent of the sale price and, accountants say, have become a way for shareholders to contribute to the long-term health of their buildings. If you are considering a transfer fee, check your proprietary lease to see what provisions govern. The board may be able to enact one without a shareholder vote. In most cases, however, a two-thirds vote is required.

According to Beer, the health of the reserve fund is one of the three things a prospective co-op or condo purchaser should inspect. “The first thing a purchaser should look for is an operating surplus, sufficient to pay all the bills,” the accountant says. “That generally is reflected on the building’s income statements. The second is the amount of debt being financed. We use a per-unit basis, and that figure has been moving up with rising property values. In Manhattan, it’s probably $30,000 to $40,000 of average debt per unit, and from $25,000 to $35,000 in the outer boroughs. The third thing is the amount in the reserve fund – and that should be a bare minimum of $100,000 in any building.”

“The reserve fund is more important for a condo than a co-op,” Beer explains. “Co-ops can refinance and take out more debt on the underlying mortgage, but condos can only do a loan based on an additional assessment of shareholders – that’s what secures the loan.”

But the value of a building’s reserve fund is intangible to many shareholders, who review operating statements with only a cursory eye. Paradoxically, by its hands-on attitude, a take-charge board may communicate that it is handling business so well that shareholders look askance at plans to raise additional money. Prudent planning and a sense of urgency often don’t mix.

And then there’s old-fashioned greed, which may drive the ship of cooperative feelings to break apart on a rocky shore. Ed Seh, president of the 183-unit co-op at 165 East 72nd Street, is still smarting from a very close vote that saw his board’s recommended 1.5 percent transfer fee lose by a three-to four-percent margin last October. The fee would have brought in an estimated $70,000 to $80,000 a year.

“One of the reasons we lost – and I don’t mind saying it – is that we have three or four real estate brokers in the building, and they felt that their commissions would be decreased by that 1.5 percent,” he says. “The brokers campaigned and did whatever they could to defeat the transfer fee. They get a little uptight about anything that takes away from their six percent. And that’s the way the cookie crumbles.”

“The board tried hard,” says Donna Ross, an account executive with Andrea Bunis Management who handles the building. “They sent out a newsletter, copies of articles from different places, and had a special meeting just for the purpose of discussing the transfer fee. They devoted a lot of time to it.”

She also says that a block of elderly residents, who had seen the market values of their apartments rise by a thousand percent and more, also voted against the transfer fee because “they were against giving up any part of their so-called profit to the transfer fee. We haven’t had a maintenance increase in six or seven years – in fact, we gave out something like six or seven months’ of maintenance abatements in the last three to four years,” he notes. “In spite of all that, we lost the vote, and I feel that in the next year to two years, we’re going to have to have a maintenance increase.”

A Better Strategy?

Angela Hirsch, a 20-year board member at The Saxony, in Forest Hills, Queens, met with her board on August 4 to argue for a transfer tax in lieu of another maintenance increase for shareholders. Hirsch says that, in all her time at the 100-unit co-op, she has been a staunch advocate of a stable reserve fund set at about $175,000.

But with recent increases in insurance costs and operating expenses, as well as the need for improvements and repairs, the stability of the reserve fund is threatened, and “we’ve been upping our maintenance, and may be putting in for an assessment as well,” she says. She hopes to persuade the board to offer competing proposals to shareholders: either take a big maintenance increase or, as an alternative, pass a flip tax and see the projected maintenance hike cut in half.

It may not be an easy sell, even to the board. “It took me an hour-and-a-half to convince them to put in an assessment recently to bring our reserves back to $175,000,” she recalls, “and it was only when I brought in our accountant, Jeff Roude [of Hoffburg, Oberfest, Burger & Berger], that they agreed to it.”

“We do have some people who don’t believe in reserve funds,” says accountant Michael Esposito of Kleiman & Weinshank. “There are some buildings where people can write a $50,000 or $100,000 check for an assessment without blinking an eye. But a building that doesn’t have those types of people has to build the fund so that it’s there when they need it.”

One Hundred Eighty-Five Prospect Park West, a 57-unit cooperative in Brooklyn, is not the home of the super-wealthy. There, board president May Fisher is also working to educate her board about the value of a transfer fee. “All our costs are going up much faster than income,” she says. “We had an eight percent increase last March, but we’re having work done on the building, which will bring our reserve fund much lower than I’d like it. The board must understand what we need, and $100,000 [the current value of the reserve fund] will not be enough. I wanted a larger maintenance increase – twelve percent instead of eight percent – but I didn’t get it. The board wants to be the good guys, but some members don’t realize that the costs are going to come anyway. These are standard repairs, like leaks and fire escape painting, and they cost a lot of money.”

Increasing the Fund

There are a few other ways to increase the fund besides flip taxes. Howard Dillon, president of the board of Cabrini Terrace, was successful in adding funds from a recent J-51 tax abatement to his reserves. Often, the simplest way to do this is to impose a special assessment equal to the J-51 money. The building is giving with one hand, and taking with the other, and the net effect is a transfer of tax rebate money into the reserve fund. Property tax refunds can be treated in a similar way, being put back into building reserves instead of back to individual shareholders.

“Another way to grow your reserve fund is through your maintenance,” says Richard Smolin, an accountant and partner at Smolin & Yavel in Brooklyn. “Your maintenance needs to cover operating expenses, but it should be adjusted a little higher to contribute to the reserve fund on an ongoing basis, especially if you’re below the $3,000 to $5,000 per unit level. You don’t have to boost it up immediately – you can do it gradually by having a small increase in maintenance.”

Here are the basic ways to increase your reserve fund:
• special assessments, as needed
• borrowing/line of credit
• transfer fees
• move in/move out fees
• storage space fees
• laundry room fees
• repair fees, in which building
personnel do work at set prices for
shareholders, and any profit after
salaries reverts to the fund
• tax rebates – J51
and property tax refunds

How Much Is Enough?

Accountant Beer says that the trick with estimating the necessary size of your reserve fund is to look at it on a per-unit basis, because co-op maintenance fees and condo common chargers vary so much from building to building. He likes a figure of $2,000 per unit, and by that logic, 2 Grace Court’s reserve should be $208,000, just about the size of Broder’s desired cushion.

“But that $2,000 number is a very thumbnail approach,” Beer elaborates. “The best way is settle on the ideal size of your reserve fund is to do a long-term capital budget. I would love to go out to ten or fifteen years, but what’s practical in the industry is about five years. Based on that analysis, you want your reserve to be continually funded, preferably with something coming out of the operating fund towards the reserve, possibly reinvesting some of it, and also taking tax abatements and putting those back into the reserve fund. A building that’s going into major projects should have a much higher reserve fund, and any prospective purchaser should be taking a look at board minutes and talking to the managing agent to see what projects are on the horizon.”

Michael Esposito agrees that there’s “no magic formula” for setting the amount of a co-op or condo reserve fund. “You’ll hear some people say three months of maintenance or common charges, but if you had two buildings,” he suggests, “one a year old and one a hundred years old, are they going to need the same reserve fund? No,” he answers. “The building that’s a year old may need the larger fund, because the hundred-year-old building could have had all the major systems done recently.”

Smolin recommends a reserve fund of “around $3K to $5K a unit, but it depends on the health of the infrastructure of the building. Your co-op or condo is a big investment, and you don’t want to mess around with it by having a financial statement that’s shoddy. A healthy reserve fund makes your unit more attractive.”

Esposito suggests that the board have “a study done by an engineer, or do the same thing informally. You go over the major systems, get a feel for the remaining life of each one – this is not an exact science – and build your reserve fund to the point where you can cover the replacement cost over the expected life of each system. Say the elevators need $500,000 for ten years of life, you try to build your reserve to get to the point in ten years where you’re going to have $500,000 for that expenditure.”

But building managers may find that accountants and engineers are sometimes wary of placing hard dollar figures on the lives of roofs, boilers, and other critical systems, for fear of liability if systems fail prematurely. Although the American Institute of Certified Public Accountants issued an audit guide in 1991, saying that accountants should disclose the life expectancy of components owned by membership associations such as co-ops and condos, this is typically not done in New York City. But contractors will usually give useful estimates of system life, and it’s wise for board members who oversee major projects to get these kinds of estimates when they look down the road at capital expenditures. The manufacturers of installed systems will also generally give an approximate figure for the remaining useful life of the equipment.

What about increasing through investing? Do so carefully: reserve fund money is bottom-line money, not to be risked. Says Smolin: “The board – and especially the treasurer – has a fiduciary responsibility to make sure the reserve funds are whole any time the building needs them, so I don’t suggest putting funds into stocks. They should be conservatively invested in either money market funds, treasury bills, or other triple-A safe investments. A ‘layering approach,’ in which you stagger the maturities of certificates of deposit or t-bills if you don’t think you will need the funds all at once, is a good idea. The principal should be safe at all times and not subject to market fluctuation.”

At Cabrini Terrace, the board’s conservative investment strategy has seen its funds go into U.S. treasury bills with different maturities, a recommended way of minimizing financial risk and taking maximum advantage of varying interest rates.

“Some of our investments are in high-grade commercial paper, that turns over every three months, some is in certificates of deposit, and some in very high-quality corporate bonds,” says Joanna Kapner, former treasurer of a 982-unit cooperative in Manhattan’s Morningside Heights. “Obviously, there’s no way we can invest the money in anything that has any risk to it.”

Capital Funds: A Tax Primer

Boards should ask their accountants about setting up a separate capital funds account to use as a defacto reserve fund – for capital projects only, however. This can bring significant tax benefits both for the co-op or condo and for the individual shareholder. Smolin says that capital contributions can be considered equity instead of income, and “having too much income may throw the co-op or condo into a precarious situation.” The Internal Revenue Service takes the position that, for a co-op or condo, it’s how the money comes in that determines whether it is considered operating money or capital money, which is why funds have to be segregated right away.

Beer notes that capital improvements, properly accounted for, can increase the original value of a shareholder’s apartment, thus saving him tax consequences at the time of sale. “Let’s take the case of a person who paid $100,000 for his apartment, got married, and now it’s worth $650,000. He wants to sell. Now, if you’re married there’s a $500,000 exclusion, so you would only have to pay taxes on $50,000. But, if there were capital expenditures in the building, every time you, as a shareholder, wrote those additional checks for capital improvements, you could add those to the original purchase price you paid.

If $50,000 of your contributions as a shareholder was spent on capital improvements, that could be added to the original purchase price, and you would owe no tax. Beer says that, for this reason, his firm sends out tax deduction letters each year indicating how much was spent on capital projects, and how much on operating expenses.

In the end, whatever method you use to fund your reserves, remember: nothing is certain. Ask Joanna Kapner. She has helped administer a well-funded reserve for years, aided by a 15 percent transfer tax enacted back in 1994. Her six-building, 21-story complex, which opened in 1957 has long had significant restrictions on both buying and selling.

To allow the building to recoup profits, apartment sales are taxed on the first turnover only – and those fees go straight into the co-op’s reserve fund. Under a resolution which Kapner pushed for and saw pass, flip taxes and any investment income earned go straight into the reserves. Additionally, large contributions to the reserve are made monthly out of operating funds, and it now stands at about $3 million – an amount which Kapner believes will be adequate for anticipated capital improvements and repairs, which will include roof replacements for all six buildings.

But once the flip taxes end on the original units, Kapner says, her building faces the same dilemma as other co-ops and condos. “I don’t know what will be decided. If they don’t want to have an ongoing flip tax, they’ll have to raise funds in some other way.” She notes that the flip tax resolution, back in 1994, “needed 51 percent of the shareholders to approve, and it got 54 percent. Now, the population has changed, prices are up, and a lot of people feel we should end all price controls and meet market demand. And today, I’d say only one-third of the shareholders would support a transfer fee.” H