Sunday, April 20, 2008

Lender Backlash?

Will New Rules Make Condominiums Harder to Sell?

By Tyler P. Berding

Last month we asked the question: “Will the sub-prime crisis impact community associations?” (, March 20, 2008) We predicted then that mounting foreclosures of condominiums and town homes would greatly impact community association budgets as owners abandoned properties leaving unpaid assessments. Lenders holding first mortgages on these properties would have no obligation to homeowners associations to cover these deficiencies, leaving large gaps in association funding when the units were sold by the banks.

Now, a new issue is looming, again involving lenders. Rules for government-backed mortgages and some private mortgage insurers are being re-written to toughen lending standards for condominiums. A recent article in the Wall Street Journal by Kenny Harney describes steps being taken by Fannie Mae and Freddie Mac; as well as mortgage insurer AIG United Guaranty.[1] These new standards will clearly make it more difficult for condominium owners to sell their units and for prospective buyers to close purchases—and they could have some other consequences as well.

The new rules promulgated by AIG include a form of “redlining” or rejection, of loan applications for properties in certain zip codes that have been designated as having declining market conditions; higher down payments; and a ban on projects where more than 30% of the units are investor-owned. These rules alone could have a major impact on the sale of condos, which are typically bought by low to mid-income buyers who already find it difficult to qualify for a loan. The redline provisions will make it impossible to obtain a loan on properties within those particular zip codes. As Harney states: “The ban is irrespective of applicants’ credit scores, assets or equity stakes.” If the property is located within those zip codes or if non-owner occupants exceed 30%—there will be no loan--period. These rules take effect on May 1, 2008. Normally buyers with 20% or more to put down would not be affected by new private mortgage insurer rules, however.

Government insurers Fannie Mae and Freddie Mac have also issued changes in their procedures that could have a dramatic effect on condominium loans. Under recently published guidelines, lenders requesting government loan guarantees will be asked to take responsibility for investigating the fiscal health of homeowners associations. According to Harney: “Under Fannie Mae’s changes, most of the due-diligence research on condominium projects’ key characteristics—their legal documentation, the adequacy of condo association operating budgets, percentage of unit owners who are late on association-fee payments, percentage of space allocated to commercial use, and percentage of units owned by investors—must now be performed upfront by loan officers.”

He continues: “Not only is this time-consuming and costly, but under the new procedures, Fannie Mae expects the lender to warrant the accuracy of its research. Some condo project legal documents run into the hundreds of pages of text, yet lenders are supposed to take legal and financial responsibility for their accuracy.” This responsibility would also include making certain “that at least 10 percent of a condominium project’s current operating budget is reserved for “capital expenditures and deferred maintenance.”

Now that’s a rule that could keep a lot of lenders awake at night. First of all, holding to a fixed percentage means that there is no room for interpretation. Harney quotes a reserve budget expert who states that this standard means that non-physical items, such as insurance, in a reserve budget will not count toward the 10%. “Some loan officers will simply look at the ‘reserves’ item and, if its below the 10 percent mark, might reject the whole building and refuse to take loan applications on individual condo units.”

If the rule only requires doing the math and calculating a ratio between reserves and the operating portion of the budget, that’s one thing, but will, of course, result in largely meaningless information. But if a real determination of adequacy is required that’s something else again. And if so, it’s going to be difficult to meet these standards with newly-developed projects, much less with older associations for all of the reasons that we have been writing about for years[2].

The California Civil Code mandates that a reserve fund be provided for any component that has a projected service life of less than 30 years.[3] With new construction, the number of components falling into that category is relatively small—roofing, painting, asphalt, etc. It’s not until a property begins to age that other major components begin to fall within that 30-year window. But when they do, they can be a costly addition. A building component like siding, for example, often has a 40-50 year service life from the time it is new, and doesn’t usually fall into the 30-year window then. But after 10 or 15 years, that component would belong in the reserve study. Given that a huge number of condominium projects are now in excess of twenty years old, a lot of exterior wood components, and such things as plumbing or electrical components, which previously were not in the reserve budget, now should be.

But evaluations like that are difficult to make, even for trained community association professionals, so how are lenders going to undertake them if that’s required? First, they will have to understand that components listed on the original developer reserve budget won’t necessarily be the only components that should be there in an older project. After that, they have to develop the means of evaluating them. They also have to understand that just addressing visible components may not be enough in an older building. What about damage to the interior framing in areas that are not accessible, or corrosion in plumbing lines, or electrical service that cannot keep up with new loads that have been put on it. These are problems that are beginning to appear in the many conversions that have been sold in the past few years—components that are not always “visible and accessible” are beginning to show damage requiring repair or replacement, skewing the original budget and increasing assessments. And just as conversions often involve older apartment buildings, so too does the reserve analysis of older condominiums.

That lenders will willingly take on such responsibility is not likely. “It’s ridiculous,’ said Phil Sutcliffe, principal of Project Support Services of Lansdale, Pa, who helps put together condominium project financings for developers. Not only does this shift huge paperwork and time burdens on lenders and brokers—who may not have the staff resources to handle the extra work—but also forces them to make ‘absolute judgments on things that are not absolute.”[4]

In the end, if lenders are going to be held responsible for the adequacy of an association’s reserves, either they are going to quit lending on condominiums, or they will begin to ask some very tough questions of management and the board of directors. And some of those questions may have merit. If a board has ignored the warning signs of deterioration in an aging building and have not expanded the scope of their investigations to look at components which are not just “visible and accessible,” lenders may start doing it for them and the results may force some difficult decisions—do we raise assessments sufficiently to accommodate components which were either not in the original budget or which have proven more costly to maintain than originally projected; or, do we not do that and take the risk that our project will be rejected for mortgage insurance?

This dilemma is not new.[5] Boards have been wrestling with it for years, but several things have happened to force the problem to critical mass: (1) An aging condo stock has begun to reveal components with a decreasing service life that were not previously detected[6]; (2) We have just gone through a new phase of condominium conversions which, unlike previous phases, involve older buildings in greater need of repair which has, in turn, focused more attention on potential budget under funding[7]; and (3) New lending rules will now force much closer scrutiny of the financial and physical condition of community associations that boards of directors can no longer ignore if they want to preserve any semblance of market value for the units in their project.

These new rules are a direct consequence of the sub-prime mortgage crisis and could have a very real impact on community associations. They will undoubtedly put pressure on boards of directors to re-evaluate their reserve budgets; to re-visit the issue of CC&R restrictions on non-owner occupancy; and to take more aggressive steps to collect delinquent assessments in order to keep their projects marketable.

Late Update: On May 16, 2008 it was announced that Fannie Mae and Freddie Mac were lifting restrictions on loans on properties in "declining market areas." While this might otherwise be good news, most private mortgage insurers, such as AIG Guarantee and similar companies which provide private insurance for home mortgages as late as May 25, said that they would not lift their own restrictions on loans in such declining areas. Also as of June 2, 2008, there was no announced change in the guidelines recently published by Fannie Mae and Freddie Mac requiring lenders to certify the adequacy of community association reserves and other elements of CID budgets and operations as discussed above.


[1] Kenney Harney, “Condo loans just got harder,” Wall Street Journal, April 20, 2008
[2] Tyler P. Berding, “The Uncertain Future of Community Associations,” January, 2005; (.pdf download)
[3] “At least once every three years the board of directors shall
cause to be conducted a reasonably competent and diligent visual
inspection of the accessible areas of the major components which the
association is obligated to repair, replace, restore, or maintain as
part of a study of the reserve account requirements of the common
interest development if the current replacement value of the major
components is equal to or greater than one-half of the gross budget
of the association which excludes the association's reserve account
for that period. The board shall review this study annually and
shall consider and implement necessary adjustments to the board's
analysis of the reserve account requirements as a result of that
The study required by this subdivision shall at a minimum include:
(1) Identification of the major components which the association
is obligated to repair, replace, restore, or maintain which, as of
the date of the study, have a remaining useful life of less than 30
(2) Identification of the probable remaining useful life of the
components identified in paragraph (1) as of the date of the study.
(3) An estimate of the cost of repair, replacement, restoration,
or maintenance of the components identified in paragraph (1) during
and at the end of their useful life.”
California Civil Code Section 1365.5(e)(1)
[4] Harney, Supra.
[5] “The Board’s Dilemma,”, April 12, 2008.
[6] Condominium projects were constructed in quantity in the United States starting around 40 years ago. That means that many buildings are beginning to show their advanced age through rot, corrosion, and obsolescence, which were not apparent when the projects were newer.
[7] “Condominium Conversions—Owner Equity at Risk?”, December 27, 2007.

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