An Alternative to De-conversion
The Dilemma Facing Some Aging Condominiums
The housing crash resulted in dramatic declines in home values in the Chicago area. By 2017 home prices were recovering in many neighborhoods. However, in some neighborhoods, the values of condominium units, particularly those in moderate income buildings, have not recovered and may not recover any time soon. At the same time, rents have been rising to the point where the value of some moderate income condominium buildings as a rental project is greater than the sum of the values of the individual units in the condominium.
Recently, many older, moderate income condominium associations have been discovering that large expenditures are needed to repair or replace deteriorating portions of the building, such as windows, risers, roofs and building exteriors. Some of these associations are also discovering that they do not have sufficient reserves to pay for the necessary work. It is generally believed that associations faced with these issues have the limited options of (a) levying a large special assessment, (b) taking out a loan secured by a pledge of assessment income, or (c) attempting to sell the building. Levying a large special assessment is often problematic because it may be unaffordable to many owners. Borrowing the necessary funds and securing repayment with the pledge of the proceeds from a multiyear special assessment is difficult to accomplish and may require a short repayment term of several years (3-5), which could substantially increase assessments, put a financial burden on owners, and depress the marketability and resale value of the units. The “nuclear option” of selling the building for de-conversion to a rental project is often strenuously resisted by owner/occupants who do not want to sell and/or are concerned that, if they are forced to sell, they would not be able to afford a comparable unit in the same neighborhood.
I believe that there is another option which could avoid de-conversion by leveraging the increased value of the building as a potential rental project to (i) allow owners who desire to remain in ownership to continue to own their units, (ii) provide an exit option for owners who desire to sell their unit, (iii) obtain long term, fixed rate non-recourse financing to pay for the needed repairs and upgrades and (iv) generally avoid the drawbacks of each of the three options mentioned above. I call it the Hybrid Condominium.
The Hybrid Condominium Concept
An existing condominium association confronted with the circumstances mentioned above could become a “Hybrid Condominium” as follows:
- Newco. The condominium association would organize a new corporation which initially would be wholly owned by the condominium association (“Newco”).
- Section 15 Transaction. Newco will acquire 100% of the units in the condominium pursuant to the vote of owners representing at least 75% of the percentage interests pursuant to Section 15 of the Illinois Condominium Property Act (“Act”). The consideration or the “purchase price” for each unit would be the agreement of Newco to take tile to each unit subject to the existing liens on the unit in return for the owner receiving a membership interest in Newco and the right to possession of his or her unit. I believe that if the acquisition of the units is structured in this way, there may not be any transfer taxes applicable. This could be a significant factor because in Chicago the transfer taxes are extremely high. For example, the total transfer taxes payable on a purchase price of $70M would be $840,000 ($315,000 of which would be payable by the sellers/unit owners). In addition, depending on how the listing agreement with the broker is structured, this transaction may not give rise to a commission. Assuming that a broker would get a 1% commission on a de-conversion sale, the commission on a $70M de-conversion sale would be $700,000. Thus the Hybrid approach could conceivably save $1.540M over a $70M sale/de-conversion.
- Refinancing. Newco would prearrange to borrow somewhere between (i) the sum of current appraised values of the units if they were to be sold at the time of the transaction and (ii) the appraised value of the building as a rental project (“Refinancing Loan”). Ideally, the Refinancing Loan would be a non-recourse, fixed rate long term, self-amortizing loan. The proceeds of the Refinancing Loan would be distributed with respect to each unit based on the Percentage Interests. If the proceeds of the Refinancing Loan generate enough funds so that the liens on each unit could be paid off and released, then the liens would be paid off and the owner of each unit would receive a distribution of the balance of the Refinancing Loan allocated to the unit. If there are underwater mortgages that cannot be fully paid off from the proceeds of the Refinancing Loan allocable to the underwater units, additional funds may need to be borrowed or the difference would need to come off of the proceeds allocable to the units which are not underwater.
- Repair Financing. Newco would then take out a loan for the required repairs (“Repair Loan”). The Repair Loan would be a construction loan, with disbursements made as needed to pay for the work as it is being done and with interest only being payable on the Repair Loan until all the funds have been disbursed, at which time it would switch to a non-recourse, fixed rate long term, self-amortizing loan.
- Blanket Mortgage(s). Each of the Refinancing Loan and the Repair Loan would be secured by a mortgage on all of the units (each a “Blanket Mortgage” and together the “Blanket Mortgages”).
- Loans to Value. For this plan to work and for Newco to secure the necessary financing, the ratio (i.e., the “loan to value ratio”) of (i) the amount of the Refinancing Loan, plus the amount of the Repair Loan to (ii) the appraised value of the building as a rental project (assuming all repairs are made and paid for) would probably need to be 85% or less. The rationale for using the value as a rental project to determine the loan to value ratio is that if there is a default under either of the loans, the holder of the Blanket Mortgages will have the right to foreclose and force the sale of the entire building to an apartment investor. This allows a potential lender to underwrite and value the building as it would approach a conventional apartment project loan.
- Continuing Owners. Those owners who desire to continue to “own” their unit (each a “Continuing Owner”) would continue to be a member of Newco and would enter into a “Proprietary Lease” with Newco, which is the way in which units are typically owned in a co-operative housing project. Alternatively, in lieu of a Proprietary Lease, the condominium declaration could be amended to assign the right to possess or lease a specific unit to each member and basically treat the member as the “owner” of the unit.
- Departing Owners. Those owners who do not desire to be Continuing Owners (“Departing Owners”) would relinquish their membership in Newco and their right to possession of their unit and Newco would rent out the units and/or Newco will offer to sell memberships to prospective owners who would become members of Newco and enter into a Proprietary Lease. Note, however, that owners may conclude that it is better to be a Continuing Owner, at least until the needed repairs are made and the building is stabilized, at which time a Continuing Owner would likely be able to sell the interest in his or her unit, subject to the Blanket Mortgages, for a price in excess of the portion of the Blanket Mortgages allocable to their unit. In the interim, an investor or non-resident owner should be able to rent their unit and realize positive cash flow after the payment of the monthly assessments with respect to the unit.
- Budget/Assessments. Newco would prepare an annual budget for the operation of the building, including the expenses and reserve build ups previously covered by the condominium budget, plus line items for payment of the loan service on the Refinancing Loan and Repair Loan and real estate taxes on the building. The assessments payable with respect to each unit under the Proprietary Lease for the unit would be equal to the cash needs as shown on the budget multiplied by the percentage interest allocated to the unit under the condominium declaration.
- Rental Units. The units previously owned by Departing Owners would be rented out by Newco with the rent from each unit being used to pay the assessments attributable to the unit, with any excess going into Newco’s reserves or being applied to defer current operating expenses. When the building is stabilized, Newco should be able to sell membership interests to buyers for a price in excess of the amount of the outstanding Blanket Mortgage debt allocable to the unit, with the excess being added to the reserves or applied to defer current operating expenses.
- Financing Source. Long term, fixed rate financing, without personal liability on the unit owners, may be available from the National Co-op Bank, a local bank or another lender. Depending on the situation, a bank may earn Community Reinvestment Act credit for making the Refinancing Loan or the Repair Loan, or both.
- Sale/Financing Options. A Continuing Owner could sell and convey his or her membership interest in Newco and assign the Proprietary Lease with respect to the Continuing Owner’s unit, subject to the Blanket Mortgages. If the purchase price is in excess of the portion of the Blanket Mortgage liens allocable to the unit, it would need to be paid in cash, although it may be possible to obtain what is commonly referred to as a “share loan”, which is a loan secured by a pledge of the owner’s membership interest in Newco and a collateral assignment of the Proprietary Lease.
- Return to Conventional Condominium Status. Once the necessary repairs have been made, the building is functioning as a viable “co-op”, and a significant number of the units are subject to Proprietary Leases to members of Newco, it may be possible to get the holder of the Blanket Mortgages to agree to permit partial releases of a unit from the Blanket Mortgages upon payment of (i) the outstanding Refinancing Loan and Repair Loan, multiplied by the (ii) the Percentage Interest assigned to the unit. If and when this occurs, it would then be possible to return the building to being a conventional condominium by conveying all of the units to the owners subject to the Blanket Mortgages. An owner would then be able to sell the owner’s unit to a buyer who would be able to obtain a new mortgage loan on the unit with the seller using the proceeds of sale to obtain a release of the Blanket Mortgages as described above.
The issues facing aging condominium buildings, particularly those with smaller units (i.e. studio, 1 and 2 bedroom units), were aggravated by the crash. The Hybrid Condominium approach suggested in this article will enable those condominiums which are faced with the need for substantial repairs or replacements and which do not have sufficient reserves to pay for such work to leverage the value of the building as a rental project (where such value is greater than the sum of the values of the individual condominium units) in order to finance necessary repairs with a non-recourse, long term, fixed rate loan Repair Loan, without levying a special assessment and without selling the building for de-conversion. The Refinancing Loan should permit all of the owners to cash out and give each owner the option of being a Continuing Owner or a Departing Owner, although, as mentioned above, there will be an incentive for owners to remain as Continuing Owners at least until the building is stabilized and all necessary repairs are made and paid for out of the Repair Loan.
The Hybrid Condominium approach is basically a conversion from condominium to co-operative, with the prospect that if the process is successful and if the values of the units increase, the building may be returned to being a conventional condominium. However, as a vehicle for promoting and preserving affordable home ownership for moderate income households, the Hybrid Condominium approach may prove to be superior to the condominium approach, especially when applied to moderate income condominiums which need to make significant repairs and can’t afford a large special assessment and where the financing of unit purchases is problematic.
A caveat, the Hybrid Condominium concept is new, and as far as I know, has not been yet done. I believe that Illinois is the only state with statutory provisions that allow a vote of at least 75% of the owners to require 100% of the owners convey their unit. Because of the unique situation in Illinois, I doubt if the Hybrid Condominium approach described in this article could happen anywhere other than Illinois.
Brian Meltzer, November, 2017