The purpose of this paper is to lay out a suggested procedure for a condominium association which desires to sell its building for de-conversion to do so in an orderly manner that will maximize the distributions to the unit owners and minimize the amount of time, effort, and conflict required to consummate the transaction.
A. Background/De-Conversion Phenomena.
Condominiums were first authorized in Illinois in 1963 when the Illinois Condominium Property Act (the “Act”) was adopted. In the 50+ years since then, the condominium form of ownership has become the dominant form of owner/occupant home ownership of units in multifamily buildings in the Chicago area.
The housing market crash which led to the Great Recession (the “Crash”) put enormous stress on the housing market in general and the condominium form of ownership in particular. Issues unique to condominiums which were exposed by the Crash include the following:
- Presale requirements, restrictions on the percentage of units that could be owned by investors, limits on the number of delinquencies and other restrictions that lenders applied to condominium projects, made it much more difficult to obtain a mortgage on a condominium unit than on a single family home or a non-condominium townhome unit.
- The rise in assessment delinquencies created serious financial issues for condominiums and their non-delinquent unit owners. Lenders required that condominium declarations make the lien for unpaid assessments subordinate to the lien of the first mortgage on the unit. When the first mortgage on a unit was foreclosed, the foreclosure sale would result in the extinguishment of the lien for unpaid assessments, depriving the association of much needed income. Non-delinquent owners were faced with rising assessments and/or special assessments to cover the shortfalls created by delinquencies and extinguished assessment liens.
- Many condominiums were unwilling or unable to accumulate sufficient reserves for major repairs or replacements when needed, resulting in the association borrowing and/or levying a special assessment to pay for needed work. In the absence of a source of funds for repairs, many condominium associations chose to defer necessary repair work, resulting in the deterioration of the property, and a decline in unit values, making it difficult for owners to sell or refinance their units.
- Restrictions or prohibitions on leasing of condominium units made it difficult for an owner no longer in occupancy of the owner’s unit to rent the unit to generate income to help pay the unit’s ownership costs until the unit could be sold.
- Large numbers of potential home buyers were shut out of the housing market because of damaged credit or large student loans. Many people who could afford to buy and who could qualify for a mortgage chose to rent rather than buy in order to keep their options open and not risk a potential diminution in, or loss of, their equity in the event of a decline in housing values. Alternatively, they were concerned that they might be stuck owning a unit they no longer were able or desired to live in. In addition, many millennials delayed marriage and family formation, and the need or desire to purchase a home. As a result, homeownership in the United States significantly declined.
As the demand for owner/occupant condominium units declined, demand for rental apartments increased, as did rental rates. As a result, demand for rental buildings which could be leased for moderate rents increased.
In recent years, investors began to look to condominiums as a source of rental units. At first, investors went after low hanging fruit in the form of recently constructed or converted condominium buildings which had stalled or failed due to lack of sales. The investor would acquire a significant percentage of the units in a troubled building from the failing developer or the lender which had repossessed the units and then would, over time, acquire the balance of the units through short sales or foreclosure sales until it owned all of the units and was able to withdraw the condominium from the terms of the Act and make it into a single owner apartment building.
As the availability of failed condominium projects decreased, investors began to focus on condominiums in which no single party owned a significant percentage of the units. However, investors found that acquiring all of the units in a condominium with multiple unit owners was much more difficult than buying the bulk of the units in one transaction and picking up the stragglers one at a time. Investors began to approach condominiums which were candidates for de-conversion—well located buildings with studio, one or two bedroom units, which were experiencing some of the problems referred to above—with an offer to buy the entire building. Investors learned, often the hard way, that acquiring a condominium building for de-conversion in Illinois is problematic, especially when there are multiple unit owners, a significant number of owner/occupants, and/or underwater mortgages.
B. Statutory Basis.
There is only one way to voluntarily de-convert a condominium in Illinois: 100% of the unit owners and 100% of the holders of liens on units must consent to do so under Section 16 of the Act. Where there are multiple owners of units, the most common way to de-convert is for one buyer to acquire 100% of the units pursuant to Section 15 of the Act, which provides for the sale of 100% of the units upon the affirmative vote of owners owning not less than 75% of the percentage interests in the condominium. Upon such a vote, each unit owner, even those who did not vote in favor of the sale, are obligated to “deliver such instruments and to perform all acts as in manner and form may be necessary to effect such sale.” Once a buyer acquires title to 100% of the units, it can terminate the condominium by withdrawing the condominium from the Act.
Although Sections 15 and 16 are brief and relatively straight-forward, the implementation of a sale/de-conversion is not easy, especially where there are owners who do not desire to sell, owners who will not co-operate with the sale, issues concerning the ownership of units, the relative values of the units do not correspond to the percentage interests, and there are liens on units which exceed the value of the units, i.e. the units are “underwater”. The presence of one or more of these issues can scuttle a proposed sale or complicate and extend the process to the point where a prospective buyer may be deterred from pursuing the sale or will need to reduce the purchase price to compensate for the time and effort required to negotiate and consummate the transaction.
The recommended plan of action for a condominium which is a candidate for sale/de-conversion is for the association to first deal with and resolve as many of the anticipated issues as possible and then offer the building for sale pursuant to a request for proposals or “RFP” which lays out the terms and conditions of the sale and only requires the prospective buyer to make a proposal based on price. It may take some time to resolve the issues and it may turn out that one or more significant issues cannot be effectively be resolved, in which case it may not be possible to sell the building. However, if the association can resolve as many of the significant issues as possible up front, it would be in a position to offer a “turnkey” sale which would maximize the sale price and the return to the owners.
C. Identify the Issues.
Following is a discussion of some of the issues which may need to be resolved by an association which is considering selling itself.
1. Basic Information. The first step is for the association to gather some basic information about the condominium, including the following:
- Information on units being leased, including, rent term, renewal options, security deposits and whether there are any delinquencies or defaults or alleged defaults by the tenant or any complaints or claims by the tenant;
- Copies of all contracts between the association and third parties and any permits and licenses held by the association;
- A copy of the recorded declaration and condominium plat;
- A current commitment for title insurance with respect to all units and copies of all documents listed in Schedule B;
- To the extent possible, the purchase price paid for each unit and the cost of significant rehab work done on the unit;
- The amount outstanding on mortgage liens and other liens with respect to each unit;
- The real estate taxes levied with respect to each unit and the status of any efforts to obtain reductions in the taxes;
- A current report showing the status of assessment payments from each unit owner, any delinquencies and the status of any collection efforts;
- Balance sheets and financial statements for the association for the last two fiscal years;
- An inspection of the building and all units to determine what work will be required immediately and the remaining useful life and the cost to replace systems and facilities within the building, such as heating, HVAC, roofing, windows, building exteriors, plumbing, electrical, etc.; and
- Information concerning any litigation, disputes or issues between the association and a third party or between the association and a unit owner or between unit owners of which the association is aware.
It is recommended that the association accumulate the above information for three reasons: first, to permit the board to make a determination of what a buyer should be willing to pay for the building; second, to assist the board in determining how the Net Sale Proceeds (defined below) should be allocated in order to maximize the vote in favor of the sale; and third, because any prospective buyer will need to review the some of the information during its “due diligence” period.
2. Allocation of Sale Proceeds.
Although it is generally assumed that the default formula for allocating the net proceeds of a sale is by applying the percentage interests to the purchase price, Section 15 does not require that percentage interests or any other formula be used to allocate the proceeds of sale among the unit owners. Agreeing on how the net proceeds of the sale will be distributed is a significant issue. If it cannot be resolved, there may be no point in continuing to pursue a sale unless a potential buyer is willing to underwrite the cost of what could be a long, drawn out and costly process.
In order to attain the 75% vote and secure the cooperation of 100% of the owners will require an approach which will seem fair, or at least reasonable, enough to get as many of the owners as possible to support the approach in order to permit the sale to occur in a timely manner. There may not be a simple formulaic solution to allocating the sale proceeds. For instance, owners may have different investments in comparable units (purchase price and/or cost of rehab or upgrades) and/or different amounts of mortgage or other liens on the units. Also, owners will often have conflicting views on the relative values of their units. With respect to those units which are underwater, it may be necessary to negotiate with the lender to accept less than the outstanding debt or else allocate enough proceeds to the unit to pay off the debt.
3. Rights of Objecting Owners.
Section 15 provides that an owner who does not vote in favor of a sale and files a written objection to the sale is entitled to receive from the “proceeds of sale” an amount equivalent to greater of (i) the “value” of the owner’s unit, as determined by a “fair appraisal” or (ii) the “outstanding balance of any bona fide debt secured by the objecting owner’s interest” (i.e., an “underwater mortgage”). In addition, a dissenting owner would be entitled to be paid “reasonable relocation costs” determined with reference to a federal relocation assistance act.
Section 15 gives no guidance of on what basis “value” is to be determined. There appears to be at least three possible ways to approach a determination of value: (a) as an owner/occupant unit in a functioning condominium; (b) as a rental unit in a functioning condominium; or (c) as a rental unit in a non-condominium apartment building. Except for an owner who would benefit from the “underwater mortgage” provision referred to above, a dissenting owner would need to be confident that the appraisal process would result in a “value” for the unit which is higher than the portion of the sale proceeds allocated to the unit, lest the owner end up with a reduced share of the sale proceeds.
4. Dealing with Owner/Occupant Issues
There may be owner/occupants who desire to remain in their unit as tenants after the sale/de-conversion. If the expectation is that the building will be de-converted into a conventional rental building, the terms of sale could require the buyer to permit former owner/occupants to remain as tenants, either short term or long term, in order to obtain the owner/occupants’ consent to the sale. Alternatively, a portion of the proceeds of the sale could be set aside to assist former owner/occupants to relocate regardless of whether the owner becomes an objecting owner.
5. Difficulty Identifying or Contacting Owners.
There could be deceased or incapacitated owners or unresponsive owners, such as lenders who have taken title through foreclosure or foreclosures in process. The association will need to identify and resolve these issues before it can deliver clear title to all of the units. The first step would be to obtain a current commitment for title insurance to determine the identity of each unit owner.
Since each unit receives its own real estate tax bill, the real estate tax prorations need to be done unit by unit. This is an issue which can be dealt with in the Sale Plan described below and implemented in the closing escrow. The same applies to any other prorations, such as rent on units which are being leased.
D. Preparing for the Sale.
If the issues described above, as well as other issues which arise, can be effectively dealt with, it is recommended that the association present to the owners, at one or more informational meetings, the terms on which the building would be sold and how the proceeds of sale would be distributed, along with a proposed form of sale agreement which will be used to effectuate the transaction with the selected buyer (the “Sale Plan”).
Since under Section 18 of the Act and at common law, the board has a fiduciary duty to the owners, the board must be careful to provide transparency and full disclosure of all relevant facts surrounding the proposed sale to the owners so that when a vote on the proposed sale is held, each owner can make an informed decision as to whether he or she will vote in favor of the proposed sale and, if not, if the owner will file an objection to the sale and go through the appraisal procedure provided for in Section 15.
It is suggested that the Sale Plan state the minimum net sales proceeds which the association will require after all costs, fees and transfer taxes have been paid (“Minimum Net Proceeds”) and, correspondingly, the minimum amount of money that each owner will receive for the owner’s unit when the sale is completed, plus or minus prorations. The Sale Plan should also include provisions for how any excess proceeds over the Minimum Net Proceeds will be distributed and how any reserves being held by the association will be used or distributed. The excess over the Minimum Net Proceeds could be distributed in any number of ways, but two logical approaches would be (i) prorata based on the allocation of the Minimum Net Proceeds (which may or may not be based on percentage interests) or (ii) by percentage interests. Since the reserves were built up from assessments based on percentage interests, any reserves remaining after the transaction is completed should be distributed based on percentage interests. Alternatively, the Sale Plan could provide that the reserves will become the property of the buyer after the sale, which could support a higher Minimum Net Proceeds requirement.
When the board believes that has reached a consensus, or at least enough support from the owners, to justify going forward, the association should prepare a request for proposals (“RFP”) which will lay out the terms of the Sale Plan.
E. Find a Buyer.
The RFP would be sent to prospective buyers who have expressed an interest in buying the building and/or disseminated by a broker. Once a qualified buyer is obtained and a formal contract negotiated and executed, the final, executed contract and the Sale Plan would be submitted to the owners for a vote to approve the contract under Section 15 of the Act and to approve the allocation of proceeds as provided in the Sale Plan.
F. Preparing for Closing.
The buyer will want to acquire all units free of liens at one time. The best way to accomplish this would be for the association and the buyer to set up a closing escrow into which each owner will be required to deposit a deed to their unit, a payoff letter or release from their lender, if any, and any other lien holders and any other closing documents required under the sale contract or by the title insurance company. In anticipation of closing and in order to expedite the process, the association may want to begin collecting closing documents from owners as soon as the sale has been approved, even before all the conditions to closing have been satisfied, and deposit them in the closing escrow. When the conditions have been satisfied, all owners’ deposits are in the escrow and the buyer’s money is in the escrow, the transaction would close and the condominium would be de-converted by the withdrawal of the property from the Act and the condominium declaration.
G. Liquidate Association and Distribute Funds.
After the closing, the net proceeds of the sale would be distributed per the Sale Plan. The balance of the funds held by the association, including reserves (if not turned over to the buyer), should, after all expenses are paid and delinquent assessments are collected or deducted, be distributed based on the percentage interests. After all funds have been distributed the association would be terminated.
A condominium association which desires to sell its building needs to spend some time, effort and money to prepare itself for sale. Following the procedure suggested above will help facilitate a sale and maximize the return to the owners, while minimizing conflicts and delays.
Brian Meltzer, November 2018