"Breaking Down Fractured Association"

As the recession went into full swing in late 2008, fractured condos became prevalent as developers, who were unable to sell their condos, opted to rent the unsold units. Debt and Equity capital is available for fractured condo acquisitions; however, there are a number of legal and underwriting issues that have to be factored into the lending/investment decision.

The first questions to ask are: Does the Sponsor have control of the Homeowner’s Association (HOA), and what risks do other owners pose to that control?

The Sponsor must have legal control through voting rights as well as the ability to manage and operate the property freely without interference from the HOA or disgruntled individual condo owners.  For example, if the Sponsor owns more than 75% of the units, has control over the board, and cannot be voted out, then capital providers feel comfortable that all HOA obligations will be fulfilled. The Sponsor needs to make sure that the existing condo owners are current with their HOA dues.  If not, the Sponsor should expect the lender to capitalize the late HOA dues into the initial capitalization of the property acquisition and potentially underwrite any shortfall as an ongoing operating expense. The Sponsor should investigate what legal remedies the HOA has for those who are delinquent on their dues (typically a lien).

Secondly, the HOA documents should coincide with a new lender’s loan documents.

For example:

- The Sponsor must ensure that the provisions within the HOA agreement regarding the use of insurance casualty proceeds and condemnation procedures are consistent with the new loan documents.

- The HOA documents (i.e. Master Deed and By-Laws) should stipulate that it cannot be amended without written consent of the mortgagee of the rental units.  Provided that the borrower has control over the HOA, this should not be an issue.

- A lender will require a notice and the right to cure any late HOA dues/default on behalf of the Sponsor under the condo documents, which naturally would require a HOA amendment.

Bottom line, a fractured condo project is just that: it’s broken. The solution for the least disruptive fix is to amend the HOA documents so that it will fit within the confines of conventional multifamily lending and investment parameters.

Economic consideration when underwriting a fractured condo property should include carefully analyzing the amount of HOA dues collections versus actual property operating expenses.

HOA dues typically go towards funding a portion of landscaping, exterior repairs, and maintenance of the property.  In the case of a recent transaction completed by MCA, their Client had owned and managed the property for several years. Moreover, their Client had a specific operating agreement with the HOA that required the HOA to fund $250/unit in reserves for any exterior repairs. Most lenders require replacement reserves of at least $250/unit/year to fund ongoing exterior/interior repairs to ensure the upkeep of the property. Since the Borrower was already collecting reserves for exterior repairs, a $250 replacement reserve from the lender would be essentially “double counting.” MCA successfully negotiated the replacement reserves issue by having the Borrower send a monthly invoice to the lender showing the collection of reserves so that their Client would only have to fund a lower amount for the interior replacement reserves.

Other additional challenges in fractured condo deals may arise when the Sponsor starts purchasing additional units within the project from individual owners or lenders who have foreclosed on a unit(s). More often than not, there needs to be at least three months of rental history for a new lender to feel comfortable enough to underwrite the rental income of the newly acquired unit(s). Underwriting expenses can also be challenging, but one solution is to analyze the historical expenses on a per/unit-basis and apply that to the new unit mix. Finally, understanding and addressing how the acquisition of new units will affect property taxes on all the units is vitally important to determining property cash flow.

The good news is that there are a number of capital providers in the market that are adept at underwriting fractured condos, but it is not as easy as simply reaching for the phone and calling your friends at Fannie Mae DUS or Freddie Mac. The control and legal issues surrounding the HOA will likely have agency lenders heading for the “Exit” sign. Financing for fractured condos is getting done with conduits, private book lenders, and banks along with opportunistic investors on the equity side. It is a highly fractured market (no pun intended) that requires the expertise of an active financier who is familiar with the issues associated with such transactions and has the market knowledge with respect to the active capital providers.