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A Muddled Budget Outlook for 2008

self serving or serving the Community's interest

As widely rumored, the cornerstone of the proposed 2008 budget most impacting homeowners will be an increase in annual assessments of $160, going from $940 to $1,100. The Finance Committee's proposed increase will generate about $1.2 million for the association, reflecting a 17% increase in homeowner assessments. In view of available information, the key question is whether that proposed increase is actually necessary? I don't think so. Regrettably, that mismanaged decision has already been made by president Mike Dixon and the Board.

I say mismanaged for a reason. To my way of thinking, association Boards should not look to homeowners for additional funds unless absolutely necessary. Association Boards have a unique fiduciary duty to preserve and conserve our resources. While proposing to raise assessments to fund our lifestyle may be a permitted discretionary act, the question of whether such an action is really necessary is always present. When making that assessment decision, at what point does the Board cross the line between managing and mismanaging the Community's resources? I believe the Board has crossed that line.

The concept of mismanagement includes actions that arise out of management ineptitude, involves an action that has major as opposed to minor consequences, and includes, among other mismanagement categories, unsupported costs. The question, then, is whether the Board can support their decision to raise member assessments. This goes to the issue of the Board's powers to manage, which admittedly are very broad. NRS 116 protects Board actions by applying what is commonly referred to as the business judgment rule (BJR). The BJR says that actions of a board in satisfying their fiduciary duties are not subject to review unless there is some allegation of conduct that (1) violates (a) the directors' duty of care, (b) duty of loyalty, or (c) duty of good faith; or (2) that the decisions of the directors lacks a rational basis.

In applying the BJR, the courts have imposed additional burdens on boards of directors. Directors must be able to show that they had reasonable grounds for their actions. They cannot merely claim their decisions are not subject to challenge because of the BJR. In order to satisfy that reasonable grounds burden, directors must be able to show good faith and reasonable investigation. Despite the relief provided directors by the BJR, directors must be able to demonstrate that they acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company, whether the company is for profit or nonprofit.

I believe that had the Board (and the Board's Finance Committee) conducted a reasonable investigation of whether an increase of $160 in assessments was necessary, they would have come to a different conclusion. A reasonable investigation would have disclosed an alternate source of funding that would have made an increase in homeowner assessments unnecessary. That alternative source of funding is from the Developer, based on the following:

• Evidence of a shortfall in reserves that were transferred at the time of transition (5/31/2005);
• Evidence that the magnitude of the shortfall was substantial, based on the 2006 Reserve Study, that reported a potential shortfall in 2006 of 43% of the amount needed to fully fund our reserves.
• If, as reported by the 2006 Reserve Study, the reserves funding level was underfunded by 43% in 2006, it is reasonable to conclude that the reserve fund was similarly underfunded one year earlier, as of 5/31/2005, the date of transition from Developer control to resident control.
• Finance Committee data on Reserve Fund Projections reflects a potential underfunding at the end of 2006 of more than 2 million dollars.
• Former Board president Favil West has already demonstrated the will and ability to address the underfunding issue. He did so in the case of the Neighborhood reserves by identifying the problem and proceeding to negotiate an agreement with Pulte in the spring of 2007 to turn over the equivalent of $280,000 for Neighborhood reserves, more than doubling the amount Pulte had turned over to the association at transition in 2005.

With the issue of reserves underfunding clearly in the picture, coupled with the apparent need to raise a million dollars, what actions should a prudent Association director be thinking about on the issue of meeting the need for additional funds? Seemingly, the Board had at least four available options:

1. Challenge proposed RMI expense estimates and decrease as appropriate
2. Cut back or eliminate desirable amenities
3. Raise homeowner assessments
4. Negotiate with the Developer on the matter of underfunded reserves

Strangely, and in the face of evidence that would relieve the Association of the need to increase annual assessments, the Board decided to ignore such evidence and go along with the Finance Committee's proposed recommendation to increase homeowner assessments. The FC was of course acting under stringent Board guidance that gave them few options to consider, like (1) and (3) above. Clearly, eliminating desirable amenities was an unacceptable option. The Board refused to adopt Option 4, thereby denying all members the obvious benefit that Option 4 (negotiating with the Developer) would provide. The Board's decision is even more disturbing given the knowledge that former president Favil West had already pursued Option 4 with a very positive outcome in the case of Neighborhood reserves.

Given the above discussion, I have a question. What "reasonable investigation" did individual directors of the Board conduct that enabled them to conclude that there was no benefit to be derived by homeowners by not negotiating with the Developer on the reserves underfunding issue? I think we are entitled to know the answer to this question, not collectively, but individually. Given the broad Community impact of their decision on this matter, along with the million dollar magnitude of the potential underfunding at issue, it is important for homeowners to understand how individual directors perceived their fiduciary duty to govern in our best interest.

For example, if a director believed in good faith that by entering into negotiations with the Developer on the reserves issue might jeopardize the Developer's commitment on Recreation Center No. 3, what "reasonable investigation" led the director to such a good faith belief. It would be helpful if our Board directors would share with us the evidence they gathered and relied on to support such a belief or actions in this matter.

The Board, sensing increasing vulnerability on their decision to ignore the growing evidence of mismanaging the 2008 budget process that continues to call for an increase in homeowner assessments, decided last month to erect what amounts to a smokescreen to hide behind their refusal to address the shortage issue while moving forward with their flawed 2008 budget proposal. While giving the appearance of tackling the reserves shortage issue, the Board was effectively walking in the opposite direction and away from the underfunding issue. The Board's tactic was to seek a bid from the company that produced the 2006 Reserve Study, asking them if it was possible to perform a regression analysis of the data back to 5/31/05, the date of transition. And, if so, how much would that cost.

President Favil West had already proved that that step was unneeded since he was able to successfully negotiate with the Developer using the data from the 2005 and 2006 Reserve Studies. If the necessary tools were already in hand for Mr. West to utilize, why give the appearance there is a need to go shopping for a tool you do not need? Meanwhile, of course, the Board will have by then already secured the necessary Community authorization at the annual meeting in November to begin assessing homeowners the additional amounts being recommended by the Finance Committee.

The importance of assessment income to the association cannot be overstated enough, technically reflecting as it does 82% of revenues received from all sources. While the given impression is that we have sources of income (18%) from other than homeowner assessments, that's a little misleading. In general, income from other sources is more than offset by related or corresponding expenses. For example, as illustrated in the first two of three accompanying charts, the $900,000 in income from the Fitness, Activities and Communications departments is offset by $1.6 million in expenses for those same departments. Our third chart illustrates how your assessment income will be allocated in 2008. This information was recently presented by the Finance Committee.

When this presentation is made to the Community at this month's Board meeting on Thursday the 25th, no doubt some effort will be devoted to justifying the proposed increase in assessments as necessary, but that sort of begs the question of how necessary is any decision by the Board to raise our annual dues. As our volunteer budget gurus are keenly aware, there are few opportunities available for increasing association revenues other than by increasing assessments.

Historically, the association has benefited financially as more Developer built lots with homes were sold. For every 800 lot/homes the Developer sold annually, overall association assessment revenues would increase by $750,000, or $940 per lot. At some point, by the end of 2007, there will be no more Developer lots to sell and increases in assessment revenue from that source will cease to exist. With no more Developer lots to fund our chosen lifestyle, frozen at 7,144 lots, homeowners can expect to be called upon to pay for any additional costs to fund our lifestyle.

Along with a leveling off of assessment income in 2008, existing homeowners will have to assume the burden of paying for the operation of our third recreation center, or RC3. That Center will have 2 major swimming pools plus a smaller warm water pool, a 21,000 sq. ft. building, a fitness center and meeting rooms, tennis and bocce courts, among other amenities. Additionally, the homeowners will need to fund reserves for RC3. Since RC3 is not expected to come online until the second half of the year, 2008 expenses estimated to operate RC3 are less certain than other typically recurring expenses. In any event, expenses to operate RC3 for 2008 is just under $500,000 for 6 months, or roughly $900 thousand annually.

Interestingly, or coincidently, the proposed increase in annual assessments of $160 is broken down as follows, $60 for operating expenses and $100 for the reserves account:

The proposed increase in assessments will generate about $1.1 million in additional association revenue. Of that amount, note that almost $430,000 will go into the operating fund, while 62.5% of that overall increase will be allocated to the reserve fund. That high percentage factor contrasts to historical assessment practice of allocating $94 for reserves, or 10%, out of a total assessment of $940 per year.

As it turns out, the projected cost to operate RC3 for one-half year is roughly $431,000, as shown in Chart 2, which happens to be about the same amount ($429,000) that will raised from increasing our assessments by $60 for operating expenses. Understanding that likely connection, however, does not necessarily justify the proposed increase in assessments. As you can readily assume, we will require double that amount to operate RC3 on a year-round basis in 2009.

The purpose of raising a little over $700,000 for the reserve fund is less clear, except that in general terms association reserves, as our auditor would advise, should be at a preferred HIGH level of funding (like 90%) rather than at a LOW level of funding. The lower the level of funding compared to the ideal or full funding level of 100%, the higher is the potential for a special assessment or the need to defer needed maintenance.

With such a substantial increase proposed in reserve funding, some may wonder why. Is there a problem or more likely, is there a shortfall in our reserve fund? Before we get there, you should also be aware that the Board will by years end have authorized in 2007 the transfer of an additional $900,000 to the reserve fund.

As reflected above, over the two-year period 2007-07 the Reserve Fund is scheduled to be augmented above and beyond what would have been collected by roughly $1.6 million. If someone should inquire "Why?," they would be told, "Because we need it." That would be the end of the discussion. No one, least of all the Board, seems disposed to address the issue of why the association now finds itself in the awkward position of having to augment the Reserve Fund by $1.6 million. Yes, the Board can tell us where the funds are coming from, such as from our current operating account and from increasing member assessments, but the Board appears reluctant to explain or justify the need to rob Peter to pay Paul, whether that be from the operating account or from homeowner pocket books to fund what some may believe is the result of mismanagement.

Wouldn't it be ironic if we should learn that the Developer had underfunded association reserves at the time of transition by $1.6 million, or thereabouts?

Here on a separarate page is a peek at some of the highlights of the proposed 2008 budget. There are three Peek Proposal (PP) charts presented: The first chart is on Operating Revenues; the second on Operating Expenses, and the third chart is how your assessments are allocated. You should pay particular attention to the major assumptions that accompany the charts since they form the basis for the 2008 budget. Those assumptions are also reproduced below.