New Loan Guidelines Create Headaches for Condos but Also Focus Attention on Maintenance Obligations

In physics, every action produces a reaction.  In the world of financial regulation, the result is often an over-reaction.  The new Fannie Mae-Freddie Mac guidelines for condominium loans provide a current, unpleasant example.

The guidelines respond to the collapse last year of Champlain Towers, a high rise condominium in Miami Beach. While devastating and tragic ─ 99 residents died and the building was completely destroyed ─ Champlain Towers hardly signaled an epidemic that is going to infect thousands of other buildings.  

But instead of targeting condos with similar risk factors ─older high rise buildings in coastal areas subject to salt water erosion ─ which would have made some sense, the guidelines apply to all condominiums with five or more units, regardless of their age, configuration, location, or condition.  

If an old, diseased tree is uprooted during a storm and falls on a home, killing or injuring its occupants, should the building department order every homeowner in the subdivision, or in the city, to have all the trees on their properties inspected to identify potential risks? Obviously not, but virtually every condominium association in the country will have to deal with the costs, administrative headaches and uncertainties these guidelines create.

Focusing on structural integrity, maintenance practices and reserves, the guidelines would bar mortgage financing for units in condominium communities that have :

·         “Significant” deferred maintenance;

·         Damage or structural defects that affect safety, soundness or structural integrity;

·         Inadequate reserves; or

·         Special assessments to finance essential repairs that could affect the community’s financial stability or the marketability of units.

The guidelines create many concerns, the most obvious among them: The difficulty defining “significant” deferred maintenance or determining whether an assessment will affect marketability; the need for communities to quickly obtain structural inspections; and the extensive questionnaire lenders are asking condominium boards or managers to complete.

A Troubling Questionnaire

The questionnaire is particularly concerning. Lenders are essentially asking managers and boards to state that a community is free of structural problems or financial risks.  This is not unlike the old secondary market questionnaire lenders introduced twenty years ago, asking condo officials to attest that there was no hazardous waste on the site, no potential for special assessments, and no zoning violations, and to provide a lot of other information board members and managers could not reasonably  know or comfortably guarantee, with potential liability and immense penalties for errors.

With this questionnaire, like the old one, lenders are looking for a third party (the association) to say “everything is fine,” so if that turns out not to be the  case, they will have someone to sue.  We’ve heard this song before; it’s all about shifting liability risks from lenders to condo associations or their managers. Why not just ask the association to guarantee the loan or co-sign the note?

 The condominium industry pushed back successfully on the old questionnaire (lenders eventually accepted an alternative form that reduced  liability risks for associations) and we’re pushing back on this one, too. We’re advising our association clients to respond to the questionnaire’s broadly worded questions either vaguely or not at all.

Financial Saber-Rattling?

Fannie and Freddie have said they won’t buy loans if lenders are unable to obtain the information they think is required to verify a community’s structural soundness and financial stability. This is unsettling, because the two secondary market giants purchase more than 60 percent of all the standard home mortgages lenders originate. But we’ve seen this financial saber-rattling before ─ thirty years ago, when Fannie and Freddie said they wouldn’t buy loans in states with superlien statutes protecting condo associations. 

There are about 156,000 condominium communities in the country and the Community Associations Institute (CAI) estimates that Fannie and Freddie back 70 percent of the loans in those communities, representing a significant share (20 to 30 percent) of their portfolios.  That’s why they didn’t stop backing condo loans in superlien states, despite the threat to do so, and why they aren’t likely to stop backing condo loans now. 

There have been anecdotal reports of loans not going through because boards aren’t responding to the questionnaire, but so far, we haven’t heard of any of our association clients in New England encountering that problem.  In any event, our job as association attorneys is to protect our clients from liability risks.  Just because an owner needs the questionnaire to sell a unit or refinance a loan doesn’t mean the other owners in the community should be exposed to the liability the association incurs by answering the questions. 

Th tug-of-war over the questionnaire is still ongoing.  CAI has asked for a one-year delay in implementing the new loan guidelines to give associations more time to deal with them.  We will probably see that delay and possibly a longer one. We may see some modifications in the guidelines as well. In the meantime, we’re advising clients to approach the questionnaires cautiously:

·         Answer only questions about which they are certain.

·         Consult the association’s attorney before responding.

·         Require buyers and sellers to indemnify the association from liability for errors.

·         Provide meeting minutes, reserve studies, inspection reports, engineering studies, maintenance records and any other relevant documentation lenders request.

·         Don’t be surprised if insurance companies start to request the same information about structural condition and maintenance  policies.  Why wouldn’t they?  Their potential exposure is likely much greater than that of any individual bank. The cost and availability of insurance may be linked increasingly to evidence that condo communities are structurally sound and well-maintained.

Focus on Maintenance

If the  new condo loan guidelines are creating headaches for condominium associations, which they clearly are, they are also putting a laser focus on the importance of maintenance, and that is by no means a bad thing. 

Most condo associations defer essential maintenance, to some extent.  It is human nature to put off unpleasant tasks, and spending large sums on maintaining and repairing buildings and critical systems is definitely unpleasant.  Owners don’t like dues increases or special assessments and boards don’t like approving them for that reason. 

Champlain Towers provided an extreme example of what deferred maintenance can do.  Buildings aren’t likely to collapse if they aren’t well-maintained, but problems will become larger, more complicated and more expensive to correct. Kicking the can is not an effective long-term management strategy for a condominium. That’s a key lesson from Champlain Towers.  It’s a lesson board members, managers and many owners have learned, and the Fannie-Freddie condo loan guidelines are re-enforcing it. 

Owners who understand that inadequate maintenance may threaten financing for units in their community may be less likely to viscerally oppose dues increases and special assessments. And boards, who have a fiduciary obligation to maintain and repair common areas, have acquired another argument to support these essential expenditures.  I’m not expecting to hear a universal chorus of Kumbaya in the condominium world, but the perennial association debates over budgets, capital expenditures and assessments may become somewhat less fractious. 

What Boards Should Do

If the new loan guidelines are strictly enforced ─and even if they are not ─there are some things all associations should do to properly maintain their communities. 

1.    Commission a structural inspection. This is something all communities, regardless of their age or condition, should do. The inspection will identify problems or potential problems; it may determine that there aren’t any, establishing a base line for future inspections.  Be prepared for sticker shock.  Associations are scrambling to obtain inspections to comply with the new loan guidelines.  It will take time to book an engineer and inspection costs are increasing. 

2.    Schedule future inspections periodically. Their frequency should depend on the age and condition of buildings and the environmental pressures to which they are exposed.  Buildings with known construction problems and those located in coastal areas where salt water erosion is a concern will require more frequent inspections than newer buildings or those located inland.    

3.    Establish a maintenance schedule for the community and follow it. Eliminate ‘deferred maintenance’ from the board’s vocabulary.

4.    If you haven’t had a reserve study done or updated an existing one in the last three years , do so now. 

5.    Make sure your reserve funding plan matches the repair and replacement projections in your reserve study. Fannie Mae’s loan guidelines require associations to contribute 10 percent of their operating budget annually to their reserves. Your reserve study or known structural concerns  may dictate a larger contribution.

6.    Review the findings from any building conditions studies you obtain. If urgent actions are required, address them.  Obtain estimates for the work and create a financing plan.  Once you know about problems, the potential liability for failing to address them increases.

Essential maintenance should be a priority for all condominium associations.  If the new lending guidelines force boards and owners to focus on it more intently and more effectively, the result will be a net benefit for condo owners, for their communities, and for the condominium industry as a whole.

Written by

Richard Brooks | rbrooks@meeb.com