The condominium segment of the nation’s ailing housing market has been especially hard hit by defaults and declining values. Mortgage loans on condominiums are generally viewed by lenders as more problematic than for single family homes because foreclosures on a few units can affect the entire condominium project, and monthly HOA fees can become difficult to collect from individual unit owners who fall behind on payment, thereby negatively impacting the vitality of the condominium project.
“Fannie Mae” (FNMA) and “Freddie Mac” (FHLMC) have responded to this reality by implementing stricter loan origination and underwriting guidelines. Since these organizations purchase the vast majority of residential mortgages made by primary lenders, they are critical sources of liquidity in the mortgage market, and it is imperative for lenders, homeowners associations and owners, purchasers and sellers of condominium units to understand and follow their criteria. Summary of condominium loan guideline changes The following non-exhaustive list is illustrative of the new guidelines:
- No more than 10% of a project can be owned by a single entity. This is intended to reduce the risk of multiple defaults in the same project, but it will be problematic for newer projects with several unsold units still owned by the developer.
- No more than 20% of the total square footage can consist of non-residential space. Many newer projects are “mixed-use” projects with retail and commercial space at street level, and prospective purchasers will have difficulty obtaining a loan if this requirement is not waived by the lender.
- For “new” construction or condominium conversions (projects where fewer than 90% of units have been sold, are not completed, are subject to phasing or if the homeowners association has not been turned over to unit owners) at least 70% of the units must be under contract to be used as the buyer’s principal residence or second home. For established projects, at least 51% of the units must be used as the owners’ primary or second home. These rules are designed to reduce the number of investment buyers.
- To ensure their financial health, homeowners associations must designate at least 10% of their budgeted income for replacement reserves and have a budget line item for the deductible on the master insurance policy. If the budget and assessments are inadequate to cover deferred maintenance of the common areas or to pay insurance deductibles, the project will suffer and the value of the units will decrease.
- No more than 15% of the total number of units in a project can be more than 30 days past due in homeowner association assessment payments. This policy is particularly problematic for projects with several foreclosures and owners who have fallen behind on assessment payments. Additionally, developers who do not pay the assessments on unsold units risk disqualifying the financing for sales of units to prospective buyers.
- Fidelity insurance, which protects the homeowners association from losses resulting from fraud, embezzlement, and dishonesty by those who handle association funds, is required for new and established projects with 20 or more units.
- Prospective unit owners must now obtain a condo-owners insurance policy with “walls-in-coverage,” otherwise known as an “HO-6” policy, for at least 20% of the unit’s appraised value. This requirement is excepted, however, if the homeowners association’s policy provides this coverage. Prior guidelines only required lenders to verify that a homeowners association carried hazard insurance to cover fixtures, equipment, and other personal property inside individual units.
- Projects where the seller is offering certain incentives, such as contributions of future homeowners association assessments, principal and interest abatements, or other concessions/ contributions that are not disclosed on the HUD-1 Settlement Statement, are now ineligible for purchase by Fannie Mae.
- For new projects with more than four units, the legal documentation, such as the Declaration or Master Deed and HOA by-laws, must be prepared in accordance with state law and must contain certain critical provisions such as notice-and-consent rights to lender/ mortgagees regarding condemnation/ casualty events, lapses in insurance coverage, or proposed changes to legal documentation or project status. Even for spot-loan approvals, lenders will look for well prepared legal documentation that provides the lender with such rights.
According to Fannie Mae publications, the guidelines can be modified for projects on a case-by-case basis. Therefore, these guidelines do not necessarily apply in every instance.
Effect of guidelines on condominium owners, buyers, sellers, homeowners associations, and lenders Aside from the specific effects discussed above, these guidelines will make obtaining condominium financing even more difficult in a time when mortgage loans in general are less available. Although other financing alternatives exist, such as FHA/VA loans or loans that are held “in house” by primary lenders, not all borrowers are eligible and if they are, they will likely pay higher interest rates. Ultimately, the increased expense of financing – or the lack thereof – will have a dampening effect on the value, sales, and refinancing of condo units.
Unit owners and prospective purchasers should be aware of the effect of the stricter loan underwriting guidelines on their ability to finance, purchase, and sell condominium units. Buyers should work with lenders to determine if the desired unit is eligible for financing; sellers should work with their homeowners association to ensure that the project complies with eligibility guidelines.
Mortgage lenders will be required to certify that a project complies with these guidelines before selling a loan to Fannie Mae or Freddie Mac. Therefore, lenders should ask relevant questions of the project developer or homeowners association and review the project’s legal documentation, HOA budget, and insurance coverage to determine compliance. Even if the lender intends to hold the loan in its own portfolio, these guidelines should be considered as an indicator of the viability of the project as a whole. Lenders should seek counsel for assistance in gathering and reviewing project information and in making representations regarding project compliance.
Likewise, homeowners associations should educate themselves on the nuances of these guidelines to help facilitate the sales of units. A review of the association’s budget and finances, legal documentation, insurance coverage, and collection and enforcement procedures for delinquent dues should be made with the assistance of the association’s attorney. Associations can also consider placing restrictions on leasing and ownership of multiple units to facilitate compliance with eligibility guidelines. In some cases, new projects can be “pre-approved” by Fannie Mae and Freddie Mac through certain project eligibility review services. Compliant projects that are eligible for Fannie Mae and Freddie Mac financing are more easily marketed to prospective buyers. At the very least, sales of units in eligible projects will be aided by the fact that buyers have more financing alternatives and the potential of lower interest rates.
Steve Nesbitt is a member of Strauss & Troy’s Real Estate Department and regularly practices in the areas of real estate, banking law, and general business. For more information on changes in condominium financing, please feel free to call Steve at 513-768-9733.