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| DISTRESSED REAL ESTATE UPDATE | |||
| December 2009 | |||
BROKEN CONDOMINIUMS  |
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Editor’s Note: This is part of an ongoing series of monthly newsletters on topics we hope will be of interest to our partners, clients and colleagues. The general theme of FrontView’s approach to distressed real estate will be articulated through the series, which we intend to begin with foundational topics and proceed to more sophisticated issues over time. Please visit our website for previous editions of Distressed Real Estate Update. The condominium is a highly useful form of real estate ownership that is common to most real estate asset classes. However, the specialized residential condo conversion arena, which has seen great distress in today’s market, often involves complex legal and practical issues not found in office, retail and industrial condos. Where people’s homes are involved, the multilateral condo ownership/governance regime raises particularly thorny conflicts of interest. This article briefly addresses four key issues that can both arise from and contribute to distress in residential condominium conversions: (i) tenant evictions, (ii) buyer cancellations, (iii) the de-conversion question and (iv) risks faced by equity capital partners and lenders. TENANT EVICTIONS A centerpiece of many residential condo conversion plans is an effort to induce existing tenants of the real estate to vacate. For obvious reasons, this effort is a delicate one that can easily backfire if tenants unite in opposition to the various tactics sponsors employ. Many sponsors, having easily persuaded equity capital partners and lenders to pour money into conversion plans in the roaring markets of the recent past, first saw the cold realities ahead of them in the form of grim-faced participants at tenant meetings they called. The tenant lawsuits that followed brought the story home to the lenders and capital partners as well, blowing apart the optimistic timelines and cost assumptions that the sponsor had originally put forth. This dysfunctional ménage a trois among sponsor, capital partner and tenant has been at the heart of many recent condo failures. Even projects launched well before the start of the residential market meltdown became embroiled in multiyear sellout delays and extensive bad press arising from tenant resistance. These battles were the first domino in a toxic chain reaction. While it is too late to do much about sponsor-tenant conflicts in many of today’s broken condos, the lessons learned about making realistic assumptions and sticking to aboveboard tactics easily translate to the next round of complex negotiations the sponsor must face – the loan workout. BUYER CANCELLATIONS Another risk that must be assessed in a distressed residential condo project is whether the buyers have grounds to evade their contractual purchase obligations. As part of the due diligence that should precede any workout, foreclosure or similar action, all purchase agreements should be reviewed to determine whether they have defects that render them void or voidable, and/or give the buyers defenses or claims. In addition, the condominium documents must be examined to determine if they are in compliance with all applicable state, federal and common law obligations and if all filings are up to date. Assessing these risks requires many complex legal inquiries. For instance, if the sponsor has marketed the property in multiple states, the lender or limited partner should determine if the project is exempt from the registration, disclosure and antifraud requirements of the Interstate Land Sales Full Disclosure Act (ILSFDA). Sponsors may seek to qualify for certain safe harbor exemptions from ILSFDA by contractually providing for certain buyer protections. If no ILSFDA exemption applies, sponsor compliance requires filing and updating a HUD Statement of Record and buyer-signed Property Report, returning any deposit in excess of 15% of the purchase price if the buyer defaults; a 20-day buyer cure period; a 7-day rescission period; and a conspicuous statement of 2-year rescission period absent Property Report delivery prior to purchase agreement execution. The ISLFDA is just one example of the many state and federal laws that contain antidiscrimination, registration, disclosure and antifraud provisions relating to residential condominiums. Lenders and capital partners need to be aware of all of the interlocking legal obligations that must be included in purchase agreements and condominium documents. A recent case concerning a mere typographical error in a New York State condominium offering plan that may release dozens of buyers from their purchase agreements only serves to highlight the high-wire risks in the area. THE DE-CONVERSION QUESTION The ultimate question that must be asked in the context of a severely troubled residential condominium is: Would the project be better off if it were converted (or reconverted) to a rental strategy? From the sponsor’s perspective (and sometimes from the lender’s as well), the expected fees and other immediate cash streams that a successful condominium sellout would entail can create a temptation to ignore reality and persist in pursuing a condo formation or conversion plan when tenant resistance, buyer disinterest or other problems make it unlikely to succeed and not necessarily in the best interests of the project's equity capital partners. RISKS FOR LENDERS AND CAPITAL PARTNERS As alluded to above, the sponsor’s role as manager of the debt and equity capital invested in a residential condo project (as well as its role as steward of the tenants’ well-being in a conversion project) can lead to perverse incentives and dramatic conflicts of interest. To take the de-conversion issue as an example, when the rental alternative is the financially sound one for the project, capital partners (or lenders with their feet on the ground) may wish to try to force the recalcitrant sponsor’s hand -- but this can give rise to legal headaches down the road. Regardless of the outcome of the reconversion question, the project may still falter in the future. In any resulting lender’s or capital partner’s enforcement action, a sponsor may attempt to use lender and/or limited capital partner participation in the reconversion debate as the basis for defenses and counterclaims. Legally resourceful and aggressive sponsors in similar circumstances have creatively claimed that lenders or limited capital partners overstepped their bounds and acted as co-GPs with the sponsor, thereby assuming responsibility for the project’s failures. We do not mean to suggest that lenders and limited capital partners should forgo well-considered negotiations on de-conversion (or other) issues, where appropriate. However, lenders and limited capital partners must always be cautious not to create a basis for claims by overreaching or inappropriately supplanting the sponsor’s role as captain of the ship. Lenders and capital partners looking to take control of a troubled project should also be aware that by doing so, they risk becoming a special declarant for the condominium. Typically, the original declarant (the sponsor) reserves special declarant rights in the condominium documents that are necessary for the completion of the project, including the right to finish construction, operate a sales office on site and sell units without condo board approval. Depending upon the governing state law, a party taking control of a condominium project may expose itself to declarant liability by receiving or exercising certain special declarant rights. This may include liability arising from implied or expressed warranties for defects in construction at the project. The risk of special declarant liability can sometimes be managed by carefully drafting the property transfer documents and/or by structuring bankruptcy remote single purpose entities to take ownership of a troubled project. However, it may be impossible to prevent some special declarant liability from accruing if active management of the development process is required in order to realize the full economic benefit of the project. In such cases, the risks associated with special declarant liability must be properly priced to determine if the party-in-interest would be better served by selling its position to a third party who will execute on the sponsor. Distressed residential condominiums present many complex questions that must be addressed in determining a workout strategy. This article has touched on a few of the relevant issues that may arise at a troubled project. Interested parties should seek professional advice as soon as distress is perceived in order to identify all the potential risks and to develop an efficient plan of action. About FrontView Advisors FrontView Advisors is a part of FrontView Group, a real estate investment advisory firm offering our clients and capital partners relevant and "current day" experience to source, underwrite, negotiate, execute and manage existing and new real estate investments and loan portfolios in today's challenging economic climate. FrontView's principals have handled in excess of $2 billion in the workout and restructuring of complex debt and equity positions throughout the capital stack since 2007. |
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For further information please visit our website at www.frontviewgroup.com or contact any of the following:
David J. Steinberg |
Bret R. Salzer |
Christopher M. Bellapianta |
Copyright © 2009. FrontView Advisors LLC. All rights reserved. FrontView Advisors LLC is not a law firm and Distressed Real Estate Update should in no way be relied upon or construed as legal, financial or other advice and should not be relied upon to address specific factual situations without the advice of legal counsel and/or other professional advisors. |