Wednesday, March 6, 2024

When Time Runs Out

Part IV

What Happens to Owner Equity?

         In past installments, we discussed why condominium projects are especially prone to a shortened service life. We analyzed why the condominium “business model” allows inadequate maintenance, leading to early deterioration. Finally, we listed the signs of failure—some obvious, some hidden—that will lead to a project’s obsolescence. In this installment, we will review what can be done with a failed or destroyed condominium project and what moves by the owners could go a long way to protecting their remaining equity.

            There are two “end-of-life” scenarios for condominium projects. The first is obvious—destruction due to natural or man-made disasters—fires, hurricanes, or earthquakes. The second is more insidious but can be just as fatal—long-term deterioration of structural components, unaddressed or undiscovered for many years—that eventually renders the buildings uninhabitable. 

            We’ll take the less obvious condition first. While AOAOs are generally responsible for maintaining and repairing all the structural parts of a condominium building, that doesn’t always happen as it should. Conditions that cause long-term damage can be hidden, even during investigations to determine the reserve budget. Even if symptoms are noticed, they may not be thoroughly analyzed, so repairs can be funded and addressed before the damage does serious harm.         

Conditions like these may not completely destroy a building, but they can be harmful enough to make it unsafe and uninhabitable for its occupants. Further, the economic cost to address hidden conditions can reach the point where necessary funding is unavailable from owners or lenders. Safety is always a consideration, and if it is discovered that the means of access to the building—stairways, landings, elevated walkways—are compromised by rot or where some have collapsed, injuries to occupants or not, building departments will not hesitate to condemn the affected parts of the building. And, if, upon further examination, similar conditions are discovered elsewhere, the entire project could be shut down. If repair funding is unavailable, the building may have reached the end of its service life.

Where the buildings still stand but require extensive rehab to become usable again, funding can only come from the owners or through lenders. Insurance provides no relief for gradual deterioration damage. Insurance for “collapse” is sometimes considered a remedy, but collapse insurance only applies to “sudden” collapse, as with wind damage. But other causes of collapse—earthquakes, structural rot, landslides—are usually excluded from typical condo policies.

The fire scenario is a little different. Most AOAOs carry fire insurance. We are examining the policies of our Lahaina clients to find coverage. Unfortunately, the limits of most condo fire policies do not expect the total destruction of a multi-building condominium project. There may be enough insurance to rebuild one or two buildings or parts of buildings that were not destroyed, but the limits we’re seeing are not enough to reconstruct an entire project. There may be several reasons limits are inadequate. Underwriters don’t expect the whole project's destruction; boards may want to keep their insurance outlay low in an era of increasing premiums, or policy limits may not be adjusted every year to stay even with the annual increase in the cost of construction. Whatever the reason, destroyed projects are often underinsured.

Whether due to long-term deterioration or catastrophic loss, owner equity is affected. When assessments are levied to rehab or rebuild these projects, they will astound the unsuspecting owners, many of whom cannot pay them. Add that to the lack of insurance and the difficulty in getting lenders interested, especially when the cost to rebuild might exceed the prior market value of the units, and you have a potential dead end. So, what can be done?

Options include selling the land outright and distributing the proceeds to the owners, but it is doubtful that the raw land would bring enough to cover the loss of all owner equity. Lenders could also step in and lien what is left of the property, further eroding the return to the owners. A unit in one destroyed condominium project valued over $800,000.00 before the fire was reportedly sold for only $140,000 afterward, reflecting the land's value alone.

What is rarely considered is the value of the land as part of a new project. An AOAO with, say, a $50 million shortfall in the cost of rebuilding must look for another approach. Many condominium projects, especially those built years ago, are low-density, considering the parcel size. We are discussing a partnership between the association and a builder to rebuild while increasing the parcel's density. This will require government approval and possibly a change in zoning. The AOAO and its development partner could cover a large portion of the funding gap by building more units on the same parcel, perhaps adding more affordable units. By taking command of the project in partnership with someone capable of rebuilding it, the owners likely have the best chance of recouping their lost equity.

The same approach can be taken in the first scenario—long-term deterioration. If the AOAO controls a large enough parcel to add more units to the project, the value of the land would be maximized. While the buildings may be destroyed or damaged, the owners, through their AOAO, still own the land, so why shouldn’t they benefit from that ownership?

Redevelopment of the property will inevitably occur where destroyed condominium complexes once stood. Will the association and the present owners redevelop to recapture their equity, or will they walk away, leaving redevelopment to lenders and outside interests? Will the government recognize the benefits of re-development—protecting owner equity and perhaps adding more affordable housing—and help with this approach? These questions are being asked on Maui now and will likely be asked elsewhere in the future. 






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