Formulating a Development or Conversion Plan for a Planned Unit Development

Formulating a Development or Conversion Plan for a Planned Unit Development


By: Brian Meltzer

© Copyright 2006 by Brian Meltzer


TABLE OF CONTENTS


I. SCOPE OF PAPER

II. BASIC PROJECT DOCUMENTATION

A. In General
B. Forms of Unit Ownership
C. Single-Product PUD
D. Multiproduct PUD

III. CHOICE OF FORM OF UNIT OWNERSHIP

A. Governmental Regulation
B. Surveying Requirements
C. Real Estate Taxes
D. Owner Financing
E. Insurance
F. Financial Independence
G. Marketing Considerations

IV. PROJECT DOCUMENTATION - ISSUES TO BE COVERED

A. Access Easements
B. Use Restrictions
C. Maintenance Covenants
D. Architectural Controls
E. Assessment Procedure
F. Mortgagee Rights
G. Developer Rights
H. Municipality Rights
I. Enforcement by Association
J. Enforcement by Owners

V. THE NEED FOR AN ASSOCIATION; ALTERNATIVES

VI. THE USE OF MULTIPLE ASSOCIATIONS

VII. CONVERSION PROJECTS

A. Statutory Constraints
B. Single Building Conversions
C. Multi-building Conversions

VIII. MULTI-BUILDING AND PHASED DEVELOPMENTS

A. Phasing
B. Commercial Space
C. Parking

IX. FEDERAL INTERSTATE LAND SALES FULL DISCLOSURE ACT ISSUES

X. REPRESENTING THE DEVELOPMENT PLAN TO THE PUBLIC

A. In General
B. Unit Owner Lawsuit
C. Suggested Precautions

XI. SECONDARY MORTGAGE MARKET

XII. CONCLUSION



I. SCOPE OF PAPER

Over the last several decades, as land became more scarce and expensive and as construction costs increased, the planned unit development (PUD) concept became a popular vehicle for building attractive, high-density housing developments. Often a residential PUD consists of one or more different types of housing products and includes common facilities owned and/or maintained by a homeowners’ association, as opposed to being dedicated or conveyed to a governmental agency. In PUDs that include multifamily housing units and/or non-dedicated common facilities, it is generally necessary to create a mechanism for administering and maintaining the PUD, allocating the costs of such work, and collecting the money to pay the costs. Such a mechanism is generally contained in a complex set of legal documents which are recorded against the real estate that makes up the PUD and which create covenants, conditions, restrictions, liens, and encumbrances that run with and bind the land. The legal documents must deal with and anticipate a number of issues. This paper does not attempt to address all such issues, but discusses primarily those basic issues which need to be resolved before the legal documents for a residential PUD are drafted so that the PUD will be workable and provide the developer with the flexibility to react to changes in market and financing conditions during the development of the PUD.

II. BASIC PROJECT DOCUMENTATION

A. In General

Generally, in a residential PUD the developer sells dwelling units to purchasers and grants nonexclusive transferable rights and easements to the purchasers so that they may use and enjoy the common areas and facilities. The different forms of unit ownership which are generally found in a residential PUD are discussed below.

B. Forms of Unit Ownership

In order for units to be sold, they must fall into one of the following categories:

1. Lot. A subdivided area of land, or a portion of a subdivided lot, which is improved with a single-family residential unit in the form of a detached or attached home or a townhome;

2. Condominium Unit. A unit in a building that has been made subject to the Illinois Condominium Property Act, 765 ILCS 605/1, et seq. (“Condominium Act”);

3. Co-op Unit. A unit in a building which is owned by an association (“Co-op Association”), generally a business corporation whose members-shareholders have the exclusive right to occupy the units, usually under a proprietary lease with the Co-op Association; or

4. Rental Unit. A unit in a rental apartment building; in this case, the owner of the building is the developer or an investor who purchases an entire building or group of buildings from the developer.

C. Single-Product PUD

A single-product PUD is a PUD which is planned to be built over a relatively short period of time (less than three years) with units of substantially the same design and construction. This type of PUD may be developed using only one of the forms of unit ownership described above. For example, the entire PUD may be developed as one condominium, in which case a condominium declaration will be recorded against the PUD and the common areas of the PUD will all be common elements of the condominium. When one unit does not encroach into the airspace above another unit, the PUD may be subdivided into lots, and a homeowner’s declaration may be recorded against the entire PUD. Under this approach, each unit owner will own his lot, and the homeowners’ association will own the common areas.

D. Multiproduct PUD

A multiproduct PUD is a PUD which is planned to be built over a relatively long period of time (greater than three years), will contain different style units, and will include substantial common areas and facilities. In this case, the use of an “umbrella” or “community” declaration is suggested. See §VI below for a more detailed discussion of the suggested structure for this type of PUD.

III. CHOICE OF FORM OF UNIT OWNERSHIP

The developer should choose the form of unit ownership that will best suit the physical aspects of a particular product and will appeal to the targeted marketing base. When a unit is located above another unit, the most common approach is to market the units as condominium units, although another alternative would be to market them as co-op units. When units do not overlap each other, the developer has the additional option of marketing the units as lots. Several issues which should be considered in choosing the form of unit ownership are discussed below.

A. Governmental Regulation

The Condominium Act has been amended numerous times since its original adoption in 1963. A number of municipalities have also adopted ordinances regulating condominium developments, particularly condominium conversions. Because compliance with the Condominium Act and local ordinances often adds to the costs of development, many builders prefer to use a form of ownership other than condominium.

Non-condominium homeowners’ associations remain relatively free from regulation in Illinois except for those that fall within the definition of “master association” in §18. 5(a) of the Condominium Act and those that fall within the definition of “common interest community association” in the forcible detainer provisions of the Code of Civil Procedure (CCP), 735 ILCS 5/9-102. A master association is a not-for-profit corporation or an unincorporated association which is created pursuant to a non-condominium declaration and which is authorized to exercise, or is delegated powers on behalf of, one or more condominium associations for the benefit of owners of the condominium units in the condominiums. Section 18. 5 of the Condominium Act imposes certain procedural requirements on a master association which are similar to those imposed on condominium associations, including procedures for the adoption of annual budgets, record retention, the conduct of meetings and the turnover of control in three (3) years after the declaration which provides for the creation of the master association is recorded. The community association referred to in Section III of this article would be a “master association” if, under the project documentation, powers of the condominium associations in the development are delegated to, or exercised by, the community association.

B. Surveying Requirements

To sell lots, the real estate must be subdivided, and a surveyor must prepare a plat of subdivision. To create condominium units, a surveyor must prepare a three-dimensional survey of the condominium property and each unit, as provided in §5 of the Condominium Act. To create co-op units, a surveyor may not be needed at all. Generally, the surveying cost for condominium units is greater than the surveying cost for lots.

It is not necessary to subdivide real estate which will be made subject to a condominium declaration, but it is necessary to subdivide land that will be sold as lots. Subdividing land often requires the approval of one or more public bodies or agencies. 55 ILCS 5/3-5029. Obtaining these approvals may not be simply or quickly accomplished and is often politically difficult.

C. Real Estate Taxes

Under §10 of the Condominium Act, each condominium unit owner will receive a real estate tax bill for his unit. The condominium unit’s assessed valuation will include the undivided interest in the common elements of the condominium which are appurtenant to the unit. The owner of a lot will receive a separate real estate tax bill for his lot. The failure of a condominium unit or lot owner to pay real estate taxes on his unit or lot may result in the tax sale of that unit or lot, but will not affect the interests of other unit or lot owners in the PUD. A co-op association will receive the real estate tax bill for the entire building, and the bill will be paid from assessments collected from the owners. If some of the co-op unit owners are delinquent in the payment of assessments and, as a result, real estate taxes are not paid, then the entire building may be sold for unpaid taxes unless the non-delinquent owners make up the deficit.

Section 10 of the Condominium Act provides that real property owned by a condominium association or a master association that is used exclusively for recreational or other residential purposes for the benefit of the unit owners shall be assessed for real estate tax purposes at $1 per year, and the balance of the value of the property shall be included in the taxes assessed to the condominium unit owners. Thus, the tax bills that are sent to the unit owners will include the value of the condominium unit, the value attributed to a percentage ownership in the common elements, and the value attributed to the right to use common area owned by the condominium or master association. A similar provision is found in §20c-2 of the Illinois Revenue Act of 1939, 35 ILCS 205/1, et seq. , and covers situations in which real estate used for recreational or other residential purposes is owned by a non-condominium homeowners’ association for the benefit of its unit owners.

Thus, the real estate tax treatment of property in all residential PUDs should be the same regardless of whether the common areas are part of the common elements of a condominium or are owned by a non-condominium homeowners’ association.

D. Owner Financing

An owner of a lot can mortgage his lot separately. Likewise, under Section 6 of the Condominium Act, each condominium unit owner may separately mortgage his unit.

Since all of the real estate in a co-op is owned by the Co-op Association, a co-op unit owner cannot give a lender a first mortgage on a fee simple interest in real estate. Instead, a co-op unit owner may grant a leasehold mortgage on his proprietary lease and pledge the stock that he holds in the Co-op Association as collateral for a loan on his co-op unit.

E. Insurance

Fire and casualty insurance on co-op and condominium buildings is obtained by the residential association. This procedure has the administrative advantage of avoiding potential disputes between multiple insurance companies in the event of a loss that affects more than one unit. Responsibility for obtaining fire and casualty insurance on lot improvements usually falls on the individual owners, potentially creating administrative confusion. The documentation for a non-condominium townhome-style development often will require the association to obtain fire and casualty insurance for the entire development, thus resulting in insurance coverage similar to that which is obtained by a Condominium Association.

F. Financial Independence

Each residential association will be responsible for paying various “common expenses” incurred by it on behalf of its unit owner-members. The greater the common expenses of a residential association, the greater the financial interdependence of the unit owners. In general, the level of common expenses is highest in the co-op because the co-op association is generally responsible for the payment of mortgage service on the blanket mortgage (if any), real estate taxes, insurance, and maintenance costs for the building. The condominium will usually generate the next highest level of common expenses because the condominium association is responsible for the payment of insurance costs for the building and maintenance costs for the common elements (but not real estate taxes). A homeowners’ association will generally have the lowest level of common expenses because it will not pay mortgage service and real estate taxes, it may not pay fire insurance premiums (except in the case of a non-condominium townhome development, as mentioned above), and its maintenance costs will generally be limited to exterior maintenance rather than maintenance of the building interiors or of operating systems that serve the building.

G. Marketing Considerations

The choice between lots, condominium units, and co-op units is often based on marketing considerations. Many marketing consultants believe that townhome-style dwellings marketed as lots will sell better than the same units marketed as condominium units because a purchaser understands ownership of real property in the form of a subdivided lot more easily than ownership of airspace in the form of a condominium unit. This perception has changed over the years as the condominium concept gained broader market acceptance.

IV. PROJECT DOCUMENTATION - ISSUES TO BE COVERED

The following sections briefly discuss the basic issues which should be covered in the documentation for a PUD.

A. Access Easements

Unless each unit is adjacent to a dedicated road, it is necessary to grant an access easement to the owner of each unit to permit the owner and his tenants, invitees, and guests to gain access from a public way to the unit over and across the common area. In a phased PUD, an easement should also be reserved or granted for the benefit of the portion of the development which is not yet subject to the project documentation. This is necessary in order to preserve the marketability of the balance of the development, so that if the PUD is not developed as originally anticipated or a different developer acquires the balance of the project, the balance of the project can be developed separate and apart from the original development.

B. Use Restrictions

Although usually the local zoning ordinance or the PUD ordinance which applies to the development will establish the permitted uses, it is often advisable to include certain additional use restrictions in the project documentation. The most common use restrictions relate to such matters as the keeping of pets in the units, fencing, signs, leasing, overnight parking of vehicles outside garages, limitations on use of a unit for business purposes, and other matters that generally affect the quality of life within the development.
C. Maintenance Covenants

The documentation should specify who is responsible for what types of maintenance. In a development which will be administered by a homeowners’ association, the association is generally responsible for maintaining common areas and facilities in the development, such as private roads, detention areas, and recreational facilities. Also, in developments which include attached units, the association is generally responsible for at least the exterior maintenance of the buildings. If the development is a condominium, then the condominium association will be responsible for maintaining all of the common elements of the condominium, which generally consist of structural portions of the building, interior corridors, elevators, roofs, and other common elements.

In both condominium and non-condominium developments, there are generally certain areas that serve less than all the units and often only one unit. In a condominium situation, these areas are generally referred to as “limited common elements”. In non-condominium situations, these areas are often referred to as “limited common area” or “limited community area”. Examples of limited common elements or limited common area include balconies, patios, tennis courts, or swimming pools that serve only a portion of the units in the development; courtyards that serve several buildings within a complex; and other similar areas. Generally, the drafter has several options in dealing with the maintenance responsibility for limited common elements or limited common areas. One approach would be to have the owner or owners who use the limited common elements or limited common areas furnish the maintenance at their own expense. Another approach would be to have the homeowners’ association or condominium association furnish the maintenance but charge the owners who use the limited common area or limited common elements on some basis. Under §9 of the Condominium Act, the cost of maintaining limited common elements may be allocated on any reasonable basis. Most often, in both the condominium and non-condominium situation, the costs of maintaining limited common elements or limited common areas are allocated in equal shares to the units which use such areas.

When the individual owners are made responsible for maintaining their units and limited common areas or limited common elements which they use exclusively, the association is often given the right and power to furnish appropriate maintenance if an owner fails to do so and charge the cost to the delinquent owner.

D. Architectural Controls

Often the documentation for a PUD will contain architectural control provisions governing the construction of a home and/or the alteration, addition, improvement, or renovation of an existing home. There are several ways to approach architectural controls. One approach would be to enumerate certain basic standards in the documentation such as floor area ratios, minimum square footage requirements, and limitations on the types of materials that may be used in connection with the construction or alteration of the exterior of the home. Alternatively, or in addition, the documentation may include a procedure by which proposed plans must be submitted to a committee that will review the plans with the power to approve or disapprove them. Often the committee is given the power to make judgments based on aesthetic considerations in addition to specific basic standards.

E. Assessment Procedure

In a development which will be administered by an association, the association will need money in order to fulfill its obligations. In order to raise this money, the association must have the power to levy assessments against units within the development. Generally, the documentation will require the association to establish an annual budget of its anticipated expenses and the buildup of reserves for anticipated periodic repairs which will have to be made by the association with respect to improvements maintained by the association. The amount of the annual budget is then divided among the units based on some rational basis. If the association is a condominium association, the assessments must be allocated among the units based on the percentage interests assigned to the units. Condominium Act §4. In a non-condominium situation, any reasonable approach may be used to allocate the assessments, but most often in a residential development the assessments are levied equally among the dwelling units.

The association needs a mechanism for enforcing the failure of a unit owner to pay assessments. Section 9 of the Condominium Act establishes a statutory lien in favor of the condominium association for the failure to pay assessments. In a non-condominium situation, the documentation must create a common law lien against each unit.

F. Mortgagee Rights

The documentation for a PUD should include provisions dealing with the rights of the holders of mortgages or trust deeds on individual units. This subject is dealt with more fully in Article X below. Basically, however, the documentation should give each mortgagee who so desires the right to receive notices or other information of interest with respect to the development and its mortgagor’s unit. Also, mortgagees should be given certain rights with respect to cash distributions made by the association to the unit owners in connection with insurance, settlements, or condemnation awards, and the lien of a first mortgage should be given priority over the association’s assessment lien.


G. Developer Rights

There are certain rights and powers the developer of a PUD should reserve to itself:

1. The developer should reserve to itself the right to maintain model units and to erect signs or other advertising and sales material on the PUD, including the right to use the model units to sell units at other sites being developed by the developer.

2. The developer should reserve to itself the right to permit prospective purchasers or lessees of units to come onto the PUD and to use the common areas and parking areas without the requirement that any fee be paid to the association.

3. The developer should reserve to itself the right to sell or lease units to whomever the developer desires on such terms as it deems appropriate.

4. The developer should reserve to itself the right to come onto the PUD in order to construct improvements to the PUD and to store necessary equipment on the PUD common area while construction continues.

5. If the PUD is to be administered by one or more associations, the developer should retain the right and power to control the associations, at least during the initial stages of the development, by reserving the right to designate all members of the board of directors of the association. Under § 18. 2 of the Condominium Act, a condominium association may be controlled by the developer only for a period of three years after the condominium is first created or until the conveyance of 75 percent of the units in the project, whichever occurs first. The same rule applies to what are defined as “master associations’ in § 18. 5 of the Condominium Act and certain “common interest communities” as defined in CCP §9-102. Other than turnover restrictions on condominium associations, master associations, and certain common interest communities, there are no limitations on when control of a homeowners’ association must be turned over to the unit owners. However, the secondary mortgage market generally will require that control of an association be turned over to the unit owners within a reasonable period of time, which generally ranges from three to seven years depending on the size of the development and the projected sellout of the units in the development.

6. The developer should reserve to itself a limited right to amend the documentation unilaterally, if necessary, in order to bring the documentation into compliance with applicable law, correct errors or omissions in the documentation, or bring the documentation into compliance with the requirements of the secondary mortgage market.

7. The documentation should specifically provide that any of the rights reserved to the developer are assignable by the developer. This will give the developer the option to sell the balance of the project together with the developer rights that are necessary to complete the development. It would also permit the developer to collaterally assign its developer rights to a lender.

8. Some builders, especially national homebuilders who have divisions on the coasts, desire the inclusion of provisions in the documentation which discourage the association from bringing a lawsuit against the declarant, especially a lawsuit that would be heard by a jury. To this end, the documentation often includes a provision requiring a super majority of the owners to affirmatively vote in favor of instituting a lawsuit for any purpose other than collecting delinquent assessments or enforcing provisions of the documentation. Other documentation contains provisions requiring that any dispute between the association and the declarant be resolved by mandatory mediation and, if mediation is not successful, mandatory binding arbitration.

H. Municipality Rights

Occasionally the municipality in which the development is located will require that certain rights and powers be granted to it in the project documentation. Generally, a municipality will be concerned about maintenance of storm-water runoff facilities, private utility lines located on the development, and private roads. However, more and more frequently a municipality will want the right to come onto a development to cause other types of maintenance or repairs to be furnished if the association or an individual unit owner fails to do so. Often a municipality will require the developer to include in the documentation a provision that gives the municipality the right to charge the association or an individual unit owner for the cost of doing any work the municipality believes is necessary and to impose a lien on portions of the development if any such amounts are not paid when due. The drafter should be careful, however, to make any such lien subordinate to the lien in favor of holders of first mortgages or first trust deeds on the units.

Some municipalities require that the documentation for a PUD be subject to the review and approval of the municipality. Occasionally, as a condition to approval, a municipality will attempt to require the developer to impose restrictions that cannot legally or politically be imposed by the municipality by ordinance. In particular, occasionally a municipality will ask that a developer prohibit or restrict the leasing of dwelling units, presumably on the theory that owner/occupants will take better care of their property, although other motivations may be at work. A developer should be wary of agreeing to these requests, because they could adversely affect marketability of the dwelling units or the ability to obtain mortgage loans on the dwelling units.


I. Enforcement by Association

In a PUD that is administered by an association, generally the association has the primary responsibility for enforcing the covenants. Enforcement may take the form of levying fines, an action for specific performance, or an action for eviction. The documentation should provide that if the association does bring enforcement action and prevails, it shall also be entitled to recover its costs, including attorneys’ fees.

J. Enforcement by Owners

The documentation should also provide for a private cause of action by one owner against another owner for a violation of the documentation. This is particularly important in a PUD in which there is no association. However, the secondary mortgage market generally requires that each owner be given a private right of action, even in a PUD which is administered by an association.

V. THE NEED FOR AN ASSOCIATION; ALTERNATIVES

A homeowners’ association which administers a PUD has the power to levy assessments and act on behalf of the unit owners. A well-run homeowners’ association can enhance the appearance of the PUD and the value of the units. However, in recent years a disturbing trend has developed. Homeowners’ associations have in some cases become the battleground for old-time “fence fights” and local political battles. A homeowners’ association is often easily controlled by a small group of proactive individuals whose arrogant use, or abuse, of power can lead to divisive disputes within the PUD which occasionally lead to costly and debilitating litigation.

Because of these developments and for other reasons, in recent years developers have increasingly attempted to avoid the creation of homeowners’ associations, minimize the number of homeowners’ associations that are created in connection with the development of a PUD, or at least minimize the likelihood that an association will initiate litigation against the developer.

The type of development in which it is easiest to avoid the use of a homeowners’ association is one in which the units are single-family, detached homes. In this situation, each owner can be made responsible for the maintenance of his own home and lot. However, in these developments occasionally there are common areas that may consist of private roads, detention areas, wetlands, or recreational areas. In years past, developers were reasonably successful in causing the municipality to accept the dedication of the roads or causing the municipality or a park district to accept a dedication or conveyance of detention areas, wetlands, or other types of open space. In recent years, however, governmental agencies have become increasingly reluctant to accept dedications of common areas, preferring instead to require the developer to establish a homeowners’ association to own common areas and maintain them at the expense of the owners of the homes.

One approach which has met with some success in this area is the use of a special service area. Special service areas are authorized under Illinois law. 35 ILCS 235/0. 01, et seq. Basically, a special service area is an area that is subject to a real estate tax, the proceeds of which are used for a specific purpose that generally relates to the area that is being taxed. In the context of a PUD, a special service area can be established for the purpose of maintaining roads, detention areas, or wetlands located within a PUD. The roadways, detention areas, or wetlands would be dedicated or conveyed to the municipality, but the cost of maintaining these areas would not be paid out of the general funds of the municipality; instead, such cost would be paid with the tax revenues generated from the special service area.

Occasionally, a PUD may have a small detention area or a monument sign area that needs to be maintained. If the detention area is relatively small, it may be possible to set it up as part of one or more subdivided lots and to impose the obligation to maintain the detention area on the owners of the lots. Similarly, a monument sign, which is generally a sign introducing the subdivision at the entrance to the subdivision, can be included as part of the lot located adjacent to the monument sign area, and the owner of the lot can be required to maintain the monument sign.

VI. THE USE OF MULTIPLE ASSOCIATIONS

Large PUDs, which may include several different types of buildings and active recreational facilities that will be available to all residents, may need to be administered by more than one association. An example of the type of project that would generally require multiple associations is a large new construction project which is planned to include several mid-rise buildings containing condominium units, a number of townhome-style buildings, a number of single-family detached homes, a clubhouse/recreational facility which will serve all residents of the development, green space, park areas, and private roads. In this situation, it is recommended that one or more condominium associations be created for the purpose of administering the mid-rise condominium buildings, one or more condominium or non-condominium townhome associations be created to administer the townhome-style buildings, and an “umbrella” or “community” association be established for the purpose of owning and maintaining the common areas and recreational facilities that serve all of the residents, as well as administering architectural controls and overseeing maintenance by the sub-associations. It may not be necessary to set up a separate association to administer the single-family detached homes, unless for some reason it is desirable to have an association to furnish exterior maintenance to the homes, landscape maintenance or snow removal.

There are benefits to using multiple associations. For example, through the use of a community association to furnish maintenance of common areas throughout the project, there is a greater likelihood that the development will be maintained in a uniform and consistent manner and that economies of scale will be realized because the community association will be buying certain essential services, such as snow removal and landscaping, for the entire development. However, this approach does have its drawbacks and disadvantages. The existence of multiple associations makes the management and administration of the development more complicated and costly. This approach also tends to create political factions within the development based on the division of responsibilities among the various associations.

From the developer’s point of view, in a large PUD in which multiple associations must be utilized, it is advisable to centralize control of the development in a community association and maintain control of the community association as long as possible. Unfortunately, the current state of the law in Illinois discourages this type of approach. In particular, under § 18. 5 of the Condominium Act, any association to which is delegated the powers of a condominium association is defined as a “master association”, and control of a master association must be turned over to the unit owners within three years after the declaration that provides for the creation of the master association has been recorded. In order to avoid being deemed to be a master association, the drafter must structure the documentation in such a way that the community association is not delegated the powers of a condominium association. For example, a community association should not be given the power to maintain the common elements of a condominium or even exercise architectural control over a condominium within the development. If, however, there are no condominium associations planned for the development, then the community association can exercise powers that would otherwise be exercised by non-condominium homeowners’ associations without falling under the definition of “master association”.

Even if a community association can be structured to avoid being deemed to be a master association under the Condominium Act, it is still possible that it may be deemed to be a “common interest community association” under the Condominium Act and CCP §9-102. Although it appears that §18. 5 of the Condominium Act and CCP §9-102 are intended to impose certain provisions of § 18. 5 of the Condominium Act on non-condominium homeowners’ associations which are not “master associations”, with careful drafting a non-condominium homeowners’ association can be established in such a way that it is not subject to §§18. 5(c) - 18. 5(h) of the Condominium Act. §18. 5 of the Condominium Act and CCP §9-102(c) both provide that §§18. 5(c) - 18. 5(h) of the Condominium Act will apply to a common interest community that is subject to the provisions of CCP §9-102(a)(8). CCP §9-102(b) sets out three conditions that must be satisfied for a non-condominium homeowners’ association to be a common interest community association. One of these conditions is that the unit owners are authorized to attend meetings of the board of the association in the same manner as provided for condominiums under the Condominium Property Act. Section 18(a)(9) of the Condominium Act basically requires that all meetings of the board be open to all members, with three exceptions. If the documentation for a non-condominium homeowners’ association does not contain provisions that track those in § 18(a) (9) of the Condominium Act, the association should not be deemed to be a common interest community association and, therefore, should not be subject to the provisions of §§ 18. 5(c) - 18. 5(h) of the Condominium Act.

VII. CONVERSION PROJECTS

Conversion of an apartment project to individually owned condominium units, has been an option available to apartment project owners since 1963, when the Condominium Act was first adopted. Condominium conversions were most popular in the mid1970s, at which time concerns about the treatment of tenants and the shrinking rental stock caused a number of municipalities, including the City of Chicago, to pass ordinances governing condominium conversions. With the high interest rates of the 1980s, condominium conversions were not a significant factor in the marketplace. In the late 1990s, and early 2000s, with home loans available at lower interest rates, the buy-versus-rent comparison once again favored buying, and condominium conversions returned.

Formulating a conversion plan for an existing apartment project differs in a number of respects from formulating a development plan for a new construction condominium or a PUD project. The following discussion covers some of the issues that should be considered when formulating a conversion plan.

A. Statutory Constraints

Section 30 of the Condominium Act deals with the procedures for making an apartment project subject to the Condominium Act. Basically, the owner of the property must give written notice of its intention to make the property subject to the Condominium Act (and thereby convert the property to a condominium) to all tenants of units in the property. The notice must be accompanied by an offer to sell to each tenant the unit in which the tenant resides and the price at which the offer is being made. The tenant will then have 30 days in which to accept the offer. If the tenant does not accept the offer and within 120 days after the date of the notice of intent a contract is entered into to sell the tenant’s unit to someone else, the tenant must be given notice of the contract and must be given the right to buy the unit at the price and terms set forth in the contract. The tenant may then exercise this right to purchase by notifying the converter within 30 days after the tenant has been given notice of the contract. This is commonly known as a right of first refusal.

In addition, any tenant whose tenancy expires within a period of 120 days after the date on which the notice of intent is given has the right to extend his tenancy to the end of the 120-day-period by the giving of written notice to the owner of the building within 30 days after he receives a notice of intent. If the tenancy is so extended, it shall be extended at the same rental the tenant is currently paying.

Furthermore, §22 of the Condominium Act requires certain disclosures to be made to the first purchaser of a unit. Section 22 provides that the purchaser have the right to cancel his contract until five days after the last of the designated documents have been delivered to the purchaser or the closing of the sale of the unit, whichever occurs first. In the case of a condominium conversion, these documents include the condominium declaration, the bylaws of the condominium association, a floor plan of the unit, a budget for the condominium association, an engineer’s report concerning the condition of the property in a form described by the Condominium Act, and, if available, an operating history of the property.

By an amendment to the Condominium Act, which became effective on July 29, 2005, a new Section 30.5 was added which authorizes a municipality to inspect units in a proposed condominium conversion and require that the units comply with current codes. Although municipalities arguably had this right without the amendment, and in fact some already impose such a requirement, the likely result of this amendment is that more municipalities will adopt ordinances that require inspections and evidence of current code compliance as a condition to conversion to condominium status.

In 1978, at the height of the condominium conversions, the Chicago City Council adopted the Chicago Condominium Ordinance (Chicago Ordinance), Chicago Municipal Code §13-72-010, et seq. The purpose of the Chicago Ordinance was to give additional protection to purchasers of units in condominium conversions, with an emphasis on protecting tenants, particularly elderly and handicapped tenants.

The notice requirements of the Condominium Act and the Chicago Ordinance generally apply to the conversion of an existing apartment project. In a loft conversion (discussed below), where the building is generally vacated, gutted and rebuilt or expanded, there are generally no tenants who would be entitled to receive notices or rights under the Condominium Act or the Chicago Ordinance.

The Chicago Ordinance is primarily a disclosure ordinance. It requires that, before the offering for sale of the unit in a newly constructed, newly rehabbed or a newly converted condominium project of more than six units, certain specific disclosures be made in the form of a property report. The Chicago Ordinance requires that the property report follow a prescribed format. This format includes, among other things, copies of all the condominium documentation, a survey of the condominium property, a statement as to the condition of title, a disclosure of any and all building code violations over the past ten years, estimates of monthly assessments and real estate taxes, information concerning any financing that will be furnished by the developer, certain basic information concerning the identity of the developer and certain professionals working with the developer, and disclosures concerning contracts and other obligations that will bind the condominium association, such as management agreements, laundry leases, and insurance contracts. In the case of a conversion, the property report must also include an engineer’s report covering the structures and operating systems. The property report must be available no later than the commencement of the sale and marketing program for the condominium. Violations of the Chicago Ordinance are punishable by fines.

In addition, a number of municipalities in the Chicago metropolitan area have adopted condominium conversion ordinances patterned after the Chicago Ordinance. Some, however, include additional substantive requirements that tend to make it more costly and/or risky for a developer to convert a property in that municipality to condominium. Anyone who is contemplating the conversion to condominium of property located within a municipality should check with municipal authorities to see if the municipality has adopted ordinances that would impact a condominium conversion.

There are additional issues that must be dealt with in connection with a phased conversion of an apartment project. Currently, for example, for the first 12 months after the condominium conversion of an apartment project begins, the Federal Housing Administration (FHA) will insure only loans made to tenants of the apartment project. This is a significant issue for converters who desire to utilize FHA-insured financing in connection with sales of units to purchasers who are not tenants of the project when the conversion begins. A converter must carefully plan the phasing of a conversion in order to maximize the number of purchasers who qualify for FHA-insured loans.

B. Single Building Conversions

When an apartment project consists of a single building, the building is generally converted at one time to the condominium form of ownership. Occasionally, large buildings have been converted in phases in order to facilitate the satisfaction of presale requirements that may be imposed by lenders. When the building contains commercial space in the form of stores or offices, it is often advisable to carve the commercial space out of the condominium. This can be done in one of two ways. One approach would be to record what is commonly known as a vertical subdivision plat that would divide the building into a number of three-dimensional lots. The lot or lots that contain the residential portion of the building would then be made into a condominium, and the lots that contain commercial space would either be made into a commercial condominium or be owned and operated as commercial property separate from the residential condominium portion of the building. Another approach would be to exclude the commercial space from the legal description of the real estate that is being made part of the condominium. The commercial space could then be owned and operated as commercial property separate and apart from the condominium. In those buildings in which the value of the commercial space is relatively small compared to the value of the residential portion of the building, it may not be necessary to separate the commercial and residential portions of the building. In such a situation, the commercial portion of the building may be made into one or more condominium units in the same condominium as the residential units. Of course, the commercial units would have to be made subject to different use restrictions than those imposed on the residential units.

C. Multi-building Conversions

In an apartment project which consists of multiple buildings, care must be taken to establish a phasing plan that gives the converter maximum access to end loan financing. Generally, the secondary mortgage market will require that between 50 percent and 70 percent of the units in the portion of a conversion development that will make up the condominium be subject to sale contracts before loans on units in the condominium may be sold in the secondary mortgage market. Thus, for example, in a 500-unit apartment project that consists of ten 50-unit buildings, instead of attempting to convert the entire project to condominium at one time, the converter should phase the conversion building by building. Thus, the first phase of the conversion can be made part of a condominium, and unit loans may be sold in the secondary mortgage market when 50 percent to 70 percent of the units in the first building (25 - 35 units out of 50) are subject to sale contracts. Generally, the presale requirement operates on a cumulative basis. Thus, if the presale requirement is 70 percent, then loans in the first phase will be saleable in the secondary mortgage market when 35 units in the first building have been sold. When the second building is added to the condominium, the presale requirement will be 70 percent of 100 units, or 70 units, but instead of being required once again to satisfy a 70-percent presale for the second building, units in both the first and second buildings can be used to satisfy the presale requirement for the first two buildings. This approach works only if the condominium is what is commonly referred to as an “add-on” condominium.

If the apartment project has significant amenities, such as a clubhouse, swimming pool, and tennis courts, the converter must pay attention to when and how the amenities are made part of the condominium. The secondary mortgage market may not approve a conversion if a large amenity package is made part of the condominium before there are sufficient units in the condominium to pay for the cost of maintaining the amenity package. However, if the condominium unit owners do not have a perpetual right to use and enjoy the amenity package, the amenity package may not be advertised as being available to the unit owners, and no portion of the value of the amenity package may be included in the value of units for appraisal purposes.

VIII. MULTI-BUILDING AND PHASED DEVELOPMENTS

In the 90’s builders and developers, with the encouragement and cooperation of local authorities, converted a large number of buildings which had previously been used for non-residential purposes into residential buildings, many of which were made into condominiums. This process, which began years ago with the conversion of old factory and warehouse buildings into residential buildings with loft style units, is commonly referred to as a “Loft Conversion”. However, in recent years the units created in buildings which were formerly used as office buildings or warehouses have taken on a much more conventional look. Instead of very high ceilings with partitions which do not extend from the floor to the ceiling and with exposed duct work, units in many recent Loft Conversions, particularly those in former office buildings, are virtually indistinguishable from units in newly constructed apartment and condominium buildings. Many of the recent so-called Loft Conversions have involved a large number of units, often in excess of 200 and often involving more than one building with different types of construction. Also, in recent years, a number of high and mid rise new construction developments have been constructed in urban areas, both in the City of Chicago and in the suburbs. Formulating a development plan for a large new construction condominium or loft conversion presents certain issues which are not normally found in the condominium conversion of an apartment project or new construction of a smaller building. Following is a discussion of some of the issues which commonly arise in connection with a large new condominium or loft conversion development.

A. Phasing. Because a Loft Conversion generally involves the gutting and rehabilitation of an old structure, there are no tenants. Also, a new construction and/or high rise building also has no tenants. Although the fact that there are no tenants makes it easier from a legal point of view because there is no need to give notice of intent to convert and rights of first refusal, the lack of tenants means that there is no source of rental income during the course of the development of the buildings. In a large apartment project conversion, if the entire building is made subject to the Act as part of a condominium, the building will generally be substantially occupied with both owners and tenants. The tenants will be paying monthly rent to the developer who can use that rent to pay assessments levied against the units which are still owned by the developer. In a new construction or loft conversion project, once a condominium unit exists, the owner of that unit must pay assessments on the same basis as the owner of every other unit, regardless of whether the unit is occupied or not. In multi floor buildings, units on the lower floors of the building are often ready for occupancy before the units on the higher floors. Also, in mult-building projects often one building may be ready for occupancy before another building. One way to deal with this issue is to add portions of the project to the condominium in phases, often floor by floor, building by building, or floor by floor within each building. The Act specifically provides for and permits property to be added to a condominium in phases. When the amendment to the Condominium Act which permits phasing was made, the particular type of phasing which was then occurring was the addition of entire buildings in new construction or apartment project conversion projects, primarily located in the suburbs. The phasing of a large new construction building or multiple buildings in a Loft Conversion project can legally be done under the provisions of the Act. This type of phasing, however, does present some unique issues, including the following:

(a) Cross Easements. When portions of a building are added in phases, it is necessary to provide in the Declaration for various support and access easements so that, until all of the building is part of a condominium, the condominium association and the owner of the portion of the building which is not yet part of the condominium have the right to maintain the portions of the building which they are responsible for maintaining. Also, to the extent that the condominium property and the non-condominium property share a common wall or floor divider, the use and maintenance of the common wall or floor divider should be covered by what are commonly known as “party wall” covenants.

(b) Assessments/Reserves. If a project is phased, then only the owners of units which are part of the condominium property from time to time are obligated to pay assessments to the condominium association. The Condominium Act provides that each owner must pay his proportionate share of the common expenses for each unit owned. Until all proposed units in a phased building are made part of the condominium, the developer needs to determine how the budget for the condominium should be prepared and what level of assessments should be payable by owners of units. For example, in a high rise building which is being phased, it is unlikely that the roof will be made part of the condominium property until the last phase and, until the entire building is made part of the condominium, portions of the operating systems, such as elevators, heating, air conditioning, and hot water will be both within and outside of the condominium property. Also, because the building will only be partially occupied, the cost of certain services, such as maintenance of hallways, may be less because of the lower occupancy. On the other hand, certain overhead costs, such as the cost of a 24 hour doorman or security service, may not be affected by the level of occupancy.

There are basically two ways to deal with this issue. One approach is to reduce the budgeted expenses to reflect reduced costs because of the reduced occupancy. Another approach would be to levy assessments based on what is commonly referred to as a “Stabilized Budget”, which is a budget based on the assumption that all portions of the property which are intended to eventually become part of the condominium are part of the condominium and that all units are fully occupied and all services are being furnished. Under a Stabilized Budget approach, each owner of a unit which is part of the condominium from time to time, including the developer for units owned by the developer (whether or not they are occupied), will pay full assessments under the Stabilized Budget for each unit owned. Depending on the costs which are actually being incurred, the assessments payable with respect to the existing units may or may not be sufficient to pay the actual operating expenses of the condominium as it then exists. If the assessments levied to pay operating expenses are not sufficient to cover such expenses, the developer should consider subsidizing the shortfall. If the assessments levied to pay operating expenses exceed the operating expenses, the developer could reduce the budget to come closer to actual costs, thus reducing the assessments payable by all owners, including the developer. The benefit to the developer of phasing is that the developer will not be required to pay those portions of the assessments which are to be set aside and added to replacement reserves for a unit until the unit is added to the condominium.

B. Commercial Space. Many mid rise, high rise and Loft Conversion buildings contain commercial space, which is generally located on the ground level, and, sometimes, on the second and/or third levels. Commercial space can be made part of the condominium property as common elements, can be made into non-residential units or can be carved out of the condominium property. If the commercial space is made part of the common elements, then the Condominium Association would have control over how the commercial space is used and would apply any rent received with respect to the commercial space to pay common expenses. If the commercial space is made into one or more non-residential units, the commercial units can be used for non-residential purposes, would have a percentage interest and would pay assessments based on the percentage interest assigned to each commercial unit. The most significant difference between non-residential units and residential units would be the use restrictions. However, because the non-residential units are units within the condominium, they would be subject to rules and regulations adopted from time to time by the Condominium Association. One potential problem with making commercial space into units is that generally the commercial space represents a small amount of the space in the building, which means that its owner would not have much voting power. A board dominated by residential unit owners could pass rules and regulations or institute procedures which could make things difficult for the owners of the non-residential units and could adversely affect the marketability of these units. The third alternative, carving commercial space out of the condominium, is probably the better choice from the point of view of the developer. By carving the commercial space out of the condominium property, the commercial space would not be subject to rules and regulations adopted by the condominium association. The commercial space would not participate in the condominium association in that it would not have a percentage interest and, therefore, would not have any right to attend meetings or vote. Similarly, the commercial space would not be required to pay assessments based on a percentage interest. Instead, the Declaration should contain provisions which require the owner or owners of the commercial space to pay a designated share of certain expenses, such as maintenance of the roof, maintenance of the exterior of the building, and the cost of maintaining any common access areas, loading docks or other areas or systems which serve both the condominium property and the commercial space. Under this approach, the commercial space owners would not be required to pay a percentage interest of all costs which would include costs for services that the commercial space would never use, such as elevator maintenance or the cost of maintaining residential areas of the building. This should result in the commercial space owners paying substantially less for maintenance costs than they would pay if they owned commercial units. Since the commercial space will not become part of the condominium property unless the developer reserves the right to add commercial space to the condominium property at a later date, there will need to be included in the Declaration cross easements of support and access between the commercial space and the condominium property. Also, there will need to be party wall provisions dealing with the walls or floor dividers which separate the commercial space from the condominium property.

C. Parking. Most larger buildings have parking as part of the project. Because most larger buildings are located in areas where parking is at a premium, the developer generally sells parking spaces. There are several ways to approach parking. They include (i) creating each parking space as a separate condominium unit which is then sold and conveyed to a buyer, (ii) setting up each parking space as a limited common element which is then assigned to a unit, (iii) setting up the parking spaces as part of the general common elements which are then assigned to the owners by the condominium association board or (iv) creating a valet parking facility within the condominium whereby each owner of a unit who desires to park a car will purchase a parking right, which will be the right to park his car at any time and from time to time in the parking garage using the valet system.

Since a buyer who is asked to pay for parking will want to know that he will have a specific assigned parking space, the most commonly used approaches are to either create the parking spaces as condominium units or assign the parking spaces as limited common elements. The valet parking approach has been used in situations where it is possible to park a larger number of cars in the garage but, because of the way the garage is configured, the only way to be able to get cars in and out when they are needed is to set the garage up as a valet parking facility.

When a specific parking space is to be assigned to a unit, the typical choice is between parking spaces which are units and parking spaces which are limited common elements. If a parking space is set up as a unit, it will have a percentage interest assigned to it, which means that an assessment will be payable with respect to the unit, the unit will have a vote equal to its percentage interest and, in addition, because it is a condominium unit, a real estate tax bill will be issued with respect to the unit. If, on the other hand, a parking space is set up as a limited common element, it will not necessarily have a percentage interest assigned to it (although it could be required to pay a share of the cost of maintaining the garage), and it will not be issued a separate real estate tax bill (although the value of the parking space may be picked up and included in the real estate tax bill for the unit to which it is assigned). Lenders prefer that parking spaces be limited common elements because a limited common element parking space will automatically be covered by the mortgage on the unit to which it is assigned, whereas a parking space unit would have to be specifically made subject to the lender’s mortgage. Also, a limited common element parking space may only be assigned from one unit to the another, usually requiring mortgagee consent, whereas a parking space unit can be conveyed separate from a residential unit without the mortgagee’s consent, although to do so may be a default under the mortgage or a breach of the terms of the declaration.

IX. FEDERAL INTERSTATE LAND SALES FULL DISCLOSURE ACT ISSUES

The Federal Interstate Land Sales Full Disclosure Act (“ILSA”), 15 U.S.C. 1701, et seq., was passed by Congress in the late 1960s in response to scandals involving land developers who sold subdivided lots in places like Florida and Arizona who were unable, or never intended, to build the necessary infrastructure for the lots, thus rendering the lots virtually worthless. ILSA requires a developer to register a development in which the developer intends to sell lots or condominium units with the Department of Housing and Urban Development (“HUD”) and requires that a HUD approved “Property Report” in a form prescribed by HUD must be delivered to each prospective purchaser prior to the purchaser entering into a contract to purchase a lot or condominium unit. Although the intention of the ILSA is laudable, being essentially a consumer protection law, it is viewed by builders and developers as another unnecessary governmental regulation. The biggest problem with registering under ILSA is the time it takes (approval generally takes 8-10 weeks after a submission is made to HUD) and the tenor of the Property Report which contains bold type warnings prescribed by HUD which are intended to make a purchaser aware of the downside risks of buying a lot or condominium unit from the builder or developer with language is that often overstated and inappropriate for the circumstances. In addition, under ILSA the purchaser of a lot or unit which is registered with HUD must be given a seven (7) day right of rescission from the date on which the contract becomes effective. Although the process is cumbersome, most builders and developers will register a development with HUD if they have the time to do so.

For those builders and developers who do not have the time to register with HUD or who choose not to do so, there are several exemptions from the registration requirements which are available. There is an exemption for the sale of lots by one developer or builder to another, as long as the purchasing builder is not acting together with the selling builder or developer in what amounts to a “common promotional plan” under the applicable regulations. Another exemption relates to a project which has less than 100 lots or units, although this exemption is not available with respect to a phase which is a part of a larger development. The most commonly used exemption, especially for projects of more than 100 units, is what is commonly referred to as the “two year exemption”. Under this exemption, the sale of a lot or condominium unit is exempt from registration if the purchase agreement obligates the builder/seller to complete construction of a home on the lot (or a condominium unit) within two years after the purchase agreement is executed by the purchaser. In order to qualify for the exemption, the purchase agreement cannot limit the remedies of the purchaser in the event that the builder/seller violates its obligation to complete the home or unit within the two year period. The courts have interpreted this requirement to prohibit the builder/seller from limiting the purchaser’s right to seek specific performance or damages as a result of a breach of this obligation. If the purchase agreement does not contain the required provisions to qualify for an exemption, then the exemption is not available, regardless of how long it takes to complete construction of the home or unit. This exemption is the most commonly used exemption for builders of single family homes, townhomes, and low density condominium projects, particularly those in the suburbs, because in those situations it is relatively easy to deliver a home or condominium unit within two years after the date that the purchaser executes the purchase agreement. However, if the builder/seller decides to abort the project or change the development plan and needs to terminate purchase agreements, it may have a difficult time doing so because the purchaser is required to be given the right of specific performance and the builder/seller cannot simply take a position that they have defaulted and their only obligation would be to return the purchaser’s earnest money, which is what many purchase agreements that do not qualify for this exemption provide. The issues become more significant in the case of a high-rise condominium building. Often the builder/seller begins a sales program before construction begins and seeks to satisfy a presale requirement imposed by its construction lender before it can open its construction loan and begin construction of the building. High-rise buildings often take from 18 months to two years to construct. Depending on how long before construction begins purchase agreements entered into, the timing or a high-rise condominium building will make it difficult to qualify for the “two year” exemption. In these situations, the best approach, if the builder/seller has time, would be to register with HUD. However, as mentioned above, many builders do not have time to wait until their registration with HUD has been completed and, as a result, attempt to qualify unit sales for the two year exemption. The regulations permit delay in completion of the unit for causes which would excuse performance under local law. Thus, a builder may have some leeway if the builder is unable to complete construction due to things like material shortages, labor disputes, war, or other causes that fall within the category of “force majeure”.

If a particular transaction does not qualify for an exemption and is not registered with HUD, the builder/seller may be subject to private, administrative and criminal sanctions, including the right to rescind the contract, injunctive relief, fines of up to $10,000 or five years in prison. 15 U.S.C. 1717 and 1717(a).

There are benefits to registering with HUD. There is no limit on the time for completing a home unit after the purchaser signs the purchase agreement. Thus, for instance, in a high-rise condominium project which is registered with HUD, the builder/seller can agree to deliver units three or four years after the date of the contract without violating the ILSA. Also, once a development is registered with HUD, the home purchase agreement can limit the remedies of the buyer in the event of a default by the seller. Generally, the purchase agreement limits the remedies of the buyer to a return of the earnest money or a return of the earnest money plus interest or liquidated damages of a modest amount. Also, under HUD regulations, the purchase agreement must provide that if the purchaser defaults under the purchase agreement, the seller can retain as damages up to the greater of (i) 15% of the purchase price or (ii) the actual damages incurred by the seller.

X. REPRESENTING THE DEVELOPMENT PLAN TO THE PUBLIC

A. In General

In a planned development, the developer may find it necessary to change the development plan as required by market conditions. To preserve and maintain maximum flexibility, it is important that the developer not make representations to purchasers or prospective purchasers that would limit this flexibility. Arguably, covenants, restrictions, and easements that bind the real estate and/or contract rights that bind the developer may be created from representations made by the developer or its agents in sales brochures, maps, scale models, newspaper advertisements, and oral statements. Although there are few reported cases directly on point, it appears that the courts are prepared to hold developers to representations made in their sales efforts. See Siegel v. Levy 0rganization Development Co. , 153 111. 2d 534, 607 N. E. 2d 194, 180 Ill. Dec. 300 (1992); Jan Z. Kransnowiecki, Townhouses with Home Associations: A New Perspective, 123 U. Pa. L. Rev. 711 (1975).

B. Unit Owner Lawsuit

A developer who has made representations to the public that the PUD will be built according to a particular plan and who later either changes or abandons the plan may be faced with a lawsuit by disappointed unit owners. A lawsuit may include actions for an implied contract based on representations made, an implied covenant running with the land owned by the developer, misrepresentation, or fraud. Among possible remedies, an owner could seek injunctive relief, monetary awards for damages, or rescission of the purchase contract of the unit.

C. Suggested Precautions

To avoid the possibility of a lawsuit, the developer should make no representations concerning the development plan without coupling the representation with a clear disclaimer. Salespeople must be cautioned to speak in terms of what the developer ‘currently’ plans to build and to add that the development plan is subject to change because of market conditions and that the purchaser cannot expect the developer to complete the PUD as “currently planned”. In addition, if in marketing units the developer uses a scale model or pictorial representation of the PUD as planned, a clear and unambiguous statement should be included that there is no obligation on the part of the developer to complete the PUD as shown.

XI. SECONDARY MORTGAGE MARKET

At several points in this paper, reference is made to the requirements of the secondary mortgage market and how it influences the formulation of the development plan. A brief description of the secondary mortgage market and its requirements follows.

The secondary mortgage market is a shifting complex of governmental and quasi governmental agencies and entities as well as institutional investors. Currently, the major investors in the secondary mortgage market are the Federal National Mortgage Association (FANNIE MAE), a federally chartered, publicly held corporation; the Federal Home Loan Mortgage Corporation (“FHLMC”), a federally chartered corporation whose shareholders are member banks of the Federal Home Loan Bank Board; and various mortgage banking operations, insurance company pension funds, and other institutional investors that buy and sell home mortgages or securities backed by pools of home mortgages.

Lenders have generally regarded loans on units in condominiums and PUDs to be more risky, if not simply more trouble, than loans on detached, single-family homes that are not part of a condominium or PUD. One way to maximize the availability of end loan financing is to conform the condominium or PUD documentation to the requirements of the secondary mortgage market. This enables the end lender to sell the mortgage loans it originates rather than to hold them in its portfolio or to shift some of the risk of the loans to entities who insure or guarantee loans.

Generally, investors in the secondary mortgage market purchase only mortgages that satisfy certain specific requirements. Since home ownership is a goal that the federal government actively supports and encourages, a number of federal or federally related programs have been developed to encourage the purchase of home mortgages by investors:

a. The Federal Housing Administration (FHA), a part of the Department of Housing and Urban Development, insures home loans that satisfy its requirements. An investor is encouraged to purchase FHA-insured home loans or securities backed by a pool of loans that includes FHA-insured loans because if an FHA-insured loan goes into default, it can be assigned to FHA in return for cash or debentures of the federal government, thus substantially reducing the investor’s risk. Currently, FHA will insure long-term fixed-rate mortgages as well as mortgages commonly known as graduated payment mortgages (GPMs), certain adjustable-rate mortgages (ARMs), shared-appreciation mortgages (SAMs), and growing-equity mortgages (GEMs) on lots in a PUD and condominium units.

b. The Department of Veterans Affairs (VA) is a federal agency that guarantees a substantial portion of a home loan to a veteran who satisfies its requirements. An investor is encouraged to purchase VA-guaranteed loans or securities backed by a pool of loans that includes VA-guaranteed loans because if a VA-guaranteed loan goes into default, the VA will stand behind its guaranty and in many cases will purchase a defaulted loan for cash. The VA will guarantee loans secured by lots in a PUD and condominium units. The VA does not guarantee co-op share loans.

c. FHLMC is an investor which purchases conventional loans (other than those that are FHA insured or VA guaranteed) that satisfy its requirements. FHLMC purchases loans from savings and loan associations, banks, and certain mortgage bankers. FHLMC will purchase long-term fixed-rate loans, GEMS, and various ARMS on lots in a PUD and condominium units. FHLMC does not purchase co-op share loans.

d. FANNIE MAE is an investor that purchases from qualified sellers/servicers FHA-insured loans, VA-guaranteed loans, and conventional loans that satisfy its own requirements. Conventional loans purchased by FANNIE MAE include long-term fixed-rate loans, GEMS, and various ARMS. FANNIE MAE will purchase loans secured by lots in a PUD and condominium units. FANNIE MAE will also purchase co-op share loans.

The FHA, VA, FANNIE MAE, and FHLMC all have requirements that must be satisfied before they will insure, guarantee, or purchase a loan, as the case may be. There is a certain amount of reciprocity between investors in the secondary mortgage market. For instance, except for certain condominium conversion projects, FHA will automatically approve a condominium or PUD that has been approved by the VA.

It is possible to draft a set of condominium or PUD documents that satisfies the legal requirements of FHA, VA, FANNIE MAE, and FHLMC. Although FHA, VA, FANNIE MAE, and FHLMC have not yet arrived at a uniform set of standards for condominium and PUD projects, there are a number of basic issues that concern them all, including the following:

Workability. The documentation must establish a workable project and, in particular, must clearly set forth responsibility for maintaining all portions of the project. The documentation must provide a logical and workable means of allocating expenses incurred by the association and of collecting assessments from unit owners.

Budgeting. The budgeting procedure must be clear, and the budget must include adequate reserves for the replacement and major repair of the common areas of the project.

Assessments. Assessments must be mandatory, and nonpayment of an assessment must result in a lien against the defaulting owner’s unit.

Priority of Mortgage Lien. With only a few exceptions, the lien of the holder of a first mortgage on a unit must have priority over the association’s lien for unpaid assessments.

Developer’s Reserved Rights. The reserved rights of the developer must be reasonable and must relate to the legitimate interests of the developer in constructing the project and selling the units. A long-term recreational facility lease is generally not acceptable to the secondary mortgage market. Also, a long-term management agreement or any contract that appears to involve self-dealing by the developer will be closely scrutinized. The developer will not be permitted to retain control of the association beyond a reasonable period of time, which is generally not later than when 75 percent of the units have been sold or five (and in some cases seven) years after the declaration is first recorded, whichever comes first.

Add-On Rights. If the developer reserves the right to add additional property to a residential association, the improvements on the added property should be of the same style, construction, and quality as the property currently being administered by the association. This requirement is intended to ensure that the maintenance costs of all units will be similar and that no one unit owner will be required to subsidize the cost of maintaining other units that may require a greater amount of maintenance than his unit. Also, the developer may have to limit its power to add property to the condominium or PUD to a reasonable period of time, which may vary depending on the character and size of the project.

Right of First Refusal. A right of first refusal in favor of the association upon the sale of a unit is generally not acceptable to the secondary mortgage market, although there are exceptions to this requirement.

Amenities. The amenities of a project, such as recreational facilities, must not be a financial burden to the existing units in the project. If the project documentation permits later annexation of additional property and if the exiting units cannot support the amenities, then a secondary mortgage market entity may approve the project but require the developer to post adequate security to guarantee that the cost of maintaining the amenities will be paid until a sufficient number of units exist.

Presale Requirement. Generally between 51 percent and 70 percent of the units in a project must be under contract for sale before a mortgage on a unit will qualify for insurance or guarantee by or sale to an entity in the secondary mortgage market. The harsh effect of the presale requirement may be mitigated by breaking a large project into phases. Also, if the project is an add-on project, the presale requirement may be applied on a cumulative basis as phases are added to the project.

Owner Occupancy Requirements. The secondary mortgage market will not approve a project if too many units are owned by nonresidents or investors. Generally, if more than 20 percent to 25 percent of the units are owned by nonresidents, the secondary mortgage market entities will not insure, guarantee, or purchase loans in the project.

Although unit loans secured by lots in PUDs and condominium units are widely traded in the secondary mortgage market, loans secured by the shares of a co-op unit owner in his co-op association have not yet gained wide acceptance in the secondary mortgage market. FANNIE MAE has a program under which it will purchase loans made by lenders to owners of co-op units that are secured by a pledge of the owner’s stock in a cooperative association and his leasehold interest in the unit. In addition, FHA will insure loans secured by a pledge of a co-op unit owner’s stock in his cooperative association.

The foregoing briefly outlines some of the major issues with which the secondary mortgage market is concerned. To obtain project approval of a PUD from a particular entity, it will be necessary to compare the documentation for the PUD to the legal requirements of that entity.

XII. CONCLUSION

A developer who considers the issues raised in this chapter should be able to formulate a development plan that will create a workable PUD and to exercise the type of control and flexibility necessary to ensure the success of the PUD under continually changing market conditions.


Copyright © 2006 by Brian Meltzer
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