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Introduction:

For the past 35 years, Lake Superior State University publishes a list of “banished” words and phrases.  The annual list includes words and phrases that are misused, over-used, and generally useless.  The 2010 list includes such gems as “sexting”, “tweet”, “app”, and “too big to fail”.  Also included on the 2010 list is probably the most overused phrase in recent memory:  “In these economic times”.  It’s everywhere.  So in writing this article about budgeting for bad debt, I decided to see I could write it without using the banished phrase.  Why, you ask?  Because budgeting for bad debt is something that associations should consider doing even in the best of times, and saying that associations need only budget for bad debt in a down economy would be as shortsighted as… well, not budgeting for bad debt.

One of the things I let collection clients know right off the bat is that they are not alone.  According to RealtyTrac, 20,960, or 1/33 of all homes in Washington have received a foreclosure notice during the first six months of 2010 (this does not include properties that are already bank-owned).  Considering that associations make up approximately 25% of the total housing market, this means that over 5,200 association lots/units in Washington are subject to bank foreclosure.  If homeowners are having that much difficulty paying their mortgage, it follows that association assessments are going unpaid.  If your association does not have any delinquencies, consider yourself fortunate, but don’t stop reading.  Budgeting for bad debt may increase the amount owners pay each month in the short term, but in the long term helps alleviate the need for special assessments, which can cripple or destroy the finances of the owners and families that make up our communities.

Why Budget for Bad Debt

Except for a few common denominators like insurance, taxes, and utilities, different associations spend their money on different items for maintenance, services, and the like.  Unless an association has an external revenue stream such as rental income, all of the money that an association uses to pay its expenses comes from the assessment payments from the members that make up the association.  If even one association member’s assessments go unpaid or short-paid, anticipated projects cannot be carried out, the association may have to withdraw from its reserves to pay for operating expenses, and eventually the membership is required to pay special assessments to make up for the loss in revenue.  Condominiums in Washington are “encouraged” to establish a reserve account to fund major maintenance, repair, and replacement of the common elements.  Associations that are not meeting their operating budgets are likely not funding their reserve accounts.  Further, if a condominium association withdraws from its established reserve fund, the Washington Condominium Act requires that the association notify its members in writing and replace the money in the reserve fund within twenty-four months unless replacing the funds would be an unreasonable burden on the owners.  How will an association raise the money to pay back the reserve fund?  By levying a special assessment.

Let’s assume a ten-unit condominium association assesses its units an average of $400.00 per month and has an annual budget of $48,000.00.  In Month 1 the owners of one unit run into financial difficulty and stop paying their assessments and mortgage.  At around Month 6, the bank will start foreclosure, and the trustee’s sale will take place sometime between Month 10 and Month 14.  After the trustee’s sale, the unit could sit vacant and on the market for another six months or more.  If the association was formed under the Washington Condominium Act, or if formed under the Horizontal Property Regimes Act and has amended its declaration to provide for lien priority over foreclosing deeds of trust, the association can recover the assessments that became due in the six months before the trustee’s sale from the purchaser.  Assuming someone buys the unit from the bank in Month 20, the bank will pay the association the assessments during the six months before the foreclosure and the assessments through the date the new owner takes title (Months 9-14 plus Months 15-20).  In this scenario, the association suffered a ten percent reduction in revenue for twenty months, only to recover 55% of the total amount owed by that unit.  If the association decides against suing the former unit owners and collecting on a judgment, or if the former unit owners file bankruptcy after the foreclosure, that is all the association will ever get.  The remaining 45% of the unit’s share of the common expenses spread out among the remaining nine units is $400.00 per unit.  Had the association a bad debt contingency of 7.5% of the total budget, the monthly assessments for the units would average $430.00 per month, but the members would not have had to come up with an additional $400.00 per unit on short notice so that the association can pay its electricity bill.

Another important situation where budgeting for bad debt comes up is when there are insufficient funds in reserves and an association takes out a loan from a lender to fund a maintenance project or capital improvement.  An association needs to levy a special assessment to pay back the lender, and will typically allow the owners to either make a lump sum payment of the full special assessment, or pay over the period where the association repays the lender the balance of the loan plus interest.  A bad debt contingency should be included when the association determines the amount of the special assessment.  In these cases, an association should get input from its owners to determine who can afford the special assessment and remain in the property.  If owners are already underwater on their property they may decide to walk away, so the Association will need to make sure that it generates enough income during the life of the bank loan in order to maintain the monthly payments to the lender during the time where one or more unit’s assessments are going unpaid.

How to Budget for Bad Debt

Because all communities are different, there is no set amount or percentage that an association should budget for bad debt.  Instead, an association should consider the following factors when deciding on what amount to budget for bad debt:

1.  The total amount needed to pay for the operating expenses and fund the reserve the account.  In adopting a budget, associations need to consider how much it will cost to pay the operating expenses and fund a reserve account, plus account for bad debt, and then work backwards to determine each unit’s assessment liability, rather than starting with an “acceptable” amount per unit.
2. The percentage of delinquent units.  Communities with a high percentage of delinquent units should budget a greater amount for bad debt.
3. The delinquent amount per unit.  The higher the delinquent amount per unit, the less likely it is for the association to recover its expenses.
4. The amount that can reasonably be collected from the owners.  Associations should consult their attorney to determine the feasibility of collecting delinquent assessments from owners.

Should an association have questions about budgeting for bad debt, it should consult its attorney, CPA, or manager when configuring its budget.  A properly adopted budget that includes a line item for bad debt will protect an association and its members from special assessments that can lead to financial difficulty for an association’s members, and ultimately the association itself.