The first-year deficit is a process that all managers and board members will experience in the first few years of a new condominium corporation’s life. Unfortunately, this is also one of the more challenging aspects of condominium management and is one that board members are often thrust into during their first year of service. Read on as we describe the process in detail.
To begin, let’s divide up the first-year deficit into a few timeframes: Pre-Construction, Year 1, Just after Year 1, and the Deficit Recovery Process. We’ll also dive into the theory of why and how a deficit arises, complete with the incentives of the different parties (builder*, corporation, etc.).
* Note that builder, declarant, vendor, and developer are not interchangeable terms, but for the purpose of this article, they have been functionally termed “the builder” as this is sufficient for this discussion.
Pre-Construction
A condominium building cannot be sold without a budget, as without a budget there is no estimate regarding common element fees. In order to take units to market (sell the building), the builder creates a first-year budget. This budget is designed to give future owners some estimate of what their common element fees will be. This budget is included in the disclosure package that all purchasers receive.
This budget is often created years in advance of building completion. 3 years prior is normal, while exceptionally large projects can have budgets created even earlier. However, it is difficult to estimate costs years in advance for a building that is not yet built. The builder cannot estimate utility costs or utility rates into the future, nor can they estimate the future costs of the dozens of contracts that a large corporation will enter (think cleaning, security, elevator maintenance, etc.). In some cases, the final size or unit mix of the building may change, as more or fewer floors are permitted or unit layouts are changed.
The First Year
Post turnover of the corporation from the builder to the Board of Directors, the board and manager operate the condominium corporation as per the budget the builder has given. However, more often than not, the corporation finds that the budget is not sufficient to meet the needs of the corporation. The common element fees that the corporation collects from owners are not enough to pay out all the bills that the corporation incurs. When this happens, the corporation is forced to draft and approve a revised budget, and to raise common element fees for owners. This does not occur because the board or manager “wants to” raise fees, but because they are legally bound to keep the corporation solvent.
This increase in common element fees is such a common occurrence that every real estate agent advising a prospective purchaser of a pre-construction condominium unit or a recently occupied unit should advise their client that an increase is coming. These increases in fees are often in the 20% to 40% range, though higher does occur.
After the First Year
Given this information, it seems that the builder has every incentive to draft the board as low as possible in order to get the building sold. There are two factors that act against this trend, however:
Reputational Damage
A builder that becomes known for intentionally budgeting far lower than actual costs risks significant reputational damage, and therefore has difficulty in selling future units. Savvy purchasers and investors will discount their valuation of the unit in order to account for uncertainties about future common element fees, and especially so for builders that aggressively under-budget.
The Condominium Act
The Condominium Act stipulates that the builder is responsible for the “first-year deficit”. In short, the builder must pay back the corporation for the difference between the actual first-year budget and the projected first-year budget. Let’s get into this in more detail.
Calculating the First-Year Deficit
Following the completion of the first fiscal year, the corporation undertakes a financial audit with the assistance of an auditor who is selected by the owners at the turnover meeting. This auditor is an impartial third party that reviews the finances of the corporation and drafts audited financial statements (also known as “the audit”).
Once the audit is finalized, the corporation can calculate the first-year deficit. This is calculated as follows:
Total expenditures in first year (as per audit)
- Total expenditures in first year (as per builder’s budget)
= the First-Year Deficit
The first-year deficit is the amount owed to the corporation, and this is the amount claimed in the manager’s opening letter to builder. However, deficit calculation is not quite this simple; just as the Condominium Act has provisions to allow the corporation to recover funds from the developer if the budget is too low, it also prevents the corporation from undertaking all sorts of expensive projects and recovering the cost of these from the builder.
In order to prevent the board from overspending, the declarant is only responsible for the expenses of the line items that were in the budget or other necessary items to maintain the safety and proper operations of the building that a reasonably prudent manager would enforce. This means that if pest control (or snow removal, etc.) is not in the builder’s budget, the manager should still undertake this work, and this would still be recovered from the builder. These are reasonable expenses, as any manager would tell you.
In order to provide more clarity, we divide the corporation’s expenses into two categories: expenses that are eligible and ineligible for recovery.
Eligible Expenses (ones that were, or should have been budgeted for by the declarant)
Normal maintenance of common areas
Site staffing
Snow removal and groundskeeping
Elevator maintenance
Annual fire inspection
Utilities (though this is not exactly black and white)
Etc.
Ineligible Expenses (increases of service, or additional improvements approved by the corporation)
Upgrades to site staffing – such as moving full time service to 24/7 service
Building a new play structure
Adding gym equipment
Installing new common element furniture
Any other similar expenses
Keep in mind the division of expenses into these two categories is not always so simple. A highly trained condominium manager can assist.
The calculation of the first-year deficit is more accurately as follows:
Total expenditures in first-year (as per audit)
- Total expenditures in first-year (as per builder’s budget)
- Ineligible expenses
= the First-Year Deficit
Determining the eligibility and ineligibility of expenses is a process best undertaken collaboratively with the builder, as we discuss in the following section.
The Deficit Recovery Process
Typically, the corporation’s manager will approach the builder to begin a conversation regarding the first-year deficit recovery. This is a discussion, as all steps that follow are highly sensitive, and a qualified manager is critical.
The manager should then submit to the builder a package containing the calculation of the first-year deficit, ignoring the items they consider ineligible – these will come out in the following steps. With this package, the manager should submit the audited financials and the builder’s own first year budget.
From here, the builder and corporation negotiate in order to resolve the case on their own. Once an agreement is reached, some legal documents follow and the matter is resolved.
When do lawyers get involved?
In some instances, the deficit recovery can be done with only minimal legal involvement (and cost). The corporation’s lawyer should be kept abreast of the negotiations and should be involved in drafting updates to the status certificate when the deficit amount is known. However, if things don’t go as smoothly, the lawyers must get directly involved. The details of this involvement will be addressed in a subsequent post.
Final Notes
A highly competent and experienced condominium manager is the key mind and driving force behind the first-year deficit recovery. The selection of a manager with the skills and experience to perform this work is often the difference between a smooth process and one that is fraught with challenges.
Written by Michael Trendota*, RCM
Chief Operating Officer of Alwington Communities
Michael is a property management professional with experience operating a diverse set of buildings, including high-rise, low-rise, and townhouse-style. His passion is bringing neighbors together to build exciting and vibrant communities. Michael draws from his own condo board member experience to advise board members on the opportunities and challenges facing their communities. Michael holds a Masters of Business Administration from Queen’s University and is a Certified Property Manager.
* Though written by a qualified and experienced Condominium Manager, this article is not intended as legal advice. Please consult your own experts for advice.
