Introduction
For decades, condominium developers made a profit by splitting the ownership of multifamily buildings into individual units and selling them at retail for significantly more than it cost to acquire or build the building. After the housing crash, circumstances were reversed, at least as it relates to those condominiums which fall into the category of what I will refer to in this article as “Affordable Condominiums”.
For purposes of this article, an “Affordable Condominium” is a condominium in which the units are occupied by tenants or owners who fall into the category of “moderate income households”, those earning between 80% and 150% of median family income. There is limited unit loan financing or refinancing available for an owner/occupant of a unit in an Affordable Condominium, especially if the percentage of units owned by owner/occupants is less than 51% of the total units.
For several years after the housing crash, the way to add value to an Affordable Condominium was to return the units to single ownership operate the building as a rental project. I believe that as of 2016, a new approach is warranted. This article explains how to set up what I call a Co-opdominium, or “Co-opdo” for short and how a Co-opdo can be used to promote stable and affordable home ownership in multifamily developments.
Background
The growth of the condominium form of ownership in the United States began with the passage of Section 234(c) of the National Housing Act in 1961 which authorized FHA to insure mortgages on condominium units. The intent of Section 234(c) was to encourage the use of the condominium concept to promote individual ownership of units in multifamily buildings through mortgages insured by FHA. In order to create a condominium in a given state, the state needed to adopt a statute which permitted the owner of real estate to create a condominium by submitting the real estate to the state’s condominium act. Within several years after the passage of Section 234(c), every state passed a form of condominium enabling act that provided for individual ownership of units in multifamily buildings, particularly those in a typical multi-story apartment building where the airspace of one unit extends over the airspace of another unit. The concept caught on big time and over the next forty years the condominium form of ownership became a major vehicle for home ownership, particularly in urban areas.
Meanwhile, the concept of cooperatives (“Co-op”) had existed long before condos came on the scene. Condominiums and Co-ops differ from each other in several respects. The basic difference is in the form of ownership. In a typical Co-op, a corporation owns the real estate on which the Co-op building is located and the shareholders of the corporation have the legal right to use and occupy their units under “proprietary leases” from the corporation. In a condominium, each unit consists of a volume of airspace and the owner of the unit has title to the airspace, together with an undivided interest in those portions of the real estate which are not part of a unit (common elements). Co-ops generally receive one real estate tax bill for the entire Co-op property and are often financed with a loan to the Co-op entity which is secured by what is referred to as a “blanket mortgage” on the building. In a condominium, each unit receives an individual real estate tax bill and is able to be financed with a separate mortgage on the unit. Both condominiums and Co-ops assess their member/owners for the cost of insuring and maintaining the building.
It was generally believed that because condominium owners were not required to share the risk of a co-owner’s default on mortgage and real estate tax obligations, condominium ownership was less risky than Co-op ownership. In addition, because condominium units could be individually financed and refinanced, they were more marketable. Indeed in the 1970s through the early 2000s it was much easier to finance a condominium unit than it was to finance a comparable unit in a Co-op, especially where the value of the unit was rising while the balance of the Co-op’s blanket mortgage loan on the building attributable to the unit was declining through monthly mortgage service payments. For many years it was not uncommon to see Co-ops that had “converted” to condominiumin order to make owners less financially interdependent and to permit their units to be more easily financed, thereby permitting the units to increase in value and be more freely marketable.
FHA, VA, Fannie Mae and Freddie Mac (sometimes referred to herein as government related enterprises or “GREs”) became the major players in the “secondary mortgage market”. FHA insured and VA guaranteed home loans (sometimes referred to as “government loans”), while Fannie Mae and Freddie Mac purchased loans that were not insured by FHA or guaranteed by VA (sometimes referred to as “conventional loans”). The secondary mortgage market facilitated the availability of home loans by insuring or purchasing loans from originating lenders, thus permitting the lenders to sell the loans and lend the money out again to other borrowers. In order for a condo unit loan to be eligible for FHA insurance and/or sale in the secondary mortgage market, the condominium project needed to be approved by Fannie Mae, Freddie Mac, FHA and/or VA. Each entity had standards and procedures for approving condo projects. For a number of reasons, the GRE programs tended to encourage primarily owner/occupied condos. A consequence of this policy was to discourage the mixing of owner/occupied units with rental units in the same project. For example, before a condominium project could be approved by the GREs, the project had to satisfy a “presale” requirement that a certain percentage of the units be sold or under contract for sale to owner/occupants. The percentage varied from 51% to 70%, but it was significant. Although the existence of rental or investor owned units in a condo was not prohibited, if a condominium had what was believed to be too high of a concentration of rental units (generally over 25%), the GREs may not approve the project.
Many condominiums in urban areas prohibited or restricted the leasing of units, presumably as part of an effort by the condominiums to maintain GRE approvals and the continued availability of GRE financing for its units. It also may have been a reflection of a belief held by some owner/occupants that renters were inferior to owner/occupants and that having too many renters in a condominium undermined the values of the units in the condominium.
The Problem
The housing market crash exposed serious flaws in the condominium concept, at least as it applies to Affordable Condominiums. The consequences of the crash and the issues that flowed from it include the following:
- Where there were severe declines in unit values, a large percentage of condominium unit owners found themselves underwater on their mortgage loans.
- Lenders tightened underwriting standards and procedures to the point where it became very difficult to obtain a home mortgage.
- Between presale requirements, restrictions on the percentage of units that could be owned by investors, limits on the number of delinquencies and other restrictions that applied to condominium projects, it became much more difficult to obtain a mortgage on a condominium unit than on a single family home or a non-condominium townhome unit.
- The lack of availability of financing made it extremely difficult for condominium units to be sold and/or refinanced. Those sellers who were able to get a buyer who could get financing or pay cash had to either come to closing with cash to pay off the balance of the mortgage or convince the holder of the mortgage to agree to a short sale, or both.
- Restrictions on, or prohibitions of, leasing of condominium units made it difficult for an owner/occupant who needed to move to be able to rent his or her unit to at least generate some income to pay the unit’s ownership costs.
- Many owner/occupants, faced with the problems mentioned above and located in a jurisdiction (like Illinois) with an archaic, cumbersome foreclosure system, opted to remain in their unit for months, even years, without paying mortgage service, real estate taxes or assessments, and then sometimes strip and/or trash the unit when they finally were required to move out.
- The rise in assessment delinquencies created serious financial issues for condominiums and their unit owners.
- Historically, many condominium associations have had trouble getting owners to participate in the governance of the association. Often the persons who did get elected to serve on condominium association boards became overzealous in the adoption and enforcement of rules, resulting in unnecessary tensions among the residents. The leadership of Affordable Condominiums came under great stress at the very time when qualified, strong and focused leadership was most needed.
The Opportunity for Affordable Unit Ownership
The housing crash resulted in dramatic declines in home values in many areas. By 2016 home prices were recovering in some areas. However, in many areas, the values of condominium units, particularly those in moderate income neighborhoods, have not recovered and may not recover any time soon.
One result of this situation is that the continued depressed values of condominium units, especially in moderate income neighborhoods, have made condominium units more affordable for purchase or rent by moderate income households than they have been for years. The comparison of rent to own in a condominium unit is more easily made than a similar comparison of single family homes because the comparison can be made “apples to apples”, that is, between units in the same condominium project, where the rent for one unit can be compared to the mortgage service, plus real estate taxes and assessments on a comparable owner/occupied unit. For moderate income households, where the monthly housing cost is a major concern, to be able to own a unit in a condominium for a monthly cost which is comparable to the monthly rent would be for a similar unit in the same building is significant. This becomes even more compelling when an owner whose monthly cost of ownership is comparable to rent can build up equity in the unit through principal reductions on the mortgage loan and, possibly, appreciation in value. In addition, increases in the cost of ownership of a unit would primarily be limited to assessment increases or real estate tax increases, which would likely be less than rent increases.
For many years it was thought that moderate income households would primarily be renters for most of their lives. Then the subprime mortgage arrived and many moderate income households were lured into ownership of homes that they could not afford. When the bubble burst, many of those owners lost their homes to foreclosure.
However, a significant segment of moderate income households, continue to aspire to home ownership, despite scary memories of the housing market crash. With values and costs of ownership down to affordable levels, at least in certain areas, the current challenge for moderate income households which desire to purchase a home is to qualify for a loan and to come up with a down payment.
I believe that there is a way to help moderate income families become homeowners so that they can have the pride of ownership and the opportunity to build up equity and generally pursue the American Dream. I call it the Co-opdominium, or “Co-opdo” for short.
The Co-opdominium Concept
Candidates for Co-opdo would include a new construction condominium building, a newly converted rental project or an existing condo project where one entity acquires, or controls, title to, a significant number of the units, particularly in an Affordable Condominium.
For purposes of this article, the entity which holds or controls title to an apartment building or a substantial number of the units in a condominium and which creates the Co-opdo will be referred to herein as the “Co-opdo Facilitator”. The Co-opdo Facilitator would set up the Co-opdo as follows:
- The property would be subject to the applicable state’s condominium act, but the Co-opdo Declaration will contain some significant deviations from what has historically been found in condo declarations
- The Co-opdo Facilitator would subject all of the units which it owns to what is commonly known as a “blanket mortgage”. The blanket mortgage would be non-recourse, i.e. no personal liability to a unit owner. It will be a long term, fixed rate, self-amortizing mortgage. As mentioned above, this type of mortgage is common in a Co-op situation.
- In a deviation from the typical Co-op model, the blanket mortgage in the Co-opdo would permit and provide for the release of a unit from the lien of the blanket mortgage upon payment to the holder of the blanket mortgage of a sum equal to the portion of the mortgage debt which is attributable to the unit. This amount, commonly referred to as the “release price”, will be determined by multiplying the outstanding principal balance of the blanket mortgage loan by a fraction, the numerator of which is the unit’s percentage interest in the condo and the denominator of which is the total percentage interests of all units then subject to the lien of the blanket mortgage. The release price will decline as amortizing payments under the blanket mortgage are made and the principal outstanding under the blanket mortgage decreases. A unit owner’s equity in the owner’s unit will increase over time due to the combination of (a) the (hopefully) rising market value of the unit and (b) the reduction of the portion of the blanket mortgage attributable to the unit as periodic payments of principal are made.
- In a typical Co-op situation, this increase in equity can only be financed through a “share loan”, or a loan secured by the owner’s interest in the cooperative entity which owns the building. Such loans are not readily available in many markets. However, condominium unit loans are available in most markets, although, as mentioned above, such loans are currently more difficult to obtain than they were prior to the housing market crash. The ability to either refinance a Co-opdo unit or to sell the unit to a buyer who can finance the purchase with a first mortgage on the unit where the proceeds are used to obtain a release from the blanket mortgage will greatly enhance the marketability and market value of units in these Co-opdos. As will be discussed more fully below, the holder of the blanket mortgage likely will not permit partial releases unless and until the Co-opdo satisfies the then applicable requirements of the secondary mortgage market for the insurance or purchase by the secondary mortgage market of loans on units in the Co-opdo.
- In a Co-opdo where the market values of units are not increasing, where the interest rate on the blanket mortgage is favorable, and/or where a buyer otherwise chooses to pay cash above the portion of the blanket mortgage which is attributable to the unit, the fact that the blanket mortgage is non-recourse to the individual owners will make it much easier to transfer ownership of a unit subject to the blanket mortgage. However, the Co-opdo Facilitator and the holder of the blanket mortgage will still likely need to approve the buyer’s credit.
- The lender which makes the non-recourse blanket mortgage will need to underwrite the loan based on the value of the real estate and may require a relatively low loan to value ratio. However, going through the effort to acquire title to, or control of, all of the units in an Affordable Condominium could add enough value to the units in the resulting Co-opdo to satisfy a conservative loan to value ratio for a blanket mortgage.
- In another deviation from the typical condo setup, the Co-opdo documents should provide that each owner will be required to pay monthly to the Co-opdo association the following with respect to the owner’s unit: (a) the monthly assessment, (b) monthly deposits of real estate taxes, and (c) the monthly mortgage service under either the blanket mortgage or any unit mortgage which replaces the blanket mortgage. The Co-opdo association would then make the necessary mortgage service and real estate tax payments as they become due on behalf of each owner. The payment of mortgage service and real estate taxes is something that Co-ops ordinarily do but condos have not done in the past. By centralizing this function in the Co-opdo association, the association will get an early warning when an owner may be experiencing financial difficulties.
- The Co-opdo association’s budget should include reserves to cover delinquencies as well as major repairs and replacements. If properly funded, the reserves could help cover the hopefully brief periods when payments with respect to a unit are disrupted and avoid delinquencies on the blanket mortgage or real estate taxes.
- In some jurisdictions, including 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 a Co-opdo becomes delinquent, the 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 due 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.
- Until a significant percentage of the units have been refinanced and released from the blanket mortgage, the holder of the blanket mortgage and the Co-opdo Facilitator should have a significant role in the administration of the Co-opdo. In particular, the mortgage holder and the Co-opdo Facilitator will want a system in place that screens each potential owner to maximize the likelihood that the owner will meet his or her financial obligations to the Co-opdo association. The use by the Co-opdo Facilitator of installment sale contracts to sell the units (discussed more fully below) would also help protect against, and better deal with, defaults by owners. Other protections can be written into the declaration or the blanket mortgage and may include review and meaningful input into the budgeting process and involvement in decisions that could affect the interests of the holder of the blanket mortgage and the Co-opdo Facilitator, at least until a significant number of units are no longer subject to the blanket mortgage.
- 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.
Creating Ownership Opportunities for Moderate Income Households
I believe that the Co-opdo approach can be effectively applied to newly constructed or newly converted condo buildings or to recycle existing condominiums to create ownership opportunities for moderate income households.
The first step as it relates to an Affordable Condominium, would be for the Co-opdo Facilitator to build, own or acquire clear (free of liens) title to, or control of all, or at least 75% of the units in a condo. Under those circumstances, the Co-opdo Facilitator would be in a position to record (in the case of a newly created condominium) or amend the condominium declaration (in the case of an existing condominium) to create a Co-opdo, as described above. A Co-opdo for moderate income households would be set up as follows:
- The blanket mortgage would be at least in an amount necessary to pay the cost of acquiring the units.
- The blanket mortgage will provide for unit by unit releases from the blanket mortgage for a “release price” equal to the balance outstanding from time to time on the blanket mortgage multiplied by the ratio of (a) the percentage interest of the unit in the Co-opdo to (b) the aggregate percentage interests of all units in the Co-opdo which are then subject to the blanket mortgage. As mentioned above, units should not be released from the lien of the blanket mortgage until secondary mortgage market approvals have been obtained with respect to the Co-opdo.
- Buyers of units could be sold their unit pursuant to what is commonly referred to as an “installment sale contract”. Under the installment sale approach, the buyer would enter into a contract to purchase a unit from the Co-opdo Facilitator for a price at or above the portion of the blanket mortgage attributable to the unit. The buyer would take possession of the unit and would become responsible for paying the monthly installments of principal and interest on the purchase price under the installment sale contract and would also be responsible for paying the real estate taxes on the unit and the assessments payable with respect to the unit to the Co-opdo association. As of mid-2016, because of the low interest rates and increased demand for rental units, the monthly cost to own a unit is often less than the cost to rent a comparable unit in the same condominium or in a comparable rental project.
- The installment sale contract will provide that the buyer will be conveyed title to the buyer’s unit when the buyer either refinances the unit and pays the balance of the purchase price in full or sells the unit and uses a portion of the proceeds of sale to pay the balance then due under the contract. The reason for suggesting the installment sale approach is twofold. First it creates an “owner/occupant” for purposes of satisfying the GRE presale requirements without actually conveying the unit to the buyer. Second, in certain jurisdictions the foreclosure system is burdensome and allows delinquent owners to remain in possession of their home without paying anything for months, even years. However, in some jurisdictions, it is easier to terminate an installment sale contract than to foreclose. In Illinois, for example, where the buyer has not yet paid at least 20% of the purchase price under an installment sale contract, the seller can terminate the contract and evict the buyer without going through a formal foreclosure proceeding. 735 ILCS 5/15-1106.
- The units which are not sold will be owned by the Co-opdo Facilitator and may be rented. Over time, as demand for owner/occupied units increases and values go up, the Co-opdo Facilitator would sell more units under installment sale contracts to qualifying buyers as described above. After the secondary mortgage market approvals are obtained for the Co-opdo, the Co-opdo Facilitator will be able to sell units to buyers without the use of the installment sale contracts and use a portion of the proceeds of sale to obtain a release of the unit from the blanket mortgage.
- Selling units using the installment sale approach will enable persons who would otherwise not be able to purchase and finance the purchase of their unit (under current secondary mortgage market rules) to become homeowners. Hopefully the owner/occupants’ pride in ownership and a stake in the success of the Co-opdo will stabilize the Co-opdo and result in more people desiring to become owners, thus increasing the market value and marketability of the units.
- The buyer under an installment sale contract is considered an owner/occupant under current GRE rules. Currently the GREs will not insure or buy loans in a condominium project unless at least 51% of the units are sold, or under contract of sale, to “owner/occupants”. Hopefully the owner/occupancy requirement will be attained through the use of installment sales contracts, at which time contract will become eligible for GRE mortgages which would permit the buyer to pay the balance of the purchase price then due under the installment sale contract and receive a deed for the unit.
- Buyers of units in a Co-opdo, especially first time home owners, will need to be counseled and trained in owning a home and how the Co-opdo works, so that they can become a successful home owner and a positive contributor to the Co-opdo and the community.
- Over time the Co-opdo will reach equilibrium between owner/occupants and renters. In the process the Co-opdo Facilitator will pay off the blanket mortgage and no longer take an active role in the administration of the Co-opdo.
Conclusion
Before the housing bust, a converter could get a construction or conversion loan that permitted unit by unit releases as units were sold. That approach worked fine as long as unit loans were available and plentiful. That is no longer the case, at least for the foreseeable future. The challenges for condominium developers in today’s market are to obtain secondary mortgage market approvals and get enough qualified buyers under contract to satisfy the presale requirement. The Co-opdo proposal provides a mechanism that allows persons with moderate incomes to become owners of affordable homes, even if they do not strictly qualify for a loan that is insurable or saleable in the secondary mortgage market. As home owners in a Co-opdo, they will have the opportunity to benefit economically from increases in the equity of their unit by being able to eventually refinance or sell their unit, thus allowing them to participate in the American Dream that was snatched from them by the housing bust.
I believe that the Co-opdo approach can effectively be used immediately to stabilize Affordable Condominiums and make affordable units available to moderate income households. I also believe that as the housing market continues to recover from the crash, the Co-opdo approach can be used to create successful moderate income housing developments in which (a) persons who may not qualify for secondary mortgage market financing can become owner/occupants, (b) owner/occupants and renters will coexist, and (c) controls will be in place that will give the Co-opdo association tools that will help it avoid the disasters that resulted from the housing crash, due in part to the structural flaws that continue to exist in the condominium concept.
Brian Meltzer, January, 2017