Hold or Sell?
Distressed condo developments may offer unseen challenges.
The real estate market
collapse resulted in countless distressed condominium developments. Lenders are
often asked to fund failed condo development completion costs and home owner
associations’ operating deficits, with little promise of a positive performance.
How do they determine whether
to sell or hold? The decision-making process illustrated below holds true for
any investor considering purchasing a distressed condo project.
Two 40-unit buildings in a
resort area, originally developed to appeal to second-home and investor
purchasers, were completed in 2007. Building one has 15 sold units and 25
unsold units. Building two has sold eight fractional share ownership units and
the remaining fractional shares are unsold.
The lender worked with the
owner/developer from 2007 to 2011. The buildings are currently being leased by
the night as vacation rental properties. The lender is not receiving interest
or principal payments and is being asked to fund ongoing operating shortfalls.
In addition, the wear and tear on the collateral is continuing and deferred
maintenance is accruing.
The Lender Approach
Before any decisions, a lender
needs to understand the true current value of the property: the cash price a
buyer would be willing to pay in today’s economy. This may require the lender
to actively pursue a third-party buyer to determine the market floor.
Next the lender needs to
determine whether it can absorb the loss required to accept the third-party
price. If the answer is no, then the lender should fund operations and employ
management to ensure the property is maintained.
Even if the answer is yes, the
lender should evaluate the outlook for market conditions and offset any
potential gains against funding operating costs during the hold period. If the
lender perceives a positive net gain over the hold period, it may elect to hold
and fund operations.
Lenders are required by law to
receive Financial Institutions Reform, Recovery, and Enforcement Act-compliant
appraisals on real estate held as collateral. In the current market, many
appraisals establish values with the caveat that the highest and best use of a
particular property would be to hold the property until more-normal market
The appraisal, therefore,
establishes a value of an illiquid asset, while the lender is interested in the
value at which the collateral can be converted to cash. As a result, lenders
should consider other avenues for testing values. One approach is to request a
broker opinion of value, engaging a broker with condo experience, comparable
sales in the geographic market, and marketing successes. Another approach is
for the lender to review its own loan portfolio for recent sales of the product
type in the geographic market. A third approach is to hire an adviser to
consider all the aspects mentioned above, plus provide an independent view of
the local market conditions. This expands the review to include further
analysis of operations and a comparison of hold time, projected value, and
ongoing operating costs.
Typically the original
developer of a condo development hires a property management group to manage
the property until it is transferred to the unit owners based on the
condominium declarations. But often the property manager’s decisions are driven
by the HOA’s board of directors, which often includes the developer as
This symbiotic relationship
may mask a number of unseen operating costs. For instance, the level of
deferred maintenance may not be openly shared with the lender. Other hidden
costs may be delinquent payment of association dues, property taxes, and fees.
This can result in reduced recovery to the lender as units sell, because unpaid
association dues must be remitted to the HOA upon sale of a unit.
The HOA board of directors
instructs the property manager and influences the operating rules of the
association, which establish cost structures and maintenance plans. A developer
may be keeping HOA dues artificially low to reduce the payments upon sale to
the HOA. Thus, unfunded operating costs may be pushed to the
lender.Alternatively, the HOA dues could be increased to bring in more
cash from third-party owners immediately, while reducing future recoveries from
Condominium laws are different
in each state and often require a professional manager to ensure compliance.
Legal counsel may need to review the current HOA status; however, the developer
may skirt the issue to avoid legal fees, creating more future costs for the
Graphing the Result
A graph comparing hold times
to net values may best illustrate the lender’s choice. The accompanying chart
depicts the property with a current market value of $7 million and a current
debt balance of $9 million. It assumes that the market value will improve rapidly
during years four through seven. It also assumes that debt and holding costs
will increase by 10 percent per year.
This analysis illustrates the
challenge posed by the difference between current appraised values and market
clearing values, and the costs to carry real estate assets. In the example
above, if a lender accepts the assumptions for market changes, the lender may
opt to incur the holding costs for the next five years to have an opportunity
to sell at break-even or at a gain starting in year six. The key risk lies in
the assumptions used to determine market appreciation, compared to the hold
Condo workouts are not easy
but a third-party adviser often provides the clear-eyed vision needed to see
the whole picture.
Jay Kelley and Juanita Schwartzkopf are managing
directors at Focus Management Group headquartered in Tampa, Fla. Contact them
at email@example.com and firstname.lastname@example.org.