The Positive Debt

Q

Our condominium is confronting several large repair projects. Everyone on the board is committed to doing the work, but we are evenly divided between those who favor a series of assessments to fund the individual projects as we do them and those who want to borrow enough money up front to pay for them all. Who’s right?

Q

Our underlying mortgage is coming due this summer. Our treasurer says that we should pay it off instead of refinancing because “every apartment in the building will jump in value once we get rid of our mortgage.” According to him, our reserve fund plus a “small” assessment would be enough to pay it off. Should we do it?

A

Both of these questions concern the role of debt. That role can be discussed in philosophical, financial, or physical terms. For example, to some people, debt is something to be avoided at all costs and, if incurred, paid off as quickly as possible.

For others, it is a way to buy things with other people’s money...so, the more, the merrier. This is the philosophical view on debt. It is rooted in a person’s upbringing, cultural background, religious affiliation, and/or life experience. It tends to be more emotional than factual.

The financial approach compares the cost of the money being borrowed to the value or benefit derived from the loan. The concept of leverage employs this comparison of interest to return. So, a building might borrow money to replace decrepit wood-framed, single-paned windows with new aluminum-framed, double-glazed windows because the operating savings are expected to exceed the interest on the loan. While there may be an emotional component to this decision in terms of shareholder comfort, the final decision will be justified by numbers.

Money (That’s What I Need)

Sometimes, the need for money is unexpected (e.g., the boiler dies in the middle of February), urgent (e.g., brickwork falls from a façade or a plumbing riser bursts), or subject to significant escalation if the problem condition is not addressed in its entirety (e.g., serious roof leaks). In these instances, the physical realities of the situation drive the decision.

For me, debt is just a tool. It is neither good nor bad – though its use may be one or the other. And, like any tool, it should be matched to the job at hand. A financial rule of thumb dictates that assets with relatively long lives should be financed with long-term debt. Therefore, a boiler or roof that might be expected to last 10 or 20 years theoretically should be purchased with 10- or 20-year debt. However, the circumstances of the individual borrower, as well as the current market conditions, might call for a modified solution.

Unlike a cooperative, the legal and capital structure of a condominium does not include underlying mortgage debt. So, the issue of financing usually comes up in relation to capital improvements. For many years, condominiums funded virtually all repairs and capital improvements through unit-owner assessments because existing law did not allow them to borrow for that purpose. Even after the law changed in 1997, many condominiums shied away from loans and continued to levy assessments. Over time, though, more condo boards are deciding to borrow, especially for very large projects that would require onerous assessments.

Since condo loans tend to be motivated by specific projects, it is easier to match loan maturity to estimated asset life. The market does restrict this a bit since the longest loan maturity currently available is 15 years, with many lenders offering only 5- and 10-year loans. A further complication is that virtually all condo loans are self-liquidating, i.e., they must be paid off over the respective loan term (either 5, 10, or 15 years). Nonetheless, paying for capital improvements through loans instead of assessments simplifies the funding process, spreads the financial burden of the capital improvement over a longer period of time, and has significant tax advantages for many unit-owners.

Cooperatives, on the other hand, almost always have some amount of underlying debt. Further, that underlying debt rarely gets paid off, instead being refinanced again and again as a permanent part of the cooperative’s capital structure. The need for repairs or improvements sometimes precipitates the refinancing of a cooperative’s underlying mortgage, but other factors usually influence the final loan structure.

Fuggedaboutit

Cooperative apartment buildings tend to be older than their condominium counterparts and usually need major repairs every 7 to 12 years. So, while a new roof might have an expected lifespan of 20 to 25 years, some other building component(s) may need repair or replacement before that time has elapsed. Also, because underlying mortgages are relatively large, overall budget issues and shareholder maintenance levels frequently dominate the discussion. Then, the current financial market may limit what is feasible. For example, present interest rates for 10-year mortgages are very favorable while those on 15- to 30-year loans are disproportionately high, making them unaffordable for many buildings.

So, getting back to the condominium trying to decide between assessment and loan, I will say that neither choice is right or wrong. However, I could make a fairly strong argument that a loan is the better solution for all involved. Assessments are unpopular and, if repeated, can have a negative effect on unit values. They also can be troublesome to collect in a timely manner, which can delay the start or progress of needed work. Loans can be closed relatively quickly, have more useful tax advantages, and provide a more equitable distribution of the financial burden than an assessment. That’s because current unit-owners pay the entire assessment for an improvement that will last for 5, 10, 20, or more years. In contrast, a loan spreads the payment of interest and principal over that longer period and the changing unit-owner population.

For the cooperative thinking about paying off its underlying mortgage with its reserve fund plus an assessment, I say, “Fuggedaboutit!” Draining a reserve fund is never a good idea, but this purpose is especially imprudent. You might ask your treasurer to explain his plan for funding the next building system that needs repair or replacement. If you exhaust your reserve fund and pay off your existing loan, you just might find yourself struggling to collect an assessment in a hurry or secure a new loan from a lender who has little incentive to help you. Keeping your underlying mortgage at a reasonable level is a wise objective and maintaining an adequate reserve fund at all times is the safe thing to do.