Friday, December 30, 2011

The Perils of Hidden Damage: Part II

How do you fix it, What Happens if you can’t?

By Tyler P. Berding JD., Ph.D.

          Every community association will face a major reconstruction project several times in the life of the development. This may occur because of clearly anticipated problems, such as re-roofing or re-painting, but it can also occur because of completely unanticipated (and unreserved-for) problems such as dry rot repair, soil subsidence, or leaks in windows and siding.

          California’s Davis-Stirling Act only requires that a community association reserve include those components that visual inspections of accessible areas reveal have a useful life of 30 years or less, and makes no allowance whatsoever for reconstruction due to hidden and unknown deterioration. There can be two decidedly different outcomes to any attempt to repair previously unknown damage. The first is a predictable project that succeeds in repairing the damage within the association’s means. That is the subject of Part I. Part II, however, considers the situation where invisible damage is so unexpected and expensive to repair that it overwhelms the association’s resources.

Part II
What if the Cost of Repair exceeds all Expectations?
            That can happen and when it does it creates a dilemma for the board of directors. The problem that was the original reason for a major repair may not be the end of the story, depending upon how much was known about the extent of that damage before the job began. Its one thing to discover some dry rot in one isolated area during a routine repair, but quite another if that dry rot is part of systemic deterioration of the building.

If your major repair project is begun with an insufficient understanding of the extent of hidden damage, your entire funding scheme may be overwhelmed and owner equity could go with it. It is critical in an older building, therefore, to determine the scope of work and the cost of repair as accurately as possible before the project begins. But what happens when all else fails and the damage exceeds all reasonable expectations and funding?

Consider a Different Option

Let’s say that you have done your due diligence, you hired an architect to investigate and prepare a scope of repair for the replacement of the siding on your building; you had the building inspected using some random intrusive testing and while you detected some hidden damage, it wasn’t extensive where you saw it; your contractor expressed confidence that he could repair the building for the costs projected in his bid. You start the project. Six months into the project the contractor reports bad news. The damage to the framing under the siding is much more extensive than the tests had revealed. His contract says that extra work is to be done on a “time and materials” basis—essentially priced over and above the base price of his contract. The costs begin to rise appreciably. Soon the cost of the job is almost twice as high as the original estimates. You’ve tapped your line of credit and all of your available reserves and the owners will likely not approve the special assessment that will be necessary to pay for all of this new work. Now it is probably too late for many options.

Many older buildings with hidden damage will turn out to be extraordinarily expensive to repair. Knowing that before the project begins may give the owners second thoughts about the utility of starting the repair. Once a construction project is well along a substantial portion of the available funding will be irrevocably committed, leaving the board of directors with few options but to complete it. At that point the ability to change direction, and with it, financial control may be lost.  Why is financial control important? Because once substantial funding is already paid or committed it will be too late to go back and reconsider whether doing the work was a good idea in the first place—it becomes too big to fail. Consider that scenario against this one—in some instances, repairing the damage may not make economic sense.

Take a condominium building with 50 units. The average unit’s market value before the need for repairs was discovered is $200,000.00 partly because of the depressed economy but also because the building appears run down and in need of repairs and paint. But the average owner equity, given the decrease in real estate values generally, is only about 10% of that with mortgage loans representing the rest. Total owner equity in that building would then be $20,000 per unit x 50 units, or only $1,000,000.  Now, if the cost to repair that building is only $200,000.00 because the hidden decay is very limited, a repair makes sense. The building will get fixed, painted, look great, and property values will rise. But what if the hidden damage is so extensive that the projected cost of repair is $2,000,000? And further, what if the association has only $100,000 in reserves? Does it make good economic sense to do those repairs? To raise $2,000,000, the association would have to either borrow it or assess its members, or both. That’s a very tough decision for the board to make.

We have seen examples where the cost of repair rose significantly well after the project was underway and the funding was already maxed out. If a $2,000,000 repair for the building in this example stretched the association’s resources to the absolute limit, what would happen if the cost ended up being double that because previously undetected damage turned out to be extensive? It may mean that the project can’t be completed, but it may also mean that it should never have begun. A $4,000,000 repair to a building in which the owners collectively have only $1,000,000 in equity makes no economic sense—at least not to the owners. To them, that building is a total loss—a concept that I know few boards have ever considered.

            Who Really Owns the Project?

            That doesn’t mean that the building has no value. Don’t forget our example; the units had a market value of $200,000 x 50 units equals a total building value of $10,000,000. Even if the $4,000,000 repair cost is deducted, the building still has residual equity of $6,000,000. But who owns that equity? It’s not the owners because their interest is second to the mortgage holders. The owners individually probably have no equity left in that building once the cost of repair is factored in. The lenders have whatever equity is left. So that leaves those owners with a very difficult decision: do they stretch their personal resources to the breaking point, including borrowing as much as they can from a bank, or assess themselves the maximum that they can personally afford, essentially to protect the interests of their lenders? If, for the moment, you wring all of the home ownership emotion out of it, as well as the fear of the credit consequences of walking away, the answer is probably no. Consider this simple equation:

Aggregate Market Value - Cost of Repair - Total of all mortgages = Total Owner Equity

Where total owner equity is under water, the owners should consider whether they have any remaining interest to protect. This is neither an extreme example nor a false assumption — similar examples can and will be found. Many buildings are reaching an age when decades of accumulated deterioration will become known and when that is combined with years of reserve underfunding it will produce a crisis. The loss of market value generally over the past few years has accelerated this process and has already reduced owner equity substantially. In many cases reserve funding has been raided to cover losses due to delinquent assessments. And in our example, critical maintenance has gone undetected for many years, and as we can see, has eaten up any positive owner equity that was left.

            Alternatives to Repairing the Damage

If the proposed cost of repair approaches or exceeds all available reserves and owner equity, perhaps another plan should be considered. There will, of course, be individual owners who own their units outright with no lender involved. But the number of such owners will be greatly exceeded by those owners who have much less or no equity and who will not see the utility in paying large special assessments to service a bank loan and will reject that idea when presented. If the debt and the demands on owners for payment are too great, they will reject the authority to borrow additional funds or to specially assess. Or, the delinquency rate will increase until even those owners who are willing to pay will have to consider whether they will be in it alone. Potential construction lenders will be reluctant to lend if the demand on owners is not affordable.

Many state laws mandate that the association assess its members as necessary to do whatever repairs are required. That’s true in California, and in many other states. But while that is the law, it was conceived in good times and for new buildings, but it may be unrealistic in the case of catastrophic loss where the damage exceeds the combined ability or willingness of the owners to pay to repair it. Does the board really have a choice? Can they actually decide not to make repairs or must they do it and assess owners whatever it costs?

            The Law Recognizes Obsolescence

The members are not without legal options. They could walk from their obligations and abandon their interest in the property. Many have and foreclosures have been rampant for several years. This is not necessarily just because an owner can no longer afford the mortgage payments. It may also occur because an owner no longer sees value in making those payments. Large, additional special assessments for re-construction could easily reduce perceived value. But abandonment can often carry with it stigma and impact the individual’s credit rating, so there are consequences to disorganized individual action.

But abandonment may not be the only option. When the cost to repair is too high, and repair is unrealistic compared to the value of the project, there are other statutes which come into play that give the board and the members a choice of whether to repair the damage or not and provides an avenue for organized group action. California Civil Code Section 1359, for example, anticipates building obsolescence and provides criteria for unwinding an association where the damage likely exceeds the owner’s ability or willingness to pay to repair it. The statute lists the following very specific circumstances when “partition,” or the combined sale of the entire parcel to a third party, may be appropriate:

 (1)          More than three years before the filing of the action, the condominium project was damaged or destroyed, so that a material part was rendered unfit for its prior use, and the condominium project has not been rebuilt or repaired substantially to its state prior to the damage or destruction.

(2)           Three-fourths or more of the project is destroyed or substantially damaged and owners of separate interests holding in the aggregate more than a 50-percent interest in the common areas oppose repair or restoration of the project.

(3)           The project has been in existence more than 50 years, is obsolete and uneconomic, and owners of separate interests holding in the aggregate more than a 50-percent interest in the common area oppose repair or restoration of the project.

(4)           The conditions for such a sale, set forth in the declaration, have been met.

                It is not difficult to envision one or more of these provisions applying to an older building which has been severely damaged by years of hidden deterioration or where critical maintenance has long been deferred because of lack of funds. The owners have the authority to decide that something other than spending a huge sum on repairs may be appropriate.

            Think Outside of the Box

            In older buildings, where damage has progressed undetected for many years, it may be too late for either preventive measures or to accumulate adequate reserves. In those cases some hard, creative choices have to be made. Here’s the dilemma: do the owners protect the lenders’ equity at all costs, or do they look for another avenue? Negotiation with lenders may be an option. Another may be to try to sell the entire project as a single parcel—maximizing unused density and attracting new developer money that may actually make the property worth more than the collective value of the units in their present state. Another may be to investigate the association’s insurance coverage to see whether its hazard insurance might cover long-term decay. Neither of those latter options would be easy, nor are they proven, but in a situation where all other options are foreclosed, a little thinking outside of the box, along with an appropriate application of the law, might actually produce a reasonable result that will preserve some owner equity.

            Next to damage from a natural disaster, a big, unexpected construction project is probably one of the most disruptive events in an association's life. Some associations never recover. This can be avoided in some cases with early inspections of all building components, whether visible and accessible or not, so that failure can be anticipated in enough time to adequately reserve for the costs of repair. Like cancer, early detection offers the best chance for a cure. In other, older buildings, however, there may be no cure, only difficult choices. In those instances creativity and a willingness to accept reality may yield a better solution.

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