Legal Briefs

Conversion Conundrum

Repositioning a condo as a rental building requires gaining control.

As the housing market continues to suffer through its worst decline in recent history and demand for unsold units within recently developed condominium projects evaporates, the repositioning of condo projects into apartments may be a successful strategy for owners or buyers of troubled properties. If units have not been sold, the repositioning process can be fairly straightforward. However, if units have been sold and the project owner wants to operate the balance of the building as rental units, there are a number of threshold issues that should be addressed to avoid potential pitfalls.

In general, if third parties own any of the units, the project must be operated as if it were a condominium in accordance with all applicable laws, rules, and regulations. For example, in California, project owners must comply with the Davis-Stirling Common Interest Development Act, which is the statutory law that governs all common interest developments. While the degree of oversight varies greatly from state to state, at the very least building owners must operate the project’s homeowners’ association and comply with its bylaws, articles of incorporation, and covenants, conditions, and restrictions. In all cases, due diligence is essential in determining whether or not a repositioning is possible or desirable.

Taking Control

A project owner who is not the original developer should seek to obtain a recordable assignment of the developer’s rights under the CC&Rs and other relevant condominium documents. This will help in overcoming
any leasing restrictions on the property, which may include a prohibition against all leasing or short-term leasing only. However, condominium developers often give themselves maximum flexibility by including an express right to lease all unsold units. Therefore, a recordable assignment of the developer’s rights is critical to the repositioning strategy.

Acquiring the developer’s rights also will help the project owner gain the voting power necessary to elect the homeowners association’s entire board of directors. The project owner also may have enough control to amend the CC&Rs and the association’s bylaws and articles, which may be a way to overcome restrictive provisions that may negatively affect the operation of the project as a rental.

The CC&Rs and the association’s bylaws will outline typical management obligations such as maintaining the common areas, insurance, and association funds and reserves; preparing and distributing annual budgets and operating statements; levying assessments; and enforcing the governing documents. Although most of these obligations are tasks that would be undertaken in connection with apartment building management, all obligations should be carefully considered to identify any additional costs that may be associated with them.

Fiduciary Duties

A project owner that controls the homeowners’ association through the appointed directors has a fiduciary duty to third-party unit owners. Association directors must be diligent and careful in performing their duties and act in the association’s best interest (which represents the interests of all owners), even at the expense of their own interests. In general, association directors may not act arbitrarily or capriciously in the exercise of their duties, and any actions taken by an association that exceed the powers granted to it under its bylaws and CC&Rs are unenforceable.

Even actions that do not expressly violate the bylaws and CC&Rs still may expose the project owner to claims of breach of fiduciary duty. For example, third-party unit owners may claim that the project owner’s leasing practices are having an adverse effect on property values, or that the project owner is failing to maintain the project or enforce CC&Rs with rental tenants. As such, project owners should be prepared to carefully consider potential exposure to claims of breach of fiduciary duty.

Acquiring Units

To avoid complications, project owners should consider acquiring all units that have been previously sold. Acquiring previously sold units may not be an issue in markets where buyers under contract are walking away from their deposits. However, in markets that are not depreciating as quickly, unit owners (especially those who recognize what the project owner is attempting to do) are likely to demand a premium for their units, which may or may not be within the project owner’s budget.

One solution is to attempt to purchase the units prior to purchasing the project. Ideally, the property’s purchase contract should provide that the acquisition of such units by the purchasing party is a condition to closing the sale. This action will greatly increase the project’s success.

Dean Pappas is a partner at law firm Goodwin Procter in Los Angeles and Jean-Jacques Dupré is president of Dupré Co., a real estate investment management firm. Contact them at dpappas@goodwinprocter.com and jjdupre@dupreco.com.

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