The Dilemma Facing Some Aging Condominiums
The housing Crash resulted in dramatic declines in home values in the Chicago area. By 2017 home prices were recovering in many neighborhoods. However, in some neighborhoods, the values of condominium units, particularly those in moderate income buildings, have not recovered and may not recover any time soon. At the same time, rents have been rising to the point where the value of some moderate income condominium buildings as a rental project is greater than the sum of the values of the individual units in the condominium.
Recently, many older, moderate income condominium associations have been discovering that large expenditures are needed to repair or replace deteriorating portions of the building, such as windows, risers, roofs and building exteriors. Some of these associations are also discovering that they do not have sufficient reserves to pay for the necessary work. It is generally believed that associations faced with these issues have the limited options of (a) levying a large special assessment, (b) taking out a loan secured by a pledge of assessment income, or (c) attempting to sell the building. Levying a large special assessment is often problematic because it may be unaffordable to many owners. Borrowing the necessary funds and securing repayment with the pledge of the proceeds from a multiyear special assessment is difficult to accomplish and may require a short repayment term of several years (3-5), which could substantially increase assessments, put a financial burden on owners, and depress the marketability and resale value of the units. The “nuclear option” of selling the building for de-conversion to a rental project is often strenuously resisted by owner/occupants who do not want to sell and/or are concerned that, if they are forced to sell, they would not be able to afford a comparable unit in the same neighborhood.
I believe that there is another option which could avoid de-conversion by leveraging the increased value of the building as a potential rental project to (i) allow owners who desire to remain in ownership to continue to own their units, (ii) provide an exit option for owners who desire to sell their unit, (iii) obtain long term, fixed rate non-recourse financing to pay for the needed repairs and upgrades and (iv) generally avoid the drawbacks of each of the three options mentioned above. I call it the Hybrid Condominium.
The Hybrid Condominium Concept
An existing condominium association confronted with the circumstances mentioned above could become a “Hybrid Condominium” as follows:
1. Newco. The condominium association would organize a new entity which would be wholly owned by the condominium association (“Newco”).
2. Section 15 Transaction. Newco will acquire (or have the right to acquire) 100% of the units in the condominium pursuant to the vote of owners representing at least 75% of the percentage interests pursuant to Section 15 of the Condominium Property Act (“Act”). The purchase price would be equal to the amount necessary to pay off all outstanding liens on the units whose owners desire to remain in ownership (“Continuing Owners”), plus the amount necessary to buy the units from those owners who desire to sell their units (“Departing Owners”). Each owner will have the right to remain in title or sell his or her unit, i.e. to be a Continuing Owner or a Departing Owner. The purchase price for each unit owned by a Departing Owner would be somewhere between (i) the current value of the unit if it were to be sold to an owner/occupant at the time of the transaction and (ii) the value of the unit as part of a bulk sale of all the units for the purpose of de-conversion, as determined by the Board with input from the unit owners. The “purchase price” for each unit owned by a Continuing Owner will be equal to what it would cost to clear all liens on the unit (other real estate taxes not yet due and payable). A consensus on the pricing is necessary in order to reach the 75% threshold under Section 15 of the Act.
3. Acquisition Financing. Newco would arrange to borrow enough money to (i) pay off all liens on all of the units of Continuing Owners and (ii) to buy the units from the Departing Owners (“Acquisition Loan”). Instead of actually acquiring title to the units of the Continuing Owners, Newco or some other party would obtain from each Continuing Owner a power of attorney to (a) pay off the liens on the Continuing Owner’s unit and (b) subject the unit to the Blanket Mortgage(s) referred to below. Ideally, the Acquisition Loan would be a non-recourse, fixed rate long term, self-amortizing loan.
4. Repair Financing. Newco would then take out a loan for the required repairs (“Repair Loan”). The Repair Loan would be a construction loan, with disbursements made as needed to pay for the work as it is being done and with interest only being payable on the Repair Loan until all the funds have been disbursed, at which time it would switch to a non-recourse, fixed rate long term, self-amortizing loan.
5. Blanket Mortgage(s). Each of the Acquisition Loan and the Repair Loan would be secured by a mortgage on all of the units (each a “Blanket Mortgage” and together the “Blanket Mortgages”). Each Blanket Mortgage will, upon the satisfaction of certain conditions, permit partial releases of a unit from the Blanket Mortgage upon the payment to the holder of the Blanket Mortgage of the portion of each Blanket Mortgage which is attributable to the unit (calculated as provided below).
6. Loans to Value. For this plan to work and for Newco to secure the necessary financing, the appraised value of the building as a rental project (assuming all repairs are made and paid for) would need to be at least 20-25% in excess of the (i) the amount of the Acquisition Loan, plus (ii) the amount of the Repair Loan, i.e. a “loan to value” ratio of less than 75-80%. The rationale for using the value as a rental project to determine the loan to value ratio is that until the Blanket Mortgages are paid off, or before the holders of the Blanket Mortgages permit unit by unit partial releases of the Blanket Mortgages, if there is a default under either of the loans, the holder of the Blanket Mortgages will have the right to foreclose and acquire, or force a foreclosure sale of, 100% of the units. The entity which acquires 100% of the units would have the power to de-convert the condominium and operate the building as a rental project. This is the same result that would have occurred if the loans were originally made to the owner of the building following a sale/de-conversion which subsequently went into default and was foreclosed.
7. Amendment of Declaration. Newco, as the owner of (and/or holder of a power of attorney or proxy with respect to) 100% of the units in the condominium, would amend the condominium declaration to create the Hybrid Condominium which would be set up and operate as set forth below.
8. Continuing Owners. Each Continuing Owner would continue to own their unit, subject to the Acquisition Loan and the Repair Loan.
9. Units Acquired from Departing Owners. Those units acquired by Newco from Departing Owners would be held by Newco or conveyed to the condominium association and either (a) sold subject to the Blanket Mortgages or (b) leased to tenants at rent sufficient to at least cover the monthly payments attributable to the unit, as described below.
10. Monthly Payments. The monthly payments with respect to each unit would be as follows:
a. Assessments for common expenses and reserve build-ups based on % interests; plus
b. The portion of the monthly service on the Acquisition Loan attributable to the owner’s unit based on the relative portion of the Acquisition Loan attributable to the unit. For each unit owned by a Continuing Owner, the portion of the Acquisition Loan attributable to the unit would be equal to the amount needed to pay off the liens on the unit at the time of the refinancing. For each unit previously owned by a Departing Owner, the portion of the Acquisition Loan attributable to the unit would be the price at which the unit was acquired from the Departing Owner; plus
c. The portion of the monthly service on the Repair Loan attributable to the unit, based on % interests; plus
d. An amount necessary to build up sufficient funds to pay, when due, the real estate taxes on the unit.
11. Blanket Mortgage Service/Real Estate Tax Payments. The Hybrid Condominium association would make the monthly service payments under each Blanket Mortgage and will pay the real estate taxes for each unit which is subject to the Blanket Mortgages.
12. Rental Units. The Hybrid Condominium association or Newco would use the rent from each unit which it owns to pay the unit’s share of the monthly payments on the unit, with any excess going into the reserves of Newco or the Hybrid Condominium association.
13. Budget. The Hybrid Condominium association’s budget would include line items for reserves to cover delinquencies and to build up sinking funds to pay for major repairs and replacements. If properly funded, the reserves could help cover the hopefully brief periods when the monthly payments with respect to a unit are disrupted, avoid delinquencies on the Blanket Mortgages and obviate the need for additional borrowings or a special assessment.
14. Forcible Detainer. In Illinois, a condominium association has the power of forcible detainer to deal with a delinquent owner. What this means is that if an owner of a unit in the Hybrid Condominium becomes delinquent, the condominium association will be able evict the occupants of the unit and rent the unit out in order to generate the cash flow necessary to pay the monthly amounts payable with respect to the unit. Although it may take some time to evict a delinquent owner or the owner’s tenant, it likely will take a lot less time than it would take to get possession in a foreclosure action.
15. Tenant Participation. In a departure from the current practice of only allowing unit owners or their designated representative to serve on the association board, tenants should be granted to right to serve on the board, at least those tenants who have been in residence at the building for a significant amount of time, say in excess of three years. Tenants should also be permitted and encouraged to serve on committees.
16. Financing Source. Long term, fixed rate financing, without personal liability on the unit owners may be available from the National Co-op Bank, a local bank or another lender. Depending on the situation, a bank may earn Community Reinvestment Act credit for making the Acquisition Loan or the Repair Loan, or both.
17. Partial Releases from Blanket Mortgages. If the above described financing is obtained, then after the secondary mortgage market approvals are obtained for the Hybrid Condominium and presale requirements are satisfied, it will be possible to sell or refinance a unit and use a portion of the proceeds of the sale to obtain a release of the unit from the Blanket Mortgages, provided that the holder of the Blanket Mortgages is willing to forego the option to foreclose on the entire building in the event of a default.
18. Sale/Financing Options. A unit owner, including the Hybrid Condominium association or Newco, could sell and convey a unit subject to the Blanket Mortgages and the buyer could put a subordinate mortgage or home equity loan on his unit, to the extent permitted under the terms of the Blanket Mortgages. This option could be the option of choice if interest rates increase, a buyer cannot qualify for a first mortgage on the unit, and/or the holder of the Blanket Mortgages will not give partial releases. Alternatively, once the holder of the Blanket Mortgages agrees to give partial releases of the Blanket Mortgages, a buyer or owner could finance or refinance their unit and use the proceeds to obtain partial releases of the unit from the Blanket Mortgages and put their mortgagee in a first lien position.
19. Hybrid Condominium. Over time, the Hybrid Condominium would become a mix of owner/occupant units, investor owned units and units owned and leased by the Hybrid Condominium association or Newco, thus the name—Hybrid Condominium .
The issues facing aging condominium buildings, particularly those with smaller units (i.e. studio, 1 and 2 bedroom units) were aggravated by the Crash. The Hybrid Condominium approach suggested in this article will enable those condominiums which are faced with the need for substantial repairs or replacements and which do not have sufficient reserves to pay for such work to leverage the value of the building as a rental project (where such value is greater than the sum of the values of the individual condominium units) in order to finance necessary repairs with a long term fixed rate loan without levying a special assessment and without selling the building. The suggested approach would also facilitate the sale of units by owners who want to sell and permit unit owners who desire to remain in ownership to do so.
Brian Meltzer, April, 2017