Busted Non-Condominium Projects in the Chicago Area

By: Brian Meltzer

There are many busted non-condominium and mixed product projects in the Chicago area, primarily in the suburbs and exurbs.  The issues for busted non-condominium projects are different and often more complicated than those for busted condominiums.  In this article, I discuss what I see going on in large suburban and exurban projects with a non-condominium element, give my view on how the problem was aggravated by builders, construction lenders and the secondary mortgage market, and discuss some of the issues that will face developers and builders in the future.

 Historically, the homebuilding industry in the Chicago area has been different from other markets.  In many other markets there are land developers and there are homebuilders. The land developers would acquire large tracts of land, entitle and  subdivide the land, put in the infrastructure—i.e. improve the lots—and sell improved, ready to build lots to homebuilders who would then build and sell homes on the lots.  In the Chicago area, homebuilding companies, often closely held local, entrepreneurial companies, would be both the developer and homebuilder; acquiring and developing land with construction financing from a bank.  Usually one bank would make the acquisition and construction loans and often would make loans to the same builder on multiple projects.  When the market crashed several years ago, many homebuilders found themselves with large partially completed projects that had stalled.  Because many local homebuilders had large positions in land, the downturn was devastating for them and their lenders.

 Following is a description of a fictional, but representative, busted suburban/exurban project that I will call Dutch Elm Estates: 

  1. Dutch Elm Estates was planned for 1,000 dwelling units, with a mixture of single family homes, townhomes, and midrise condominiums. It has an extensive amenity package, including a large clubhouse with a swimming pool, exercise rooms, tennis courts, detention and retention areas, parks and playgrounds, walking and jogging paths, much of which was built early on in the project to attract buyers. 

  2. It is governed by multiple declarations, including a Community Declaration which governs the entire development, and separate declarations which govern each product type, such as single family detached homes, townhomes and condominiums.  About 400 of the 1,000 dwelling units have been built and closed.  The point where the amenity package could be supported by the owners of dwelling units without a subsidy from the developer, or substantially increased assessments, was in the area of 700 to 800 of the 1,000 planned dwelling units.

  3. Special Service Area bonds were issued by the municipality to pay for the infrastructure, with the bonds to be repaid from a line item on the real estate tax bill for each dwelling unit and unbuilt dwelling unit of around $2,100 per year to be increased by 1.5 % per year for 25 years until the bonds are paid off.

  4. The original builder/developer is out of business, insolvent or in bankruptcy. The lender is either foreclosing or has foreclosed on the balance of the project, taken back the project by deed in lieu or is pushing the developer/builder to do a short sale of the project or there is a trustee in bankruptcy trying to liquidate the project.

  5. The current values of the closed dwelling units are less than what the original buyers paid for them and, in many cases, not substantially less.  Many homeowners are delinquent in their mortgage payments and assessments.

  6. The infrastructure is not yet completed.  There were bonds or letters of credit that were posted by the original developer as collateral for its obligation to do the work not paid for by the SSA bonds.  The municipality is reluctant to draw the bonds and if they do attempt to draw the bonds, the bonding company is insolvent or refuses to honor the bonds.  By the time the municipality attempts to draw on the letters of credit, the bank that issued the letters of credit failed was taken over by the  FDIC and the letters of credit issued by the bank are now worthless.

  7. Potential buyers of homes have trouble getting mortgages because the appraisals are coming in lower than the purchase price and/or there are too many homes in foreclosure and/or owners delinquent in the payment of assessments.

  8. A builder is reluctant to buy lots because, even if it buys the lots at a very low price, it will have trouble selling a new home for enough to make a profit since short sales and sales of foreclosed homes are being made at less than it costs to build the home, much less to buy and improve the lot. The burden of the SSA taxes arguably makes the value of the lots effectively negative.

  9. Whoever currently owns the balance of the project is not required to pay or, if legally required, is not paying assessments or shortfalls. The Community Association cannot maintain the amenities with the number of units that have been built and sold, especially with the numerous delinquencies and extinguishment of assessments due to foreclosures.

  10. Maybe one or two of the sub-associations have been turned over, but the Community Association has not yet been turned over, even though three (3) years have passed since the Community Declaration was recorded.

  11. The municipality in which the project is located is not willing to change the zoning or reduce the impact fees and other fees provided for in the annexation agreement, development agreement or other ordinances of the municipality in order to cooperate with an investor or builder to help make the homes more affordable and marketable.

 How Dutch Elm Estates ended up where it is today is the result of a number of factors, including the subprime mess, governmental policies encouraging home ownership, such as tax breaks and government assistance offered to the mortgage market, and basic greed.  The role played by construction lenders and the policies of the secondary mortgage market aggravated the situation and resulted in the Dutch Elm Estates situation being worse than it otherwise may have been.  The construction lenders generally did not analyze or attempt to understand the complexity of the projects on which they were making loans.  For years loans on projects like Dutch Elm Estates were being made and the projects were invariably built and sold out and the lender got repaid and made money.  In my opinion, over the fifteen or so years prior to the housing crash, lenders got complacent and stopped doing their homework.  Also, nobody was examining these projects at the point of making end loans. 

 From the 70’s until a few years ago, each of Fannie Mae, Freddie Mac and FHA had programs requiring that condominium and non condominium projects follow certain guidelines and regulations to be approved for the sale of unit loans to Freddie or Fannie or the insurance of unit loans by FHA, permitting lenders to sell off loans and recycle the funds.  A few years ago Freddie, Fannie and FHA all eliminated their regulations and approval requirements for non-condominium projects, but continued them for condominium projects.  This lack of regulation and the rise of the securitization of home loans without any involvement of Freddie, Fannie or FHA (where even condominium projects were not required to be approved in order to package and sell loans) allowed developers to build large upfront amenities which could not be supported by the owners until a much larger number of units were built and sold and to engage in other risky practices (like using SSAs to fund infrastructure) that were previously prohibited by Freddie, Fannie and FHA regulations or, in the case of SSAs, should have been prohibited.  In fact, in the year or two before the housing crash, Fannie and Freddie were buying mortgage backed securities that were backed by subprime loans in projects that were not approved by Fannie or Freddie.

 When projects like Dutch Elm Estates ran into trouble, many lenders did not know what to do because they never understood the project or the issues that were aggravating the effect of the downturn.  At first the lenders believed and hoped that the market would turn and sales would pick up and they would get repaid.  When that did not happen and things got worse, the lenders hoped that another builder would come along, buy the project and bail them out.  When that did not happen, the lenders started to realize that they needed to do something or the regulators would come down on them.  Some of them extended and revised the loans, thus kicking the can down the road. Eventually the lenders started to realize that they needed to take over the projects and start doing things to liquidate them even if it meant taking large losses.  Those who did take over projects by way of foreclosure, deed in lieu of foreclosure or through bankruptcy proceedings, still did not understand these complicated projects and could not determine the value of the project or whether it was marketable.

 The pool of potential buyers for large busted non-condominium projects is small.  It consists of deep pocket investors with lots of cash, who are willing to hold the project until the market returns and national homebuilders who are looking to build up an inexpensive inventory of land that they can use to build and sell homes at a profit over the next few years. 

 In the case of Dutch Elm Estates and other similar projects the most important issues for a potential acquiring entity are the following: 

  1. Developer/Declarant Rights. Because often land needs to be added to the declarations and homes need to be built and sold, the acquiring entity needs to have the rights and powers of the developer or declarant under the documents. Developer rights include, among other things, the rights to (i) control the association until turnover (i.e. the right to set budgets and control costs), (ii) add property to the declaration, (iii) enforce the terms of the declaration and the rules and regulations of the association, (iv) exercise architectural controls, (v) maintain sales and leasing offices and (vi) conduct sales, marketing and leasing programs at the project. Many lenders do not understand that this is the case and do not get these rights and powers when they foreclose or take a deed in lieu of foreclosure.  Many of them did not get a collateral assignment of these rights when they first made the loan on the project.  Generally, the developer/declarant rights are held to be personal rights of the developer/declarant that do not run with the land.  Accordingly, it is generally advisable and necessary to obtain an assignment of these rights and powers from the developer/declarant. A potential problem with taking the developer rights is that these rights may come with liability for acts of the original developer.  However, this is a risk that may need to be taken in order to be in a position to assign the developer rights to an acquiring entity and, thus, make the project more marketable.  Also, we generally provide in declarations that we draft that an assignee of the developer/declarant rights is not liable for the acts of any prior developer/declarant.  As far as we can tell this provision has not yet been tested before an Illinois court, at least not in any reported case that we are aware of.

  2. Assessments/Shortfalls.  The obligation of the acquiring entity to pay assessments or shortfalls needs to be understood and it may depend on whether the acquiring entity will be the developer/declarant.  In the condominium situation, the owner of every unit in the condominium must pay full assessments on the unit, regardless of whether the unit is incomplete or unoccupied.  In the non-condominium situation, the declarant has broad flexibility to provide in the declaration who is required to pay what share of the cost of running the association and can exempt certain units from paying assessments altogether, or until a specified event occurs, such as issuance of a certificate of occupancy, actual occupancy, or turnover of control. We generally provide in the declarations which we draft, that in lieu of paying assessments prior to turnover the declarant/developer pays the shortfall in the operating expenses, but does not make any contributions to reserves.  I believe this is a fair and equitable approach, but it is not one which is required under any applicable law or regulations.  Some attorneys do not provide for the payment of shortfalls; they simply exempt all units owned by the declarant from paying any assessments. We also provide in the declarations which we draft that, after turnover, the declarant is not required to pay an assessment with respect to a lot or parcel which is subject to the declaration until a certificate of occupancy has been issued with respect to the lot or parcel.  This is done on the theory that the declarant could easily keep a lot or parcel out of the declaration until a certificate of occupancy is issued, but often for convenience adds the lots or parcels to the declaration before they are built. 

  3. Turnover.  The turnover of control is also a significant issue.  Most homebuilders want to control the association as long as possible.  Also, often (at least in the documents that we draft) the obligation of the developer to subsidize the association, if there is a shortfall, ends when the association is turned over, because it is at that point that the developer loses the power to control the budget and the expenses incurred.  No developer wants to be obligated to subsidize an association where it does not control the purse strings.  The issue of when turnover must occur in a non-condominium is a complicated and convoluted issue that has been a significant issue for many years.  A discussion of the turnover issue and how to deal with it is beyond the scope of this article.  Suffice it to say that with careful drafting and planning, we believe it is possible for a developer to retain control of a non-condominium association beyond three years or the closing of 75% of the planned dwelling units.

  4. Cooperation of the Municipality.  Many projects are saddled with fees and costs, such as impact fees and requirements of offsite improvements, that may have made sense before the housing crash, but which, if not relaxed, will make the completion of the project economically unfeasible.  Accordingly, the acquiring entity would need to obtain concessions from the municipality in order to proceed with the acquisition.  This may require an amendment to the applicable annexation agreement or development agreement. 

 Nobody knows where this is all going.  I believe the market will eventually come back and homebuilders will build homes and make money doing it, but it is not clear when.  I expect to see some or all of the following happen: 

 A.  Some homeowners associations will fail and possibly go into bankruptcy.  

B.  When the market returns, the Chicago market will be more like other markets where developers develop the land and sell finished lots to builders, who will build and sell homes.  

C.  Some type of secondary mortgage market will emerge out of the ashes of Fannie and Freddie and there will be more controls and regulation of non-condominium projects than there have been in the last 15 years.  

D.  Projects will be smaller and amenity packages will be phased to fit the development as it is built out instead of being built up front. 

E.  If and when lenders get back to making construction loans, I expect that they will be more careful to understand what they are getting into, they will not allow a builder to get into a situation with a project that cannot support itself, and they will insist that the builder collaterally assign to the lender the developer/declarant rights.  

F.  Hopefully, developers will hire knowledgeable and experienced attorneys who will participate with the developer in the formulation of development plans and who will draft association documents which will give the developer maximum flexibility to promote a successful project. 

G. Hopefully, the municipalities will become more realistic and be receptive to changes in the annexation agreement or development agreement and will reduce fees and costs in order to encourage continuation and completion of a project.  

In the last five years there has been a major shift in the public’s perception of housing.  Owning a home is no longer viewed as living the American dream or as a sure fire investment that will only increase in value or as a means of financing an unaffordable life style.  To add to this negative view, it is likely that Fannie Mae and Freddie Mac will be dismantled and the Federal support of home lending will disappear along with the mortgage interest deduction and the favorable capital gains treatment on the sale of a primary residence.  In past cyclical downturns, housing was the first sector to decline, but was also generally the first to recover.    This time around housing is trailing the recovery.  To make matters worse it is actually holding back the recovery because many homeowners are tied to a home that is financed for more than it is worth and which cannot be sold, thus preventing people from moving to an area with better employment opportunities.  The current situation is the result of over building and greed.  Hopefully, before too long, the market will recover and people will return to the practice of buying homes as a place to live, as opposed to a speculative investment, and in order to obtain a loan, the buyer will be required to have a substantial down payment and a verifiable source of income to repay the loan.


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