Published on: June 20, 2008
An already difficult condominium market is likely to become more challenging for buyers, sellers, and especially for lenders as a result of new underwriting guidelines adopted recently by Fannie Mae and mirrored, in key respects, by Freddie Mac. The revised rules respond to the mounting loan delinquencies and defaults that have bruised the bottom lines of Fannie, Freddie, and just about everyone else involved in financing residential mortgages. But the new policies also reflect concerns — long-standing, though not often enforced aggressively in the past — about the need for lenders to assess the financial strength of community associations as well as the credit profile of the borrowers purchasing units in them. In addition to tightening the qualifying standards for condominium buyers, the new rules will require lenders to assume more responsibility for reviewing the finances of community associations and will, as an indirect result, push community associations to focus more intently on their budgets and their reserve policies than many have tended to do in the past.
Full Reviews Required
For lenders, the most significant procedural change is the virtual elimination of the streamlined “spot” loan approval process through which Fannie and Freddie have provided automated reviews of condominium loans originated for sale to them. (This article is based on an analysis of Fannie Mae’s policy announcement, but as noted earlier, Freddie Mac’s new requirements are essentially the same.) Fannie’s new rules will require full project reviews for loans to individuals purchasing units (for primary residences or second homes) in new condominium developments and for loans to investors buying units in both new and established communities. Lenders financing multiple loans in existing communities – defined as more than one loan in a given community within a year – will have to subject those loans to a full project review as well. Spot loans — single loans in existing communities —will be allowed only for borrowers making a minimum down payment of 10 percent – another significant change from the former policy, which allowed 100 percent financing for some condominium loans. Clearly, Fannie wants lenders to perform full-scale rather than limited reviews on most of the condominium loans the company buys. The company also wants communities to be primarily owner-occupied. Fannie will not approve an investor loan unless at least 51 percent of the units are owned or (in a new development) under contract to owner-occupants or second-home owners. Under the full project review now required for most condominium loans, lenders must verify and warrant to Fannie that:
- The community association has an “adequate” budget.
- The budget contains a line item allocating 10 percent of annual revenues for the association’s reserves
- The association has available funds equaling the deductible under the association’s master insurance policy.
- No more than 15 percent of the common area fees are delinquent by more than one month.
- Limits on Delinquencies
All of these changes are significant for lenders, but the delinquency limit is likely to prove most problematic. Community associations in Massachusetts and nationwide are already struggling with rising delinquencies and foreclosures, exacerbated by a weakening economy and restrictive lending policies that had already begun to tighten before Fannie announced the new guidelines. Even with an aggressive collection policy in place, it takes time for a community association to collect delinquent payments or to foreclose on delinquent owners. In Massachusetts, associations can’t even begin the collection process under the state’s super lien statute until an owner has fallen two months in arrears. Lenders, struggling with delinquency overloads themselves and under pressure to work with struggling borrowers, are delaying foreclosure actions and (in turn) delaying the point at which they must assume responsibility for paying the fees for the units they acquire. Under these circumstances, it is likely that large numbers of associations are already tripping over the new 15 percent delinquency requirement, or will be soon. The full impact is unclear, but at a minimum, this policy seems to be at odds with federal and state efforts to stimulate the sagging housing market. The policy also seems inconsistent with another recent Fannie Mae announcement telling loan servicers that they can increase the forbearance period on delinquent loans from four to six months, to give borrowers more time to seek financing alternatives that will allow them to avoid foreclosure. (I asked Fannie Mae officials if they have considered some of these potential problems, but hadn’t gotten a response as of this writing.) The new guidelines will increase the paperwork and expand the potential liability for lenders, who must now warrant on each condominium loan sold to Fannie Mae that the community association meets all of Fannie’s legal requirements. In a follow-up memorandum clarifying the policy, Fannie Mae explained that for new condominiums, lenders must submit a formal written opinion from an attorney verifying that the association’s documents are in compliance, but for existing communities and smaller developments (two-to-four units), Fannie said, the attorneys’ review “need not rise to the level of a formal written legal opinion.”
Distinction without a Difference
In theory, Fannie seems to be suggesting that the review for existing communities will be less extensive; in practice, however, this will be a distinction without a difference. No lender is going to warrant compliance for a new or existing development without obtaining an attorney’s written opinion on which to rely. And no attorney is going to provide that written opinion – whatever it’s called – without performing the analysis necessary to offer an informed assessment. Whether they are dealing with a new development or an existing community, attorneys are going to have to review and analyze the association’s documents, and they are going to charge lenders for that work. Having the attorney who represents the association or who prepared the original documents perform the review may reduce the cost, but there will be legal fees involved and lenders will almost certainly pass those expenses along to borrowers, increasing the cost of condominium loans. Community associations will also feel the impact of the new condominium standards, in two ways. First, they will have to respond to requests from lenders seeking to verify that they have they have the “adequate” budget, 10 percent reserve allocation, and deductible funding the new rules require. It’s not clear how lenders will determine that an association’s budget is “adequate,” but at a minimum, they will probably want copies of the budget and most recent reserve study, plus some fairly detailed background information explaining the community’s reserve policies and its reserve replacement history. Association boards should anticipate these requests and develop policies for dealing with them. Owners should anticipate that boards will require them to pay for the reasonable cost of providing the information requested by lenders financing the units owners are trying to sell.
Pushing for Reserves
The new condominium policies will require community associations not just to provide information about their policies, but in many cases, to adopt policies they don’t currently have. Fannie clearly wants homeowners associations to have budgets (preferably “adequate” ones), to maintain reserves for replacing major building components, and to have the capacity to cover their insurance deductible. Among these, the reserve requirement will likely prove most challenging. Most communities do not have adequate reserves – defined as existing savings and a funding policy matching the replacement recommendations in the association’s reserve study, which many also do not have; some communities don’t have any reserves at all; few, if any, have line items in their budget specifying that 10 percent of their annual revenues will be allocated for the reserve account. But here’s the critical bottom line: Lenders selling loans to Fannie and Freddie will not finance units in condominium communities that do not meet the 10 percent -of-budget reserve requirement. Associations may be able to win a waiver if they can demonstrate that their reserve study supports a lower reserve to budget ratio. But Fannie Mae is serious about the reserve requirement and associations are going to have to be serious about it, too. Arguably, the new underwriting standards for condominiums will require lenders and community associations to do things they should have been doing all along – associations may become stronger financially, lenders may adopt more prudent policies, and everyone – lenders, associations, condominium buyers and sellers – may eventually end up in a better place as a result. But the trip from where we are to where these policies are driving us is going to be bumpy at best, and it is unlikely that anyone is going to enjoy the ride.