Published on: July 31, 2011
Those who fail to learn from history will almost certainly repeat it. Although few question this adage, many fail to heed it. The Federal Housing Administration’s (FHA’s) new guidance for condominium loans offers an unfortunate case in point.
The agency published the first iteration of this guidance in June 2009, with little, if any, input from the community association industry. The outcry from industry executives was immediate, loud and effective. Agency officials withdrew the guidance, reviewed the feedback and tried again. The revisions, published in December of that year, didn’t fare much better, so agency officials went back to their drawing board once again.
The results of those efforts — unveiled in late June – indicate that FHA officials listened to the concerns expressed by the Community Associations Institute (CAI) and others, and responded to at least some of them. But once again, agency officials failed to solicit industry input in advance. (CAI is challenging the guidance for that reason, arguing that FHA violated both the Administrative Procedures Act and its own rule-making procedures by failing to consult affected industries and interest groups.) Although improved in some areas, the revised guidance is still problematic (in some cases, even more problematic than before) in others.
The guidance details the requirements community associations must meet in order for owners and prospective buyers to qualify for FHA-insured mortgages. FHA certification has become more important for community associations since the financial meltdown, because the FHA has assumed a much larger role in the home finance market, now insuring an estimated 30 percent of residential mortgages originated or refinanced today.
But the requirements outlined in the new FHA guidance will complicate the certification process, to say the least, and may discourage some communities from undertaking it.
Attorneys, managers and other industry executives who reviewed the guidance in mid-July compiled a laundry list of problems and potential problems, the most serious among them including:
- An expanded, and apparently open-ended requirement that association representatives guarantee a community’s financial viability and marketability;
- A more detailed but ill-defined review of association finances;
- A new fidelity bond requirement for management companies;
- A revised formula for calculating delinquent common area payments; and
- New documentation and insurance requirements for gut rehab conversions.
All of the issues on this list will create headaches, varying in intensity and size, for community associations. Some (the financial guarantees, in particular) seem designed to shift liability for failed mortgages from the lenders originating the loans to the individuals providing the information on which FHA certification is based. And many reflect a lack of understanding of community associations and how they operate.
A new insurance provision, requiring management companies to obtain fidelity bonds for their employees is one example of what the FHA doesn’t know about condominiums. Not only would this coverage be difficult to find and expensive, it would also be duplicative. Most communities already have fidelity insurance policies that cover malfeasance by managers, which many states, including Massachusetts, require. Bonding management company employees, as the FHA now requires, won’t increase the protection associations already have, but it will add significantly to the cost.
In another indication that the FHA does not fully understand the condominium industry, the guidance establishes new requirements for condominium conversions, applicable to both gut rehab and non-gut-rehab projects. The guidance recognizes correctly that these requirements (including a reserve study and extensive preliminary reserve funding) aren’t appropriate for new construction, but fails to recognize that gut rehab conversions are the equivalent of new construction and should be treated in the same way.
The new delinquency formula is similarly misguided. The FHA has revised the 2009 guidance, which established a firm 15 percent delinquency cap, by adding waiver conditions that will enable many communities exceeding the cap to obtain certification anyway – a much-appreciated change. But what the FHA has given with one hand, it is taking back and more with another by now including units on which lenders have foreclosed in the delinquency calculation.
Lenders holding foreclosed units – HUD among them – are notorious for not making timely payments of common area fees. And given the general disarray in the foreclosure arena today, it is often not clear who actually owns a foreclosed unit, making it virtually impossible for communities to demonstrate their efforts to collect delinquent payments, as one of the waiver provisions requires.
Who will sign?
The delinquency, insurance, and gut-rehab conversion issues represent headaches – serious and in need of correction, to be sure, but headaches, nonetheless, compared with the FHA’s certification language, which is more akin to a stroke in its potential impact on community associations.
The agency wants the association’s board, manager or “authorized representative” to affirm that the community complies with “all state and local condominium laws and all FHA condominium approval requirements” and to attest further that they know of no “circumstances or conditions that might have an adverse effect on the project or cause a mortgage secured by a unit in the project to become delinquent.” The guidance includes among these possible adverse conditions: Construction defects and “substantial disputes or dissatisfaction among unit owners about the operation of the project [or the association], and disputes concerning unit owners’ rights, privileges, and obligations.” As if this open-ended assurance that the community is completely problem-free isn’t unnerving enough, the individual providing the certification also has “a continuing obligation to inform HUD if any material information [submitted] is no longer true and correct.”
I can’t imagine that any association managers or trustees would be willing to accept that “continuing obligation” or provide the guarantees FHA is demanding, even without the threat of up to 30 years in prison and a $1 million fine if the FHA subsequently finds any of the information certified to be inaccurate or untrue.
First, it is impossible for anyone to know or predict what “adverse circumstances” might affect a community’s financial stability. Even if a problem isn’t evident when the application is submitted, HUD could argue that the manager or board members “knew or should have known” about it anyway.
As for the “continuing obligation” to inform HUD of adverse changes in the future – how could that possibly work? Do trustees who sign the certification application incur a permanent obligation to inform HUD of changes? Does that obligation continue when the trustees are no longer on the board or no longer living in the community? Same question for the consultants who submit certification applications for community associations? Are they responsible for monitoring all the communities they represent, and do they incur that obligation forever?
The certification language is unreasonable and unworkable, but it could also be fixed, or at least partially fixed, fairly easily, by separating the affirmations. Verifying compliance with state and local laws requires a legal assessment that managers and boards aren’t qualified to make, but the association’s attorney could provide that assurance. Likewise, the lender or the lender’s attorney should be able to attest that the community complies with the FHA’s regulations, although the outsized penalty for errors might understandably discourage some from doing so.
These changes would fix part of the certification problem. The required assurance that there are no “dissatisfied owners” or other adverse conditions that could affect the community’s marketability is harder to address. I certainly wouldn’t advise our clients to sign such a document and consultants who reviewed the guidance initially said they weren’t comfortable signing it either. But I think we may have found a route around this obstacle, through a short affidavit that boards or managers could sign. The affidavit poses four questions:
- Has any litigation been filed against the association board or manager relating to the operation and management of the condominium?
- Has any petition to remove the board by unit owners been submitted to the board or manager?
- Has any engineering report been received within the past 12 months which indicates defects in construction or major repairs?
- Have any lawsuits been filed by any unit owner or resident relating to failure to repair the common areas?
The association representatives signing this affidavit also agree that they will inform the individual submitting the FHA certification application of any “material and adverse changes” in the answers they have submitted.
Two consultants with whom I have communicated: Philip Sutcliffe, a principal in Project Support Services, LLC (firstname.lastname@example.org) and Orest Tomaselli, Chief Executive Officer of National Condo Advisors, LLC (email@example.com), agreed that if boards or managers sign this affidavit, they would be willing to sign the FHA certifications after all. That’s significant, because both represent association clients in in all 50 states.
The affidavit targets some of the assurances the FHA is seeking, but not all of them. A separate provision in the guidance requires the certifying entity to explain the purpose of any special assessment currently in effect – a perfectly reasonable request. But the FHA also wants the association’s representative to describe the impact the assessment will have on the community’s “financial stability” and its “future value and marketability.” I don’t know how anyone could make those predictions and I don’t know of any crystal ball that would help.
Even more disturbing, the FHA appears to be viewing assessments and loans as negative indicators, reflecting poor financial management. The agency has reportedly rejected two certification applications because the communities had special assessments and one because the community had an outstanding loan.
We don’t know the details. Perhaps agency officials were concerned about the terms of this particular loan or the structure of these particular assessments. Certainly nothing in the guidance says communities can’t have loans or assessments. But the agency’s questions about how assessments might affect a community’s finances, value and marketability seem to reflect a generalized concern that is misguided, to say the least. The long-term impact of an assessment is hard to predict, but the community that levies an assessment or obtains a bank loan to finance essential repairs will almost certainly be better off financially and in most other respects than the community that chooses instead to ignore these problems.
It is clear from this revised guidance that the FHA is boring down more deeply into association finances, requiring income and expense statements and financial guarantees that the earlier certification guidelines didn’t include. What isn’t at all clear are the criteria the FHA will be applying to this financial review. If agency officials are viewing assessments and loans as undesirable, what about reserves? Will they begin looking not just at the required annual contributions to reserves but also at total reserve levels over time, and will they apply their own subjective judgments about what those reserve levels should be?
Questions and Concerns
This is one of many questions the FHA guidance has triggered. We discussed those questions and others at a seminar Marcus-Errico sponsored July 27th. Although the seminar, like this article, focused on the problems industry professionals have identified, the guidance contains some welcome changes. In addition to softening the delinquency cap, as noted earlier, the FHA has reduced the pre-sale requirements for non-gut rehab condominium conversion developments, clarified that associations are allowed to restrict rentals, and patched a provision that would have barred FHA approval for some developments with a mix of market –rate and affordable units.
The FHA responded to these and other industry concerns and there is reason to expect, or at least to hope, that problems with the revised guidance will be addressed, as well. With that goal in mind, CAI is taking steps to resume discussions with agency officials. The organization has also formally challenged the guidance, arguing that the FHA violated both the Administrative Procedures Act and its own rulemaking procedures by failing to consult affected industries and interest groups.
It is also worth remembering that the guidance is still new. We don’t know how the FHA will interpret the certification requirements or how agency staff will apply them in application reviews. Sometimes the initial reaction to new regulations is an over-reaction. Requirements that seem rigid on paper may become less severe in practice. But this guidance on paper provides considerable cause for concern. If the major problems aren’t corrected, Andrew Fortin, CAI’s vice president of government and public affairs has warned, “FHA approvals for community associations will come to a loud, screeching halt.”