How should a homeowners’ association optimally compose its balance sheet to minimise levy increases?

HOAs are on the horns of a dilemma: how to live up to the new, stricter regulations on capital reserves while minimising long-term levies and answering the call from investors for new amenities and lifestyle upgrades.

These are the relevant questions: Which balance sheet (BS) positions do we have to expand, and which do we have to reduce? How much capital should we hold to be prepared for unforeseen events? Over a five-year period, how can we optimally compose our balance sheet in order to minimise the burden on residents in respect of their monthly cash flow while meeting all the obligations of the HOA?

HOA business models around the world are under pressure, now more than ever, to be able to respond more speedily to volatile developments in the global markets. They have to demonstrate that they have the ability to carry out a ‘fire drill’ for the recovery from severe shocks under a stress test and provide robust analysis of risks pertinent to potential barriers of survival.

Over the years, I have observed that the same pain points remain:

• How to demonstrate that unprecedented remedial actions can be viable in extreme conditions and can be implemented even in a very short time frame.

• How to demonstrate that unprecedented remedial actions can be viable in extreme conditions and can be implemented even in a very short time frame.

• How to transform the risk appetite and management framework to include a sufficient range of material and credible options.

• How to address a wider range of crisis scenarios including both distinctive and industry-wide stresses.

• How to streamline the complexity of risk monitoring, indicators and triggers to enable targeted intervention even during rapid deterioration of industry conditions.

• How to identify the effects on capital reserves, but ensure that the investments made don’t solve short-term lifestyle goals that cause problems later with the HOA cash flow or reserves for the ongoing upkeep of those investments.

HOAs are forced to prepare for their unthinkable demise, so they need to create agile structures that enable them to quantify risks in a much swifter manner, and to deal with impending crises at an early stage. There’s no doubt that eye-watering legislation and new capital reserve reporting requirements have acted as a catalyst for action. Post the property market crash, trust needs to be rebuilt, so the residential sector is facing more intensive and intrusive re-regulation as legislators seek to protect those who have placed their trust in what in essence is a consolidated wealth survival model in a volatile economic environment.

The regulatory environment has shifted toward dynamic and continual monitoring of risk. The HOA must demonstrate that it has mitigation actions in the event of the parameters being recalibrated under stress, so it must have a dynamic view of capital reserves and liquidity.

Regulators and property developers need to avoid another boom-and-bust cycle, and are now trying to ensure that new, post-crash rules or laws are designed to stop it before it happens on a micro scale in these business models we call HOAs. The interface between these initiatives is the need for a prudent and efficient management model of the balance sheet.

Thus, the onus is on HOA boards to challenge and ensure that they have robust answers to the following questions:

• Is the business model sustainable? Yes, an HOA is a business – if you have not realised this, you need to, and soon.

• What is the development’s competitive advantage?

• Can the development continue to invest money in a volatile environment?

• Under what macro and micro conditions would the development survive/cease to be a liquid going concern?

• What impact does the development have from a systemic viewpoint on the society and the economic requirements of those invested in it?

However, a lot of this new focus and future regulation is still bedding in, or is yet to start, and often it is experimental, overly bureaucratic and subject to the law of unintended consequences.

The worry is that the new post-residential-market-crash environment may encourage box-ticking compliance only, as well as the generation of millions of pages of documentation and reports from even more powerful computing technologies, which don’t positively impact the bottom line, or even integrate with an HOA’s wider operational stack or risk. A million in the bank when the second reservoir, new security upgrade or offices should already have been completed is just as dangerous.

Each wave of regulation has a direct, quantifiable impact on the target operating model, profitability, and provisions feeding into the levy base of an HOA, but it also has an indirect but material impact on a wide range of factors contributing to shareholder value and ultimately the cost-to-pocket cost for living in these developments. If the industry does not ensure that a balance is found, it can face the very real risk that the cost starts to outweigh the benefits.

Some takeaways

The financial crisis exposed HOAs and the developers in the past, often leaving an HOA with major assets that were not previously included in its operational cost and for which no capital reserve was in place. Regulators will in future require an HOA to investigate possible unanticipated risks and to find business models to adequately address them.

In hindsight, many managers and supervisory authorities now realise that the manner in which risk was analysed and quantified can result in the wreckage of their reputation, prompted by business models collapsing and moral hazard to society as a whole.

It is also apparent that the executive boards were essentially blindsided, as risk data wasn’t actionable and risk could not be aggregated and analysed on demand. The board decisions did not fully take into account the likely impact or outcome of a decision at each level. They were based on current portfolio trends in a benign environment, or even ‘gut feel’ or social pressure from the community they represented at that moment in time.

All decisions have trade-offs and there are usually many choices for making a similar level of lifestyle advance – some needing more or less capital. Roll all these options up and one can turn the board question around – instead of “How can we reduce capital needs by Rxxx million?” it becomes “What combination of changes in capital allocation will optimise reserve contributions for the very lifestyle upgrades invested into, also subject to the regulatory constraints and risk appetite limits of their unique development?”

I strongly believe that:

As long as capital remains scarce, capital adequacy and capital management will top the strategic agenda and propel the adoption of technology optimisation programmes and capital-focused business models in the future.

The adoption of decision optimisation tools is key to survival in economically hard and volatile times, as developments are forced to remain more conservative about their strategy, and focus on maintaining high liquidity and solvency ratios while still remaining relevant in a fast evolving world, focused on lifestyle versus bank balance and ‘me now’ versus ‘the future me’.

Surviving the perfect regulatory storm rests heavily on creating agile structures that enable an HOA to quantify risks in a much swifter manner, and to deal with impending crises at an early stage.

A prerequisite is the access to and aggregation of the data needed for business decisions, regulatory reporting as well as stress testing. Governance is not a word or a paper trail; it’s a robust system to second-guess every decision made.

Therefore the vision and project objectives need to take into account all these factors. The strategic direction must also be set for the implementation and optimising impacts across the long-term HOA’s social and lifestyle needs – all of this without exploiting future investors or leaving a development unprotected from future crises.

Francois Schoeman – CEO Pecanwood Estate and Pecanwood Country Club