Thursday, December 27, 2007

Condominium Conversions: Owner Equity at Risk?

Why We Should Stop Converting Old Apartments to Condos.

Condominium conversions, a really bad idea, are here again. You don’t need statistics to tell you that condominiums converted from old apartment houses have been all the rage for several years. Just look around. Numerous apartment buildings are being sold as condominiums. We saw it twenty years ago when home prices in California experienced the same kind of super heated run-up that we’ve seen in the first part of this decade. Anything with a door and a roof sold quickly, often with multiple offers. The market has cooled now, but builders with homes to sell made a lot of money...however, the price of admission was often misrepresented. How so? If the actual reserve and operations assessments are many times more than was actually stated by the converter, the association will have to face the possibility that they will never accumulate enough money to maintain the project...

Please click on the title link to read the rest of this article.

Stealth Reserves: Tapping Unused Assessment Authority

Thinking Outside the Box...

The latest survey done by Berding & Weil and The Levy Company confirms that  the average community association reserves are only 53% funded. The result of this is that vital repairs—roof replacement, painting, repair of siding and trim, and similar work—may be either deferred or done in a substandard manner all because of lack of necessary funding...Once a problem has a repair price tag that exceeds the available cash in reserves, the board may not be able to easily solve the problem...

Click on the title link to read the rest of this article.

Construction Defects and the Statute of Limitations

Have Changes in the Law Imperiled your Associations Right to Recover for Construction Defects?

It’s 1998. The plumbing in your association’s 5-year old condo project has started to leak. You hire a plumber who discovers that the plumbing lines are made out of imported galvanized pipe and it is corroding from within leaving pinhole leaks throughout. Further investigation reveals that this pipe was withdrawn from the market years ago because of this tendency to corrode and leak. It’s 2008. Same facts as above, except that the condominiums were built in 2003. Although your attorney files suit within a year after you discover these problems, this time the suit is dismissed by the court as being untimely filed. What happened? How can two identical suits, filed 10 years apart by two community associations succeed for one and completely fail for the other?

Please click on the title link to read the rest of this article.

Sharing the Internet in a Community Association

No existing law prevents a community association from sharing an internet connection. Of course, agreements with Internet service providers would have to be reviewed to be sure that their contract language did not conflict with the intended use, but with all of the competition among providers, it would seem that some deal could be struck that would allow the connection to be shared by neighbors. The fact is that it is probably already happening informally. How many people who use a wireless connection for their laptop, for example, find multiple networks available when they log on to their computers? In multi-family projects, many of these signals come from neighbors, and if they are not encrypted, anyone can log on to the Internet on one or more of them...

Please click on the link above to read the entire article.

Construction Problems and Community Association Financial Stability

With many associations surprises have become the rule, and there are no bigger surprises than those that arise from various construction problems. There are, of course the problems found early in an association’s life--those that emanate from defects in original construction. But there are others, also related to the construction of the buildings that can affect financial stability much later...

Please click on the link above to read the entire article.

Monday, December 24, 2007

The Uncertain Future of Community Associations

Community Associations, especially condominium complexes, are in financial trouble. Most don't know it. Unfortunately, many find out after its too late to solve the problem. Underestimated repairs and rehabilitation costs, and years of inadequate budgeting for them, have exposed many of these projects to massive underfunding from which they may not recover. An explanation of the problem, and some suggestions for solving it, are discussed in the treatise: "The Uncertain Future of Community Associations" which can be read and downloaded from the "Publications Download" section in the column on the left or by simply by clicking on the cover of the publication above.

Please read it and if you agree, discuss it with your fellow owners and board members. You are welcome to print as many copies as you need.  Every condominium owner and board member should have a copy.  It could be the most important information your community association every gets...


Saturday, December 15, 2007

Condominium Conversions: Owner Equity at Risk?

By Tyler P. Berding

Condominium conversions, a really bad idea, are here again. You don't need statistics to tell you that condo¬miniums converted from old apartment houses have been all the rage for several years. Just look around. Numerous apartment buildings are being sold as condominiums. We saw it twenty years ago when home prices in California experienced the same kind of super heated run-up that we saw in the first part of this decade. Anything with a door and a roof sold quickly, often with multiple offers. The market has cooled some now, but builders with inventory to sell made a lot of money.

Having homes to sell, of course, is the key. You can't profit from sales without inventory, and new homes can only be built so fast. With more inventory to sell, there is, of course, more profit; so the question became how to increase inventory quickly to take advantage of a hot market. You could build faster, with more crews, but the limiting factor is always available land and proper zoning. How far into the Sacramento Valley will a commuter be willing to drive on his or her evening commute from Oakland or San Francisco or San Jose before that house in Tracy or Modesto or Salinas loses its allure? Not much further would be our guess. And since most of the available empty land is now maybe at least an hour's commute away from available jobs, some would-be real estate developers had to look elsewhere.

And when they looked around they saw thousands of apartment units in buildings in good, close-in locations. These were naturals in the hot sales market of the last few years. Further, many apartment complexes that were built in previous boom times like the mid-seventies and late eighties had now been depreciated by their owners to the point where further repair and maintenance did not make good investment sense; thus their owners were willing to sell them, especially when converters were offering much more than the properties could command as rentals.

Apartment conversions appeared to solve everyone's problems. They provided a source of low to moderately priced housing in built-up urban areas where the average price of a single family home is out of reach of many working families. Cities can improve the availability of low cost housing in a single stroke. No change of zoning, no new utilities, streets, or other expensive city-maintained infrastructure is necessary-it's already there! And most important, the city can instantly increase property tax revenues.


Since 1978, the recipients of the greatest benefit from California's Proposition 13 have been the owners of
residential apartments. That apartment owners got the greatest benefit from Prop 13 should come as no surprise; the apartment owners were sponsors of that initiative. The initiative capped increases in property taxes to a fixed percentage instead of following market value. Owners of apartments typically hold such properties for many years longer than owners of homes; so the adjustment mechanism in Proposition 13, which ratchets property taxes up to current levels only upon sale to a new owner, affects apartment properties much less than individually owned homes. As long as an owner remains on the title to a residential property, the assessed value of a property for property tax purposes can only be increased by something like one percent a year.

Put another way, the property taxes on apartment houses increase only this statutory maximum for all of the years they are owned by the same owner, regardless of a market value increase of many times that. The same is true for individually owned homes, but homes statistically turn over more frequently; when they do, the appraised value increases to market value more often. The result is that homeowners pay higher property taxes than do owners of apartment buildings; therefore the more recently sold homes the city can create, the more property tax it can collect. If you convert a 200 unit apartment house into 200 individually owned homes, the increase in property taxes that results from all of those sales is too tempting for a city to resist. As a consequence, cities have shown a remarkable lack of self-restraint when considering whether to approve such developments.

Some cities have conversion ordinances that require some minimal level of rehabilitation or disclosure. Yet such ordinances frequently fail to protect the buyers. Although we have seen very high-end conversions from newer buildings that actually do not need a great deal of rehabilitation, most conversions are from older apartment buildings with years of deferred maintenance and with tragically under-funded budgets for the maintenance and repair of these properties. The new owners will never be able to afford to maintain the property properly due to the fact that the many converters fail to do any significant rehabilitation at all. This has the effect of dumping hundreds of thousands, perhaps millions, of dollars in unfunded liability for deferred maintenance on to unsuspecting buyers. It is likely that in most cases a city inspector has given these projects only a cursory review prior to approving the development for conversion. The California Department of Real Estate has also failed the buyers of these maintenance nightmares. The budgets are submitted by the developer, and as long as they appear to comply with DRE guidelines, the projects are approved by the state.


Budgets are only as good as the estimates of useful life for each component that will require repair. If the siding is already worn out and requires replacement, estimating that it will last 20 more years may look good to the State of California; but it isn't true and the buyers will be misled. Worse, the owner's assessments will be calculated on an artificially calculated useful life and as a consequence the reserve for siding replacement will be grossly underfunded. Similarly, if the siding is accurately estimated to last only two more years, but the reserve budget projected is based on artificially low assessments, the community association will not accumulate anywhere near enough cash to replace the siding in that time, and again the buyers have been misled and stuck with something that they cannot hope to maintain. It is also important to note that in either of the foregoing circumstances, the owner's assessment will appear as affordable, and more low to moderate buyers will qualify to buy the condominium, broadening the market for sales. The truth, however, is that the misrepresentations of the cost of ownership that result from misstated or inaccurate reserve budgets will eventually result in a much higher cost of ownership than is indicated by the purchase pnce.

And who ends up buying conversions? Some of the high-end conversions are bought by owners who have the financial wherewithal to fund necessary repairs, but not many are so fortunate. It is our experience that the worst buildings end up in the hands of low or very moderate-income people who can least afford to deal with these extensive maintenance problems.


The buyers of a condominium built as new construction have one thing going for them that their friends who bought the condominium conversion do not-time. Newly constructed condominiums, once the initial construction issues are dealt with, will survive neglect and poor maintenance for a number of years. If a new condominium association pays at least some attention to ail of the projected repair needs of a building, they will budget adequately while there is still time-perhaps ten or fifteen years or more-to save the cash to fund those eventual repairs.

The buyers of a converted apartment house, however, may find that the same components need repair. or major rehabilitation, but right now, not 25 years from now, and hence with no time to accumulate the cash to do it. If you convert a 25-year old apartment house to condominiums and do not do major rehabilitation in the process, all of those years of deferred maintenance are left on the doorstep of the new owners. No reserve budget can hope to adequately head off such a grossly unfunded liability with anything close to afford-
able assessments. There simply is no time to save the money.

Let's say that a project has plywood siding. Let's also assume it costs about $20,000 per unit to re-side the project. If the reserve budget includes a line item for siding replacement, as opposed to just painting, a newly-built 20D-unit project would have say, 20 or 25 years to accumulate the roughly $4 million that it will eventually need to replace the siding. This is possible with a well-managed funding plan and if the reserves are fully funded for most of those 25 years.

But now let's assume that the community association is formed to manage a condominium project converted from a 25-year old apartment building that has not been maintained all that well. The siding will likely be at the end of its useful life when the condominium project is sold to its lucky new owners. If the converter has not replaced the siding or seeded the reserve funds with substantial capital, the owners will face a daunting, and probably impossible, task-coming up with several million dollars in just a few short years! What community association do you know that could possibly raise that much money, either borrowed or by assessing its members, or both, in that short amount of time? Few that we know. Further, the buildings where the deferred maintenance is the worst are not the high-end projects where the owners might be able to afford a large special assessment, but rather low-to moderate income projects where the residents have little chance of either borrowing or contributing the necessary funds.


In the example above, the $4 million repair bill distributed among 200 owners will mean that each owner has to consider that her assumed equity in her home, when based on the purchase price, is actually $20,000 less the moment she closes escrow. Put another way, the true price of the condominium just went up by a lot.
And that's if all that's wrong with this 25 year-old apartment house is confined to one component. That's rarely the case, of course. Owners who defer maintenance for a building usually don't just defer it for one component they defer it for the entire building. All the wood products, not just siding, but also balconies, walkways, retaining walls, doors, window trim, roofs and plumbing will all deteriorate if not maintained properly or replaced when worn out, and at 25 years of age most of these components will be at the end of their useful lives. The loss of equity or diminution in value due to the cost of all deferred maintenance that must be addressed by the new owners can deal a major blow to property value once discovered.

We can create a simple formula for this loss of equity:Cost of Rehabilitation at Time of Sale (CR) less Converter Contribution to Reserves (CC)= Lost Owner Equity (LOE). Now if the converter were to rehabilitate the project completely-new siding, paint, trim, entry structures, balconies, roof, asphalt -putting the project into an "as new" condition, the CR would be very low to non-existent, leaving little owner liability or LOE. Conversely, if the CR is high and is not offset sufficiently by converter contributions to capital, LOE will be high also.

Price is usually based on perceived value, based in turn on the reasonable assumptions of a buyer. It is reasonable for a buyer to assume that the advertised price of the condominium plus the monthly assessment listed will, taken together, equal the long-term cost of ownership. But if the hidden cost of accumulated deferred maintenance results in immediate LOE, the price advertised is not the true price, and the buyer:s reasonable expectations are thwarted because she lacks information essential to determining the value of the property. The CR can sometimes be so high that virtually all owner equity is wiped out, at least on paper. Consider a $300 thousand condominium purchased with 10 percent down. Equity would be $30,000. In the case of a converted 25 year old apartment complex, with $3 to $4 million in deferred repairs, it is easy to see how aggregate owner equity could be reduced to zero.


The prior owner of the apartment complex may have calculated that the accumulating cost of rehabilitating the buildings was in excess of any profit he obtained from renting the apartments-a losing investment. If the apartment owner doesn't rehab the buildings, rents will continue to sag. If he substantially rehabilitates the apartment complex, he may invest more than the rents he can obtain will justify; so he decides to sell. If the converter buys the complex for more than its worth as rental property and adds to his acquisition cost the cost of all necessary rehabilitation, his total development cost may not only exceed the rental value of the building but may exceed its value as condominiums as well. If he did all of the repairs necessary to bring the property to an "as new" (zero CR) condition, it is difficult to see how a converter could make any money at prices that the market would accept. We suspect that the answer is that he couldn't; and therefore he doesn't do much rehabilitation and he passes most of the deferred maintenance on to the buyers as a hidden additional cost of ownership. Rarely is this disclosed to or understood by the condominium buyer.

Only substantial rehabilitation will eliminate all deferred maintenance. But because, as we said, to rehab the buildings as we describe may consume most or all of the expected profit from the development, this work is simply not done. If it were to be done, the price of the condominium unit might have to be so high that few sales would result. All of this leaves one to wonder about the economics, and ethics, of this entire enterprise. If the "converted" condominiums cannot be sold for a price high enough to allow the converter to reduce the CR to zero
and thereby justify the advertised price and owner assessments, can conversions really provide new housing without having to rely on misrepresentations to hide the true cost of ownership? Simply put, do the economics of this type of development allow for an ethical transaction? We don't know, but we suspect that the ethical envelope is pushed out quite far in the sales of some converted condominiums, a situation that we plan to investigate further.

And if this is all true, what will happen to the project? An already bad maintenance situation will become remarkably worse. The actual useful life of the entire project may be way less than the length of the mortgage. A 25 year-old apartment house that has accumulated a lot of deferred maintenance doesn't have another 25 years to live if nothing is done about it. Given the potential shortfall that exists in many of the conversions today it is not likely that anything can be done about this problem except to not convert old apartments into condominiums in the first place unless the converter is prepared to make a substantial capital investment in eliminating deferred maintenance.

This is not to say that all condominium conversion projects are suspect. Many converters have invested substantial cash in rehabilitation so as to give the buyers what they expect. Also, some "conversions" are not conversions at all, but rather a relatively new condominium project that was rented for a year or two. But others, looking for a way to turn a profit quickly, have simply "flipped" the project and passed deferred maintenance on to unsuspecting buyers. The best way to be sure is to ask the right questions and insist on answers before closing the deal.

A "Community" by Contract

Why Community Associations Are Not Governments And Why That Matters

By Tyler P. Berding

Articles devoted to the science of community association operations and management often discuss the concept of "community association" as if it were just another subdivision of local government. It is a common perception because so much discussion about this unique housing type is devoted to questions of governance. We have boards of directors, which in some respects appear to be like city councils. There are property managers who carry out many of the same functions as city staff. The property so governed has many of the same physical accoutrements as a town or city--streets, utilities, parking, recreation facilities, etc.

There are controls which are seemingly analogous to municipal government, where ordinances such as zoning place restrictions on individual property rights in order to give effect to the paramount needs of the city or county--as determined by the elected policy-makers. But while these two governance systems may appear similar, their respective legal bases are really quite different. Understanding this difference may help to understand why the occasional characterization of community associations as "mini-governments" or "quasi¬government agencies" is particularly inapt and can lead to false assumptions about community associations.

The sovereignty of our political government is subject to the limitations imposed upon its authority by various constitutional provisions, but its continued existence, short of war or violent revolution, is assured. A community association is not a sovereign entity, even though in many cases and in many of its duties, it appears as one. Its continued existence is wholly dependent upon the collective will of the owners of the property, and it has no assurance whatever of perpetual life.

Most of the law of community associations, both common and statutory, is based upon one fundamental concept-that the interests of the individual and those of the community must function in a kind of consensual harmony in order for the community association to work. That is, virtually every operation of a community association, and all of its authority, is derived from a private, contractual relationship among the owners, and these agreements, while stated in the CC&Rs and in the Bylaws, are nevertheless wholly dependent upon the collective will of the parties to that contract-the owners, and others who may share an ownership interest, such as mortgage lenders. The entity exists only with their continuing acquiescence. At any time, these owners, by whatever voting percentage is required, could terminate the community association by the simple expedient of amending the governing documents to eliminate it. Of course, the voting percentage may in some cases be as high as 100% of the owners. Also, the law of partition and corporate dissolution would have to come in to play in order to parcel out the common property, and the interests of lenders would have to be considered, but at least in theory, it could be done.

The same is not true for public entities which, as subdivisions of federal and state government derive their right to exist from the authority of the "sovereign" to use an old but still valid concept, limited only by the rights granted to individuals by the Constitution of the United States, the Bill of Rights, and the various state constitutions. Even if 100% of the citizens of the United States voted to do it, they could not terminate this country's existence-only Congress, supported by a significant number of state legislatures, has the power to amend the Constitution. From this sovereign authority comes the police power with which all government entities enforce their authority to govern.

The authority of the community association is not derived from constitutional law, per se, but rather from the common law of contract, as augmented by a few relevant statutes, and as such, are completely at the mercy of the parties to the contract-usually the owners of the separate interests. Government agencies are founded upon the principal of government supremacy-that while they must recognize and obey the constitutional rights and liberties of the individual, the public interest, where it has been clearly defined, is always paramount, and the rights of individuals must give way to it when a conflict in authority arises.

There are no better examples than the right of the government to tax its citizens and the right of Eminent Domain. To the extent of its authority to levy taxes on individuals, the government's authority is clearly superior to that of any individual citizen. Similarly, where the public need for property exists, the government may acquire it (with adequate compensation to the owner) for such public good as rights of way or redevelopment. Now of course, each of these governmental powers is limited by certain constitutional guarantees such as the rights to equal protection and due process, but when those requirements are satisfied, the government is free to act without further restraint. The importance of the public, or "community," interest as it relates to government is clearly carved into stone, and in this democracy little doubt of the supremacy of the public interest, as defined and limited by the Constitution, exists. Such assumptions are based upon hundreds of years of democratic political history.

We may think that similar assumptions apply to the common interest in a community association, but clearly they do not. The legal underpinning of a community association is a mere contract, one that depends upon the continuing mutual obligations of the owners to function. For example, the power of an association to assess its members is not analogous to the power of the government to tax. The power to tax is limited only by the vote of the legislature or Congress, and except for a few constitutional limitations, there is virtually no limit on that power other than those imposed by political considerations. The power of a community association to assess is limited both by the contract itself and by statute, and any such limitation cannot be set aside by the board of directors acting alone but must come from a consensus of the individual owners-a true "grass roots" democracy.

The right of individual property ownership is clearly paramount to the common interest in a community association. There is no mechanism, in the absence of severe damage or destruction, even by a vote of the members, whereby a typical community association could take possession of an individual's separate interest no matter how pressing the need, unless it were the result of non-payment of assessments, for example. There is no community association equivalent to "Eminent Domain."

So, while we sometimes describe them as "mini-governments" or "quasi governmental agencies" community associations are anything but. They have no power outside of that conferred upon them by the contracts among the owners. They have no "sovereign" or “constitutional” right to exist independent of those contracts, and they exist only until the parties to the "contract" agree otherwise. As such, community associations are not "governments" at all, but merely real property with a management and organizational scheme imposed upon it. They cannot print money. Their continuing existence is completely reliant upon the owners adhering to the contract and continuing to supply the necessary operating capital. They are also quite capable of becoming obsolete. When they do, there will be no constitutional precedent to save them, only the laws of economics will ultimately govern their fate.

Firestorm! Thoughts on the Recent Brushfires in California


Let’s mourn the loss of life and property, but let’s not deceive ourselves about the real cause of the destruction in southern California

By Tyler Berding

2007 will set yet another record for California acres consumed by fire. As I write this, after a week of massive destruction, firefighters in southern California are finally achieving some level of control over what will may be the most costly fire in California history, perhaps with 1906 excepted. Nevertheless, massive wildfire destruction is becoming a regular occurrence in this state and certainly has earned enough ink and video footage to put it right up there with other major disasters around the country. Over a thousand homes and several lives have been lost this past week, and by any measure you would care to use, it qualifies as a tragedy of epic proportions. Let’s mourn the loss of life and property, but let’s not deceive ourselves as to the real cause of this destruction.

Whatever loss is tallied in this particular fire, it will be due, not to global warming, criminal acts, or any lack of preparedness by state government to fight the fire, but rather to a callous lack of control over the unbridled development of California wild lands. This is not an environmental piece decrying the loss of habitat for various species or open space, although those are certainly consequences as well. This is an appeal for the primacy of common sense over the pressures of development profit.

California has been burning for thousands of years. Grasslands and chaparral burn. That’s a fact. Whether by lightning, a careless campfire, or an intentional match, the wild lands of California burn frequently and that’s what usually prevents the magnitude of fire damage that we are beginning to see. When wild lands burn periodically, the underbrush, which serves to spread fire, is burned off quickly and the larger trees remain. When we suppress this natural occurrence, we simply build up kindling for a much larger fire. When we build homes in this natural undergrowth, we demand fire suppression, and that’s exactly what we get—more kindling for a much bigger future fire like the one we’ve just seen and this time the homes burn too. It’s a vicious cycle for sure, because just as we protect these homes by suppressing small local brush fires, we are setting the stage for hugely destructive firestorms.

We cannot have it both ways. Life in the suburbs may be appealing, but the cost of massive fire suppression efforts to protect outlying areas is born by everyone in the state, not just the homeowners and insurance companies who pay for the loss. And for what? So more developers can build more homes on more marginal land way outside of established cities which in turn require more water, freeways, and firefighting readiness to protect and service them? Also the cost of service is way out of proportion to the number of homeowners serviced. There is no economy of scale in rural development. Cities, where population is concentrated, can offer necessary services at much less per resident than in sparsely populated areas.

But you don’t need an economic argument when common sense will do. When we see that the towns that are burning were not even on a map thirty years ago, we have to believe that responsibility for this destruction lies with the city and county planners who allowed this massive wild land development to happen in the first place. Preventing development in fire prone regions of the state would seem to be a logical way to avoid fire tragedy in the future. But self-restraint is hard to come by when developers can make huge profits from building homes in new areas. But restraint is exactly what we need. If the county planners are too easily persuaded, then perhaps the state needs to get involved when it comes to approving development in certain fire-prone regions. In any case, we need to worry less about why wild lands burn and focus more on keeping homes out of harm’s way.