From Distressed to Success: Strategies for Lenders Holding Distressed Planned Community and Condominium Assets

Many developers in New Jersey and other states are now facing difficulties in completing construction of planned communities and condominium projects. As these difficulties mount, some developers are unable to meet mortgage obligations resulting in troubled loans and assets for lenders. The lender must develop a strategy for owning and operating such distressed assets, particularly when such properties may be held for increasingly longer periods of time and these projects involve not only traditional collateral, such as improvements and property, but also components of an operating community. In determining the best approach for handling a distressed planned community or condominium project, lenders' counsel should carefully consider the lender's existing rights and obligations; operational issues; and marketing and sales of the development. Ultimately, each of these issues will affect the subsequent disposition of the distressed assets by the lender. This article discusses the unique issues that a lender will likely encounter when acquiring or holding distressed developments as a result of foreclosure or deed in lieu.

Existing Rights and Obligations

The lender must understand the rights and obligations of the original developer and determine whether any such rights and obligations will pass to the lender. Examine the governing documents, including any declaration of covenants, conditions and restrictions, declaration of condominium, and/or master deed articles of incorporation and bylaws for any owners association; cost sharing agreements; and reciprocal easement agreements. Confirm whether the lender consented to the documents. If not, will the lender's interest and the value of the project be better served by challenging or retaining the governing structure?

Consider the definition of "declarant" in the documents and under New Jersey or applicable state law. Whether "declarant" is specifically defined as the developer or includes successors and assigns, as well as any mortgagee acquiring declarant's interest in the property by foreclosure or deed in lieu, will impact whether the foreclosing lender will likely assume the rights and obligations of the developer under the declaration.

Review the declaration for any "special declarant rights." These special rights are particularly important when the lender, or a third party acquiring from the lender, intends to complete construction of the project and frequently include: (1) rights to add and withdraw property; (2) rights to use existing facilities for selling, marketing and leasing activities; (3) rights to complete improvements; (4) the right to control association operations for a specific period; (5) rights to unilaterally amend the declaration; and (6) easements and the right to create additional easements to serve adjacent property that may not be added to the project (such as those needed for access, utilities, construction, and use of amenities).

Additional obligations may arise under government approvals for the development, such as planned unit development zoning, development agreements or other similar approvals. Consider whether such entitlements establish deadlines for completing infrastructure. Similarly, confirm the status of any zoning, variances, permitting and other related approvals granted on the local, state or federal level to ensure that the anticipated use of the development and any contemplated construction activities are permissible.

Operational Issues

While holding the distressed development, a lender may face ongoing obligations of the owners association. Verify whether the developer has maintained official records of the association, paid taxes and registration fees, and is current on all corporate filings for the association.

Determine whether the lender will control the association and when it is required to turn over control of the association, and what obligations it may inherit in operating the association. Condominium associations in New Jersey have a staggered turnover. Verify that the association has obtained adequate insurance for casualty losses and liability claims. Keep in mind the association's fiduciary responsibility to the lot or unit owners. Liability may be imposed if the association funds are mismanaged, voting control is misused, or if fiduciary obligations are violated.

Consider the impact of the association's financial status on the development's value. In a distressed development the lender will likely find substantial unpaid assessments and deferred maintenance resulting from lack of funding. Ensure that the association's budget adequately reflects the anticipated income and expenses and identify any deficits or inadequate reserves. A lender faced with inadequate reserves may be required to contribute additional capital to the association or increase assessments. Any increase in assessments must comply with applicable laws and the declaration, particularly any caps on increases.

Determine whether existing owners are delinquent in the payment of the assessments and the association's lien rights. Verify whether the developer has guaranteed assessment levels, exempted any owners from assessments, or has the obligation to pay assessments or subsidize any shortfall between the association's operating costs and income. Although the extent of the lender's liability for assessments may vary between states, these issues cannot be ignored when there is a strong likelihood that a lender will be operating the development for an extended period of time.

Review the master plans, recorded plats, condominium surveys and the declaration for designations of common areas or elements, which are essential components to the value of the development. Assess if the developer marketed the project with specific facilities and whether those facilities were merely proposed or actually promised. Confirm whether the lender may be required to complete any amenities. Review all contracts related to construction of the facilities to determine any remaining obligations of the developer. If common areas have been conveyed to the association, review the conveyance documents.

With respect to a partially completed development, consider whether completing improvements will affect the value of the distressed development and whether any liabilities for such improvements exist. For example, determine if any amounts are owed to general contractors, subcontractors, and/or design professionals and whether any liens have been placed on the common areas or recreational facilities.

Evaluate the operational structure of the facilities. If the facilities are operated through a club membership program, review all club documents, including the membership plan, individual membership agreements, rules and any other club documentation.

To maintain property values, many declarations include provisions which preserve the architectural integrity of the development. Determine whether the lender will have: (1) rights to appoint members of any architectural review board; (2) the same rights afforded to the developer (particularly any exemptions from architectural review); and (3) rights to modify the architectural guidelines. The lender may want to exert architectural control rights over existing owners to preserve the scheme and design of the development and, hence, its value.

Marketing and Sale of Developments

Land sales laws impact a lender's potential risk with regard to a distressed development but also its ability to dispose of such property. The offer and sale of property, within the United States, is regulated by the Interstate Land Sales Full Disclosure Act. Likewise, the offer and sale of any in-state planned real estate development or any out-of-state real estate development marketed within New Jersey is regulated by the Planned Real Estate Development Full Disclosure Act and the Real Estate Sales Full Disclosure Act, respectively. Unless an exemption is met, the development must be registered with HUD and the applicable state agency.

If a development is not registered, confirm whether the developer relied on and complied with an exemption, which is crucial to measuring the risk of rescission of past sales. For example, under ILSFDA, if the development is not exempt and not registered, a purchaser is entitled to cancel the contract for two years after the purchaser has signed the contract. This cancellation right survives closing.

Evaluate the marketing activities of the developer and the status of any HUD or state registrations. Depending on the status of the development, certain exemptions may no longer be applicable. For example, the ILFSDA Improved Lot Exemption is available for lots or units sold pursuant to a contract that obligates the seller to complete a home or a condominium unit within two years of the date that the purchaser signed the sales contract. This exemption is particularly important to distressed developments where construction has commenced but has not been completed. A contract may provide for a delay in the two-year obligation, but only under extremely narrow circumstances. Review closely any contracts that have relied upon the Improved Lot Exemption, as there has been significant recent litigation over specific contract provisions under this exemption.

Be aware that exemption at the federal level may not necessarily mean that the development is exempt at the state level. New Jersey, for example, has a comprehensive registration process and the requirements may change based on the specifics of the development. New Jersey land sales registration now includes a "secondary registration." If a project qualifies for a secondary registration, the developer may respond to inquiries about the project initiated by prospective New Jersey purchasers in response to the project's Web site or other multistate advertising by providing general information about the project. Until the secondary registration is accepted, no contract may be offered, deposit collected or travel subsidy provided, to a New Jersey resident.

The lender, upon acquiring a distressed development, may have an obligation to amend or refile any report filed with HUD or any applicable state agency.

The viability of a distressed development rests upon a keen understanding of the status of the development and the strategies to protect the investment. The above is an overview of issues for consideration by a lender that acquires a distressed development by foreclosure or deed in lieu whether in New Jersey or elsewhere. While this list is not exhaustive of the matters of concern to lenders, it provides a starting point for evaluation of distressed developments.