Question: What happens to a person's investment if someone buys one of the first units in a condominium, and the project goes bankrupt, before a significant number have been sold? Could you possibly lose all you invested. This is a concern for people who are retired and can't afford to lose such a significant sum.
Answer: This is a concern for anyone -- young or old -- especially in today's soft condominium market. To some degree, condominium buyers are protected by lender pre-sale requirements, but for all practical purposes, it is "caveat emptor" -- let the buyer beware.
To understand this rather complex issue, we have to go back to basics -- namely how a condominium is created. There are two important legal documents involved with a condominium: The Declaration and the Bylaws.
The Declaration serves as a deed which establishes and defines the condominium and which recites the manner in which the Declarant desires to convert or construct the property as a condominium. The Declaration describes with specificity the various components of the property, which generally includes common elements, limited common elements and units.
The Bylaws contain the rules for self-government of the condominium by an association of the unit owners, which directs the affairs of the condominium, administers policies outlined in the Bylaws and generally oversees the upkeep and administration of the condominium.
Whether this is a newly constructed project or a conversion condominium, the developer generally must obtain some form of governmental approval of the legal documents. The requirements will differ from state to state. Once the association documents have been approved, they are recorded among the land records in the jurisdiction where the property is located.
At the moment these documents are recorded, the condominium association springs into being. And since the developer owns all of the units, the developer wears another hat -- namely to serve as the initial Board of Directors.
All legal association documents require that every owner must pay his/her share of the condominium assessments. The percentage will be spelled out in the Declaration. So in our situation, since the developer now owns all of the units, it must pay the entire condominium fee to the association. As units are sold, the developer's obligation for these assessments will diminish, until the day when the last unit is sold, at which time the developer will no longer be obligated to make these payments.
It should be noted that this is the generally accepted practice. Some developers -- and some state laws -- permit variations on this requirement. For example, some developers will agree to pay all of the association expenses, regardless of whether this is greater or less than the obligation to pay all of the fee assessments. In other situations, a developer will pay the condominium fee for the units it still owns, but will not pay any moneys into a reserve account.
In my opinion, and especially in a converted condominium project, where the infrastructure is not always completely modernized, this latter arrangement is not in the best interest of the new owners. They find themselves without adequate reserves, should emergency problems arise, and will have to significantly increase the monthly assessment so as to bring the reserve account up to a reasonable level.
So if you are the first buyer in a multi-unit project, and the developer files for bankruptcy protection, there is some modicum of protection. Whoever ultimately will own the remainder of the units will be obligated to pay the assessments for those remaining units.
However, while this sounds good in theory, as a practical matter it can be disastrous. The bankruptcy court may take a long time before deciding on the disposition of the unsold units, and there will no moneys in the association to pay the ongoing and necessary monthly expenses, such as insurance, utility bills and maintenance.
Here is where the lender protection comes into the picture. Most mortgage loans are sold in the secondary market, through such organizations as Freddie Mac or Fannie Mae. And these entities have established pre-sale requirements which originating mortgage lenders theoretically are required to follow.
For example, the Fannie Mae guideline for conversion projects states:
At least 70 percent of the total units in the project must have been conveyed (or must be under contract to be sold) to owner-occupant principal residence or second home purchasers.
For new construction projects, Fannie Mae explains:
We do not have a standard presale requirement ... . Instead, we establish varying presale requirements based on local market conditions or the developer's track record. Generally, ... the presale requirement can be satisfied if (at least 70 percent of the units) have been conveyed to the unit purchasers or it the units are under contract for sale.
However, the Fannie Mae guideline goes on to state that this "seventy percent requirement applies in most cases, although we will determine a specific presale requirement for each project based on its feasibility and marketability."
It has been my experience that most developers will not allow any unit to go to closing until it has a decent number of units under contract. This number, however, may not be consistent with the secondary mortgage requirements.
Obviously, in a hot market where properties values are appreciating, it makes sense to be the first buyer in the block. In fact, in the past few years, many speculators were signing up to buy condominiums at start-up prices, solely for the purpose of flipping the unit -- or even the contract -- so as to make a quick buck or two. In fact, this practice became so pervasive that developers have imposed a number of restrictions in their contracts so as to curb this speculation. Many developers required potential buyers to contractually agree that they will not rent the unit for a period of at least one year, and should they sell within the year, the difference between the initial purchase price and the resale price would go exclusively to the developer.
But we are no longer in a real estate bull market. Condominium prices are either flat or decreasing in value. Developers are now offering all sorts of incentives -- from reduced prices, free plasma televisions sets to prepaid car rentals for a year or so -- in order to entice consumers to buy their units.
This may be a good time to buy. No one knows when this sluggish market will rebound, and for a reasonably foreseeable time, mortgage interest rates are still at a comfortable level. However, to protect yourself, here are some suggestions:
- ask the developer how many units are under contract;
- insist that the developer -- and your mortgage lender -- strictly adhere to a requirement that at least 50 percent of the units be under contract before you are obligated to go to settlement;
- try to get the developer to agree that should comparable units in the project be discounted greater than 10 percent of your sales price, that you can either match that lower price or get your money refunded. This may not be possible, but is worth asking.
Finally, whether you are considering buying in a newly constructed building, or in a conversion complex, after you sign a sales contract, you will receive a lengthy document called a Public Offering Statement (POS). Depending on what jurisdiction the property is in, you will have a number of days in which to decide not to purchase and to unilaterally terminate the contract.
The POS contains such matters as the legal documents, the proposed budget, any warranties provided by the developer as well as the rules and regulations which will govern your conduct as a condominium owner.
You must read this document very carefully. If you have questions, before your time limitation expires, ask the developer to answer your concerns. Go to the project over a weekend or early in the evening and try to discuss the building condition with some of the new owners. And have your attorney and your financial advisors review the legal documents and the proposed budget to determine if they are in order.
Buying a condominium is a serious matter. Buying in a slow market requires even more attention.