Many HOAs have language in their governing documents that act as a spending cap on capital improvement projects without member approval (often at 5% of the annual budget). However, the term “capital improvement” is often not defined. This often leads to confusion as to whether an expense requires member approval. “Capital improvement” is an accounting term. Unfortunately, there is no industry adopted definition of what constitutes a “capital improvement” in the HOA context.
A “capital improvement” is often defined as the addition of a permanent structural improvement or the restoration of some aspect of a property that will either enhance the property’s overall value or increase its useful life. This definition of “capital improvement” provides little guidance to a Board as to whether an expense is a “capital improvement” which might require member approval. For example, new roofs on a building both enhance the property’s overall value and increase its useful life. Therefore, they could be considered a “capital improvement”. Treating new roofs as a “capital improvement” may require member approval prior to incurring the expense. Such a requirement would conflict with the Board’s authority to maintain the common area facilities. Therefore, a better definition for common interest developments is needed for purposes of CC&R restrictions.
Some in the industry suggest Associations consider adopting the following definition for capital improvement:
A capital improvement is any (i) substantial discretionary addition to the common areas, (ii) voluntary significant upgrade to common area materials, or (iii) discretionary material alterations to the appearance of the development.
While adopting such a definition would go a long way towards resolving the confusion caused by the use of an accounting term in the HOA context, even this definition is subject to confusion in its application. A Board would still have to determine if an expense is for a “substantial” discretionary addition or if it is for an “insubstantial” discretionary addition, or if the expense is for a “significant” upgrade to common area or if it is an “insignificant” upgrade.
Even with these potential pitfalls, to best deal with the uncertainty created by a capital improvement restriction Boards should consider defining “capital improvement” whenever they amend or restate their CC&Rs. If amendment is not a viable option, at minimum, Associations should adopt the definition and follow the procedure for a rule change to give notice to the members that it is considering the adoption of a given definition of “capital improvement”. Neither option will guarantee that an expense will not be challenged. However, a Board’s decision will stand a greater chance of surviving scrutiny, whether it is by a member or a court, when the membership is given advance notice and a chance to vote or at least provide their input to the Board prior to the adoption of any such definition.
Several courts in and out of California have ruled on various challenges to HOA expenses and determined whether expenses qualified as capital improvements. The results have been mixed, and are often factually specific. Therefore, it is impossible to provide a bright line test for Boards to follow when attempting to determine if an expense is a “capital expenditure” and subject to a cap on spending. Exceptions to the capital expenditure limitation have been found in cases of expenses required by governmental mandate and expenses which are necessary to protect Association assets. In such cases, the expenditures may be seen as within the Board’s authority to maintain and repair the common area property. However, any such expense must be examined in light of the individual factual circumstances. Any Board faced with a spending cap should consult with their legal experts to determine whether a vote of the members is required before undertaking an expense which could be viewed as a capital improvement.
Some considerations for a Board attempting to determine if an item is a Capital Expense subject to a spending cap are:
1) Do the Governing Documents place a spending cap on Capital Improvements? – If not, no vote is necessary.
2) Do the Governing Documents define “Capital Improvement?” – If so, determine if the expense falls within definition.
3) Is the expense less than the spending cap? – If so, no vote is necessary.
4) If the expense is above spending cap, is it for a new facility? – If so, it may be a capital improvement and member vote may be required.
5) Is the expense for repair or replacement of an existing item with like quality, or is it an upgrade?
a) If the expense is for a like quality repair or replacement, it most likely falls within the Board’s authority to maintain, repair and replace, and a member vote may not be necessary.
b) If the expense is for an upgrade or improvement to an existing item, determine if there are any possible exceptions to requirement for a member vote.
i) Is the expense necessary due to governmental requirement (ex: replacing wood shingles with fire retardant material)? – If so, members cannot veto, and a vote may not be necessary.
ii) Is the expense necessary to protect Association assets (ex.: underpinning of building foundation to prevent settlement)? – If so the expense is most likely within the Board’s authority to maintain, repair and replace, and a vote may not be necessary.
iii) Is the expense for a new technology or building material that did not exist at the time of construction that will last longer and not need to be maintained or replaced as frequently? – If so, it may fall within the Board’s discretion and business judgment, and a vote may not be necessary.
c) If the expense is for an upgrade to an existing facility, and no exceptions apply, it will most likely be considered a capital improvement and approval of the members may be required.