January 4, 2021

“Condolike Conversions” Coming to a Mall Near You

Introduction/Background

Shopping centers and malls (collectively referred to herein as “Malls” or individually as a “Mall”) throughout the country were dealing with the effects of changing consumer buying habits due to the rise of online shopping, which was accelerated by the Corona virus. Big box retailers have been closing stores and filing for bankruptcy in growing numbers. Small retailers have been closing shops. Mall owners and operators don’t expect this trend to subside even after the virus is no longer a threat. Even before the virus hit, changes were being made to Malls and other and other large commercial projects. The Macy’s in Northbrook Court was torn down and replaced with an apartment project; the Sears in Hawthorn Mall (Vernon Hills) will be replaced with apartments and small retail spaces; the Bannockburn Green shopping center was set up so buildings could be sold off to investors or owner/users; half of a Regal Cinema multiplex in Lincolnshire was torn down and replaced with an apartment project, to name a few. Large older buildings are being repurposed. The old post office building near downtown Chicago was turned into a commercial center. The million + square foot old Marshall Field warehouse on the north side of Chicago was converted to multiple uses, including offices, apartments, a grocery store, restaurants, and other commercial uses. Many owners of Malls are considering adding residential projects (rental or owner occupant) to the Mall to replace existing buildings in, or adjacent to, the Mall or on the large parking area that typically surrounds a large Mall.

Many Malls are owned by one entity; however, in larger Malls, often the big box stores which surround the base mall are owned by national retailers, like Macy’s, Penney, Sear’s, etc. Many of the larger Malls were built in the 1970s or earlier. Malls with multiple owners needed legal documentation to grant necessary easements and provide for the construction and operation of the Mall.

The development of large Malls predated or occurred around same time the introduction of the condominium concept in the United States in the 1960s. Although the progression of the condominium/homeowner association (“HOA”) concept, the governing statutory basis, documentation, and case law has evolved and become more sophisticated over the years as HOAs became more widely used and accepted, the same has generally not been the case with large Malls. For example, although the central structure of most large Malls was owned by a single entity, many Malls had multiple owners of big box buildings adjacent to the central structure or on an outlot. The basic documentation for Malls with multiple owners has not changed much over the years due to inertia or because the documentation did not include a meaningful mechanism for amendment. During the heyday of condominium development and conversions, from the 1970s until the Crash, many newly constructed urban buildings had a mix of residential condominium units, apartments, hotels, office, retail and/or other commercial uses that required separate ownership, such as in the Hancock Building and Water Tower Place or smaller buildings with residential condominiums or apartments on the upper floors and retail space on the ground floor. The methodology for dividing ownership of portions of a large commercial or mixed use development into separately owned parcels based on use and providing for the allocation of responsibility for maintenance of the parcels and a sharing of the costs of maintenance, has evolved over the years in the residential/mixed use arena and, we believe, can effectively be applied to new or existing Malls.

In the 1960s residential condominium conversions took off, leading to a phenomenon in the 1970s which was dubbed “Condomania.” Many longtime renters were forced to decide between buying the apartment that they had rented for years, often decades, or having the apartment sold out from under them and being required to move out. In the early years of conversions, the monthly cost to own a unit (including mortgage payments, real estate taxes, and assessments) was often less than the monthly rent on a comparable unit. Longtime renters who were faced with the “buy or move out” option found the economics to be favorable. But condominium was a new concept; people did not understand it and initially were wary of buying condominium units. As time passed and the condominium concept became better understood and accepted, the prices for condominium units increased to the point where the monthly cost to own a unit approximated, and then exceeded, the monthly rent for the same or a comparable unit. At first, converters compared the after-income tax monthly cost to own a unit to monthly rent, by taking into account the deductions then available for real estate taxes and mortgage interest. When Condomania was in full swing, the cost to own a unit far exceeded the cost to rent, even after accounting for income tax savings, yet condominium units continued to sell. For a converter, converting an apartment building to condominium resulted in the sum of the value of the parts far exceeding the cost of acquisition and conversion. For several years, condominium converters were outbidding investors for apartment buildings.

The situation for Malls is different than what is was for apartment buildings in the late 1960s and 1970s, but the conditions are such that it could lead to the same result, namely the sale of buildings or portions of buildings in central Malls or surrounding outlots (“Parcels”) to owner/users or investors (a “Mall Conversion”). Several factors are at work:

  • Rental delinquencies are rising, vacancies are increasing, and the value of Malls is declining, sometimes at an alarming speed.
  • Defaults on mortgages and foreclosures are increasing and lenders are reluctant to make new loans on struggling Malls.
  • As usage of the space changes from big box stores and retail outlets to residential (apartments or condominiums) use and other uses not historically found in a Mall, the Mall becomes more difficult to manage and maintain. Mall owners are generally not familiar with owning or operating a residential project. The ability to separate the ownership of a residential project from the balance of the Mall would facilitate the sale of the residential project to an investor or condominium converter that would not be interested in buying the entire Mall. Condominium conversions would necessitate a division of ownership of converted residential project, something that older documentation was not drafted to facilitate.
  • Covid has created tension between Mall owners and tenants concerning rent reductions, change of use, and the right to sublease the space or assign the lease.
  • Having a Parcel owned by an individual owner/user or investor, with a separate real estate tax bill, would permit the owner to (i) finance the Parcel as it best suits the owner, and (ii) have control over their Parcel’s real estate tax valuation and assessment. These two factors are what historically differentiated condominiums from co-operative housing projects and played a major role in the rise of the popularity of condominium ownership.
  • Separate ownership of Parcels, especially restaurants and other uses requiring expensive buildouts, will permit the owners to finance the buildout with an acquisition mortgage and eliminate the tension over costly “tenant improvements” and a tenant’s concern about a lease not being renewed or the rent being substantially increased at the end of the term. This is an especially significant issue for an owners whose Parcel’s location is an important element of the value of the business, like a restaurant or doctor’s office. These issues are very similar to the issues that motivated many renters to buy condominium units.
  • Tenants in Malls generally do not have the concern which many tenants in office buildings have about potential expansion or contraction that would discourage the office tenant from buying its space.

Relevant Statutes/Ordinances
Since the 1960s, the statutory structure that governs condominiums as well as mixed use/mixed ownership developments has also evolved. A review of the statutes that may affect the legal structure and governance of Mall Conversions in Illinois would help to better understand how the governing documents could be drafted to give a Mall’s owner the ability (i) to maximize the return on the sale of the Parcels, (ii) greatly expand the pool of potential Parcel buyers to include owner/users or investors interested in owning a particular type of Parcel, as opposed to the entire Mall, and (iii) provide a mechanism for effectively maintaining the Mall and allocating the costs of maintenance.

Illinois Condominium Property Act
Illinois adopted the Condominium Property Act, 765 ILCS 605/1, et seq., in 1963 (“Illinois Condominium Property Act”). It is what is referred to as a first-generation condominium enabling statute. Many states updated and upgraded their condominium acts with second and third generation acts, but Illinois did not. Instead, Illinois made multiple amendments to the original Illinois Condominium Property Act, resulting, in our opinion, with a piecemeal statute that works, in the sense that it permits condominiums to be created, but does not adequately address many issues which have arisen and evolved over the years. Although condominium acts, including the Illinois Condominium Property Act, were initially intended to facilitate residential condominiums, most acts, including Illinois’s, permit commercial and mixed-use condominiums. However, the Illinois Condominium Property Act includes consumer-oriented provisions which tend to discourage a condominium conversion of a commercial property.

Chicago Condominium Ordinance
In 1978, at the height of Condomania, the City of Chicago adopted the Chicago Condominium Ordinance, Chicago Municipal Code §13-72-010, et seq. Unlike ordinances or laws adopted in other jurisdictions, the Chicago ordinance was a disclosure ordinance, but it also includes consumer-oriented provisions which do not translate well to a commercial conversion. Several Chicago suburbs followed the lead of Chicago and adopted similar ordinances.

Illinois Common Interest Community Association Act
Even before the condominium concept was introduced in the United States, it was not uncommon for subdivisions to be made subject to restrictive covenants. Many of these subdivisions were governed by declarations of covenants, conditions, restrictions, and easements, and some of these declarations provided that the subdivision be administered by an association of the owners of the lots in the subdivision, especially where the subdivision included common areas that needed to be owned and maintained by an association. This type of community came to be known as a common interest community (“CIC”). A CIC could be either a condominium or a non-condominium community. In Illinois, until 2010, when the Common Interest Community Association Act (“CICAA”), 765 ILCS 160/1-1, et seq., was adopted, non-condominium CICs were governed by common-law declarations with limited statutory regulation. The CICAA incorporates many of the flawed provisions and concepts that are in the Illinois Condominium Property Act (even some that did not translate to non-condominium projects) and added new and different flawed provisions.

For property to be made subject to the Illinois Condominium Property Act, the owner of the property must affirmatively make the property subject to the Illinois Condominium Property Act. By contrast, the CICAA is not intended to operate in the same manner as the Condominium Property Act. The CICAA attempts to cover all non-condominium and noncooperative developments, regardless of the intentions of the owner of the development. As will be discussed more fully below, there are significant reasons why the owner of a Mall will not want the Mall to become subject to the CICAA, and there are ways to accomplish this result.

Condominium vs Non-Condominium/REA
In order to convey Parcels in a Mall to multiple owners, the Mall needs to be made subject to a condominium declaration or subdivided or otherwise set up for the conveyance of Parcels by way of a subdivision (possibly a vertical subdivision) or through an exemption from applicable plat acts and made subject to a non-condominium declaration (commonly referred to in the commercial arena as a “REA”). For several reasons, including the following, we recommend that, unless it cannot be avoided, the condominium form of ownership should not be used:

  • An incorporated not-for-profit corporation or unincorporated association must be created to operate a condominium property through a board of directors consisting of individuals. At least quarterly board meetings must be held and must be open to all owners. Management of a residential condominium by a Board, often consisting of laymen with little or no experience in managing real estate, is challenging, at best, but it doesn’t work well in a commercial project
  • Turnover of control of the association to the owners is required to occur no more than 3 years after the condominium declaration is recorded, often resulting in the election of owners of units to serve on the Board before the project has been completed and ready to be turned over to the owners.
  • Most expenses of operating the association are required to be allocated based on the percentage of ownership interests in the common elements held by each unit owner, which percentage interests must be allocated based on “value”, that may not align with the benefit received. More flexibility is needed in a Mall.

An alternative to condominium would be to have a property owners association governed by a Declaration similar in legal structure to a homeowners’ association. Unfortunately, an association which is governed by the CICAA would have many of the same drawbacks as a condominium association, especially the turnover timing issue.

The preferred approach, which we recommend, is to not have an association. The Mall would be made subject to an REA. The REA would reserve to an entity defined in the REA as the “Administrative Entity”, which would generally initially be the Declarant under the REA or a related entity, a number of rights and powers with respect to the management and operation of the Mall. The Administrative Entity would act in place of a Property Owners’ Association (“POA”), thus avoiding the drawbacks under the Condominium Property Act or the CICAA mentioned above.

We suggest that the REA have the following basic structure:

  1. The entire Mall would be made subject to an REA which will divide the Mall into various Parcels, with each Parcel being designated either as a “Contributing Parcel” or a “Non-Contributing Parcel”. A Contributing Parcel would be a parcel which has improvements which are used for commercial or residential purposes, such as rental apartments, offices, and retail. A Non-Contributing Parcels would be a parcel that is essentially common area which serves one or more Contributing Parcels.
  2. The REA would (i) provide for the maintenance, repair, replacement and operation of certain portions of the Mall by allocating responsibility for the furnishing of certain services with respect to such portions of the Mall to what will be defined therein as “Maintenance Providers”, and (ii) establish a mechanism for allocating the cost of furnishing such services among the Contributing Parcels. A Maintenance Provider could be the Declarant, a Contributing Parcel owner, a POA or a third party. Initially the Administrative Entity would hold all Maintenance Provider rights and powers and would have the right to retain some or all of the powers and/or assign them to Contributing Parcel owners, a POA, or a third party.
  3. The Maintenance Providers will be responsible for furnishing what will be defined as “Property Wide Maintenance and Services”, which will generally consist of maintenance, repair and replacement of portions of the Mall which serve all of the Contributing Parcels, as well as providing services which benefit all of the Contributing Parcels. Each Contributing Parcel owner will pay to the applicable Maintenance Provider a share of the cost of furnishing the Property Wide Maintenance and Services as set forth in the REA.
  4. The Maintenance Providers will also be responsible for furnishing what will be defined as “Limited Shared Area Maintenance and Services”, which generally consist of maintenance, repair and replacement of portions of the Mall which serve less than all of the Contributing Parcels, as well as services which benefit less than all of the Contributing Parcels. Each Contributing Parcel owner will be responsible for paying to the applicable Maintenance Provider a share of the cost of Limited Shared Area Maintenance and Services which benefit the owner’s Parcel. In each Mall, there will likely be certain Limited Shared Areas that serve less than all the Contributing Parcels, possibly only one Contributing Parcel. Examples include the roof and certain operating systems of a building that consists of more than one Contributing Parcel. In that situation, the owner of one of the Contributing Parcels could be designated as the Maintenance Provider for the systems in question, with the owners of the other Contributing Parcels in the building paying a share of the costs.
  5. A Contributing Parcel may be made subject to a separate condominium declaration or non-condominium declaration, in which event the association under the declaration would be authorized to act as the Contributing Parcel’s owner under the REA.
  6. The Administrative Entity will be granted broad powers to unilaterally make changes in the scope of the development, the boundaries and characterization of Parcels, the use of Parcels and the cost sharing obligations of Contributing Parcels. The powers and rights of the Administrative Entity and Maintenance Providers will be personal and would not run with the land. The Administrative Entity and Maintenance Providers (with the consent of the Administrative Entity) will have the right to assign some, or all, of its powers and rights to a Contributing Parcel owner, a Maintenance Provider, a POA, or a third party.

Drafting Workable Documents/Issues to Consider
Easements
Unless each Parcel is adjacent to a dedicated road, it is necessary to grant an access easement to the owner of the Parcel to permit the owner and its tenants, invitees, and the public to have access from a public way to the Parcel. In a phased development, an access easement also should be reserved or granted for the benefit of the owner or owners of portions of the development that are 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 Mall is not developed or converted as originally anticipated or if a different developer or converter acquires the balance of the project, the balance of the project can be developed separate and apart from the original development, with appropriate provisions for sharing the cost of maintaining the shared areas. Where the airspace of a Parcel in a structure is above the airspace of another Parcel in the structure, easements must be provided for structural support of the Parcel.

Use Restrictions
Although the local zoning ordinance or the planned-unit development ordinance, if any, that applies to the development usually will establish the permitted uses, it is often advisable to include certain additional use restrictions in the project documentation. The most common use restrictions in a REA limit certain inappropriate or unwanted uses such as strip clubs, industrial facilities, and other uses that could adversely affect the reputation or operation of the Mall, as well as certain uses that would compete with another permitted use, such as more than one grocery store or specialty store.

Maintenance Covenants
The REA should specify who (i.e. which Maintenance Provider) will be responsible for what types of maintenance and which Contributing Parcels will be required to pay what share of the costs of such maintenance. Initially, the Administrative Entity should be assigned the maintenance responsibilities for all Property Wide Maintenance and Services and all Limited Shared Area Maintenance and Services, with the power to assign some, or all, of those responsibilities to one or more Maintenance Providers.

Architectural Controls
Often a REA will include architectural control provisions governing proposed changes to the appearance of a building in the Mall. There are several ways to approach architectural controls. Generally, the REA should provide a procedure by which proposed plans must be submitted to an entity (which could be the Administrative Entity) that will review the plans with the power to approve or disapprove them based on aesthetic considerations in addition to specific basic standards.

Assessment Procedure
In a Mall that is administered by an association, the association will need money to fulfill its obligations. To raise this money, the association must have the power to levy assessments against Parcels. Generally, the documentation will require the association to adopt an annual budget of its anticipated expenses and the buildup of reserves for anticipated periodic major repairs and replacements that will have to be made by the association with respect to improvements maintained by the association. Assessmewnts are then allocated among the benefitted Parcels based on some rational basis.

If the association is a condominium association, the assessments, with a few exceptions, must be allocated among the units based on the percentage interests assigned to the units. See 765 ILCS 605/4(e).

Under a REA, where no association is provided for, any reasonable approach may be used to allocate costs. We recommend cost sharing provisions based on the benefit received by each Contributing Parcel with respect to each category of maintenance or services provided, with lien rights granted to Maintenance Providers to enforce the obligation to pay.

Rights of the Administrative Entity
Certain rights and powers should be reserved to the Administrative Entity in a REA, including the following:

  • Architectural control over proposed modifications to improvements in the Mall and the right, at its discretion, to assign this right to another entity.
  • The right to construct improvements and to store necessary equipment.
  • The right to (a) amend the REA, in order to bring it into compliance with applicable laws, ordinances or agreements, (b)correct errors or omissions in the documentation; (c) add, recharacterize or withdraw property from the REA, or (d) make changes to the documentation when the proposed change is adequately disclosed to all owners and would not unduly burden the owners.
  • The rights and powers of the Administrative Entity will not run with the land; they will be personal and may be separately assigned or pledged. This gives the Administrative Entity the option to convey the Parcels and designate Maintenance Providers to take on responsibilities, while still retaining many of the Administrative Entity’s rights and powers.

Rights of Mortgagees
A mortgagee may request certain rights similar to those in a residential condominium or non-condominium declaration, including the right to have the lien of a first mortgage prime the assessment lien, the right to consent to certain proposed amendments to the REA, or the right of its lien to have priority in the event of a distribution of funds resulting from insurance proceeds, if a building is destroyed and not rebuilt, or a condemnation award. In our opinion, the only right that a mortgagee should be granted is a right to receive notice of events which are specifically enumerated in the REA and notice of which is specifically requested by a mortgagee, such as a default by the Owner in paying assessment or the occurrence of significant damage to the owner’s Parcel.

Rights of the Municipality
The municipality may request that certain rights be granted to it in the REA. Generally, a municipality will be concerned about maintenance of storm water runoff facilities, private utility lines located on the development, and private roads. However, frequently, a municipality wants the right to come onto a development to cause maintenance or repairs to be furnished if the responsible parties fail to do so. Often, a municipality requires the developer to include in the documentation a provision that gives the municipality the right to charge the association or an individual Parcel 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. Sometimes a municipality will request that a “Back Up” Special Service Area (“SSA”) be created with respect to the property so if the property is not being properly maintained, the municipality can activate the SSA to provide the necessary maintenance and charge the cost to the owners of Parcels in the form of a line item on the owners’ real estate tax bills.

Single Point of Contact
Municipalities and other parties are accustomed to dealing with one point of contact on issues relating to a Mall. In a Mall with multiple owners and without a POA to centrally manage and maintain it, there may need to be a mechanism for having what is referred to as a single point of contact. That could be the Administrative Entity, one of the Maintenance Providers, a Parcel Owner or a committee of Maintenance Providers or Parcel Owners.

Conclusion
It remains to be seen what the future holds for Malls. Our best guess is that many of them will be sold by the current owner or transferred as the result of a foreclosure or bankruptcy. In the meantime, the occupancy and use of Malls will continue to change and evolve. We believe that one way respond to this trend and better serve the owners, users and tenants would be to facilitate the division of the ownership of a Mall into multiple Parcels which can be acquired by investors or users that will prefer to own a Parcel rather than the entire Mall, thus expanding the pool of potential owners. We believe that a likely result of this strategy will be that the owners will be more financially independent of one another, the Mall will be more efficiently maintained and the sum of the value of the parts will exceed the value of the whole, without the need to create a condominium or property owners association to administer the Mall.