Yes You Can Restrict Condominium Rentals but Beware Unintended Consequences

Like the garden perennials that bloom in spring and fall, some condominium law issues surface repeatedly, if not seasonally. How to deal with rentals is one of them. The triggers that make this an agenda item (problems with renters, economic conditions, changing owner populations) vary in different communities, but the questions boards ask are always the same:

• Can associations prohibit rentals or restrict them?
• Can they do so retroactively? And if so
• What form should these restrictions take?

The answers to the first two questions are straightforward: Yes and yes. Associations can restrict rentals – if a supermajority of owners (at least 67 percent and sometimes more) agree to amend their condo bylaws; and they can impose these restrictions retroactively, making them applicable to existing owners, who bought their units when rentals were allowed, as well as to future purchasers who buy when the rules are in effect.Courts in Massachusetts and other jurisdictions have long recognized that, with the requisite vote of the unit owners, condominium associations can change their rules. They can prohibit pets, they can ban smoking and they can restrict rentals in the community, notwithstanding the potentially adverse impact on owners who purchased with rental in mind.

The Rules Can Change

A Washington, D.C. court stated the issue clearly in a decision refusing to overturn one condominium’s rental ban: “Potential purchasersof condominium units should realize that the regime in existence at the time of purchase may not continue indefinitely and that changes in the declaration may take the form of restrictions on the unit owner’s use of his property.”The Massachusetts Supreme Judicial Court echoed that view in a 1983 decision (Franklin v. Spadafora) upholding an association’s right to limit the number of units owned by an individual. “Those who live in condominiums must be willing to give up a certain degree of personal choice in order to promote the welfare of the majority of the owners,” the court observed. The court also agreed that preserving the community’s ownership character and protecting property values (two of the major arguments for restricting rentals), are appropriate and justifiable goals.A third argument – complying with secondary market rules for condominium mortgages – is equally compelling. Fannie Mae, Freddie Mac and the Federal Housing Administration (FHA), which collectively purchase most of the residential mortgages financial institutions originate, all impose some restrictions on rentals in condominium communities, and they will not finance loans in communities that do not comply with their guidelines. However, the secondary market limits are considerably less restrictive than they used to be and significantly looser than many condominium boards assume.For example, at one time, Fannie Mae and Freddie Mac would not approve condominium loans if more than 30 percent of the units in a community were investor-owned, and they still impose strict limits on loans to investors. But they currently set no rental ratio limits at all on loans to owner-occupants.Condominium associations that want to obtain FHA certification – a requirement for anyone who wants to obtain an FHA loan to finance or refinance a condominium in the community – must have an owner-occupancy rate of at least 50 percent; no more than half the units can be investor-owned. That is not a difficult standard to meet; associations can easily comply without setting excessively low rental ceilings, which can have unintended negative consequences. These include:

• Reducing the pool of prospective buyers for units in the community. (Investors who plan to rent their units and owner-occupants who think they might want to do so in the future will avoid condominiums in which rental caps are set too low); and
• Limiting the options available to owners in a weak real estate market, forcing them either to sell their units at a loss or lose them to foreclosure.

Real World Problems

These problems are not theoretical. They are all too real byproducts of the economic downturn that has depressed real estate values and left many condominium owners financially “under water”, struggling with units worth less than they paid for them and with mortgages exceeding the current value of their homes.To cite just a couple of recent examples from my practice: One condominium owner who has lost his job is moving in with his parents. He can’t sell his unit for enough to pay off the mortgage, but the rent he could command would cover his mortgage payments and common area fees. He can’t rent the unit, however, because the community has reached its 10 percent rental cap. As a result, this owner will lose his unit to a foreclosure he might otherwise be able to avoid.The somewhat more fortunate owner of a unit in another building has found a job in another city. But the unit he purchased for $750,000 is worth only $650,000 today. He’d like to rent the unit until the market recovers, avoiding a $100,000 loss, but again, his community has reached its rental limit, precluding that option for him.These outcomes aren’t desirable, to say the least, for the two owners involved, but foreclosures and below-market sales will impair the value of other units in their communities as well. Many boards think strict rental limits are needed to preserve property values, but as these examples illustrate, they could have the opposite effect.

Troubling Decisions

Overly restrictive rent restrictions could create legal as well as financial problems for condominium associations. Although the courts have generally upheld their right to restrict rentals and even prohibit them, there have been some exceptions to these favorable rulings. An Indiana appeals court found that rental restrictions in one community had a discriminatory ”disparate impact” on minorities, who were most likely to be affected by a shortage of rental units in the area. The state’s Supreme Court eventually overturned that decision, but it made a lot of industry executives very nervous at the time.More recently, a condominium owner in Florida argued that a rental restriction should be overturned because the board had granted a waiver to a non-profit organization that planned to rent units to handicapped tenants. The owner maintained that enforcement of the rule was arbitrary and improperly created two classes of owners, but the state Supreme Court backed the association, finding that the waiver was a reasonable and necessary accommodation required by the Fair Housing Act.While there is nothing in these decisions to suggest that courts won’t uphold rental restrictions, they do highlight a point boards should keep in mind: The more restrictive a community’s rental limits are, the more likely they will be challenged.That said, there are legitimate concerns on the other side – permitting too many rentals can also have adverse and undesirable consequences, starting with this one: Communities that exceed the 50 percent investor ratio will not meet the FHA’s certification guidelines, making it impossible for owners to or prospective buyers to obtain FHA-insured loans. Even if that isn’t a concern – and it isn’t for all communities – investors controlling a large number of the units could dominate the association’s board, rejecting necessary maintenance expenditures and increases in common areas fees in the interest of reducing expenses and maximizing their profits.Investors do not always wear the black hat in these debates, by any means; sometimes the desire to protect their investment will make them more supportive of maintenance and capital expenditures than owner-occupants. But investor dominance can create potential risks that boards should not ignore.

Aversion to Tenants

For many condominium boards and owners, it is the tenants who rent the units, not the investors who own them, that are the primary concern. Conventional wisdom holds that tenants, by definition, will less conscientious caretakers of the units they occupy, less respectful of common property and more likely than owner residents to violate association rules. Experience suggests that those assumptions are largely unfounded.Tenants are no more likely than owners to park illegally, dispose of trash improperly, fail to clean up after their dogs, have loud parties and otherwise annoy or offend their neighbors. There are as many drug-dealing tenants as there are drug-dealing owners. The only real difference: Landlords can evict a bad tenant; condominium associations can’t evict a bad owner.There is no question that excessive concentration of tenants – more than 30 or 40 percent – can change the ownership character of a community, and that is a legitimate concern. But it is a concern boards can address with a balanced approach, setting reasonable limits that address the concerns of owners who occupy their units while protecting the interests of owners who are renting their units or want to ensure their ability to do so.

Setting ‘Reasonable’ Limits

Those reasonable limits won’t be the same for all condominium associations. They will vary depending on a community’s location, the price of its units, the age of its residents, and the demand for rentals in the local market. A community with a large population of older residents might want to establish a higher rental cap, anticipating that many owners may have to vacate their homes for extended periods (because of illness) or face other age-related concerns (estate-planning for example) that may make rental an appealing and possibly a necessary option.A community with low-or moderately priced units surrounded by colleges can reasonably expect rental demand to be strong and so might want to set lower rental limits, to prevent investor dominance and avoid an undue concentration of tenants. But a community of multi-million-dollar units far-removed from colleges, where rental demand is slim and rental prices would be prohibitive, would not share that concern.Boards should avoid the knee-jerk assumption that rent restrictions are necessary or desirable. They should reflect the needs of the community and the preferences of its owners. A poll of owners is the best way to assess their views. If owners want to set limits, there are several ways to go about it. You can:

• Limit the number or percentage of units that can be rented
• Establish a minimum lease term – one-year is common – to prevent hotel-type occupancies and avoid the transient atmosphere frequent turnover can create.
• Restrict the number of units a single individual can own. While this aims to discourage investors, it can be difficult to enforce. Determined investors can buy multiple units in the names of relatives or friends.
• Require owners to live in their units for a minimum period before renting them. A one-year requirement is common; longer occupancy periods (two years or more) violate FHA rules and would disqualify the community for FHA certification

Grandfathers and Hardships

Boards may also want to consider grandfather provisions exempting some or all current owners from the rental caps, and hardship waivers for owners who would be severely disadvantaged by them. Both provisions can reduce opposition to rental restrictions, but they also create potential problems of which boards need to be aware.Exempting all current owners from the rental limits – one grandfathering option – would effectively preclude all new owners from renting their units and would eliminate investors as prospective buyers. Exempting existing tenants avoids that problem; owners currently renting their units could continue renting them. But if rentals have reached the community’s cap when the existing tenants leave, the landlord would go to the end of the rental queue and might have to wait years before renting the unit again.The cap in this case has effectively destroyed this owner’s investment. And the grandfather provision has created something of an administrative nightmare for the association. Someone will have to keep track of the rental tally, maintain a list of current tenants and lease expiration dates, and monitor the priority positions of owners who are waiting for their turn to rent their units. Establishing a sensible rental cap in the first place will avoid most of these problems and may make a grandfathering provision unnecessary.A hardship exemption, on the other hand, is essential. Boards need the flexibility to bend the rules when necessary to address extraordinary problems. But it is important to define hardships clearly and narrowly: The unemployed owner who has to relocate to accept a new job but can’t sell his unit has a hardship; the owner who wants to rent her unit in order to move in with her boyfriend has an inconvenience. Boards should expect to use the hardship waiver only rarely; if they are using it frequently, the association’s rental cap is probably too low.Associations should also make sure their rental caps don’t interfere inadvertently with estate-planning strategies. For example, older owners may put the unit they own in the name of a child to keep it out of their estate, making the owners technically tenants. The FHA will count the unit as a rental for purposes of its 50 percent investor limit, but the association does not have to count this unit toward its internal cap. Similarly, if a unit is owned by a trust – another estate –planning tool – the rental rules could specify that either the named trustee or the trust’s beneficiary is allowed to occupy the unit as its “owner” keeping the unit out of the rental pool.Rental caps also should not apply to units on which lenders have foreclosed. The foreclosure process can be protracted and lenders may want to rent units they have seized to offset their carrying costs in the interim. Most condominium documents require mortgagees to approve material changes in association bylaws, and they would be unlikely to approve a rental limit that doesn’t exempt them.

Tenant Approval – Not the Board’s Job

Some associations want to make the preapproval of tenants a condition for landlords who want to rent their units, but this is a bad idea for several reasons. First, FHA rules specifically prohibit prior tenant approval, making this requirement a non-starter for any community that needs FHA certification or want to retain it. Equally important, the lease is between the unit’s owner and the tenant; the association is not a party to the agreement. The obligation to vet tenants rests entirely with the landlord, who also shoulders the financial consequences of a poor choice. If a tenant fails to pay the rent, that’s the landlord’s problem; it doesn’t affect the landlord’s obligation as the unit’s owner to pay common area fees and special assessments.Moreover, if the board were to insist on pre-approving tenants, what criteria would the trustees use for rejecting them? Race, sex, gender, marital status, and age all would violate Fair Housing laws. Boards that reject tenants for any reason risk being sued, even if they had a non-discriminatory basis for the decision. Getting involved in the tenant selection process creates unnecessary liability exposure for the association. Associations don’t have a horse in the landlord-tenant race and risk getting trampled if they get in the way.While boards should leave tenant selection to the owners, they can and should insist on lease provisions that protect the association’s interests and ensure the board’s ability to deal with problem tenants if the landlord (whose responsibility that is) fails to do so.Among other measures, associations should require landlords to incorporate in their leases the community’s bylaws and rules and regulations; this makes violations of association rules ground for evicting the tenant. The lease should also specify that while landlords are responsible for ensuring that their tenants obey association rules, the board has the authority to evict problem tenants if the landlord fails to do so and can assess the eviction costs to the landlord.That threat – and the board’s authority to fine landlords if their tenants violate the rules – is usually sufficient to persuade landlords to deal with problem tenants and evict them if necessary. If you make it sufficiently uneconomical for landlords to retain bad tenants, they will replace them with good ones.