Tuesday, December 15, 2009

Does Caveat Emptor Apply to Condominium Conversions?

The spate of conversion of old apartments to condominiums has finally abated largely due to the failed economy. For many reasons which we have previously noted, buyers prefer new construction and only buy conversions when the housing market is in a selling frenzy. Nevertheless, thousands were sold and owner claims have arisen which range from minor issues with the unit itself to major waterproofing and structural failures in the buildings which will require very expensive reconstruction for which no funding was provided by the converter.

These claims are often defended by developers with the argument that since what was purchased was not new, the owners cannot expect that the converter should pay the cost of rehabilitation. That the conversions are not new construction is not usually hidden from buyers. Everyone buying into a converted apartment project did or should know that the buildings were more than just a few years old and that deterioration can be expected.


But what most buyers do not know and should not have to expect is that the maintenance and repair funding plan which was coupled with the sale of the unit was inadequate for the eventual repair of the buildings. And why is this important? Because a condominium conversion is not just a used apartment alone. It is a new product assembled from several important pieces.


In order to sell an old apartment as a condominium the converter has to create a salable product. This includes recording a condominium map which changes a single parcel into multiple separate parcels. They have to draft and record Covenants, Conditions, and Restrictions (CCRs) which enable the new owners to jointly manage the project. They have to comply with various regulations of the California Department of Real Estate which include preparation of a funding plan adequate to meet the needs of the new common interest development. If any of these parts are missing, the units cannot be sold.


A car can be manufactured of re-cycled steel, but without wheels and a motor, it’s not a “car” that can be sold. The same is true for converted apartments. Without legal status as a condominium and an adequate funding plan, it cannot be sold as a condominium. A converter must create a new product from that old apartment and the other necessary parts. This “package” carries with it certain representations of fitness, not the least of which is that the funds necessary to properly maintain the project will be available when needed.


Adequate funding could be assured by depositing enough cash into the association’s accounts so that it can afford future repairs. It could also occur by completing the necessary repairs at the time of the conversion so that less cash is needed in the future. The converter could also fund the association by setting the owner’s assessments high enough to pay for repairs. Or, the seller could do some combination of all three. The converter cannot, however, do “none of the above.” The buildings can have defects or un-repaired conditions, but if they do, there has to be a budget adequate to maintain or repair them properly and if the funding plan fails to accomplish this, the converter is liable for the shortfall for failing to disclose the true cost of ownership.


A common misconception among conversion developers and also many judges is that the buyer of a used apartment should be subject to the same rule of “caveat emptor” or “buyers beware” as the buyer of a used single family house. The buyer of a single family home is personally responsible for all of its maintenance once escrow closes, so why shouldn’t the buyer of a condominium conversion bear similar risks?


A condominium is a different animal entirely. An individual condo owner cannot repair his or her portion of say, the roof, which is shared by other owners, not only because it’s physically impossible, but also because an individual is without the legal authority to touch that component. Only the community association can legally maintain the “common area” which includes the roof and other exterior and certain interior components of the building. And to do that, it must raise the necessary funds through the funding plan provided by the original seller. A condominium owner is completely reliant on the community association and the funding plan, unlike the owner of a single family home. “Buyers beware” has no application to a condominium conversion, and the buyer has every right to assume that the funding plan provided by the converter is fit for the purpose for which it was intended.


So, if we think of a converted condominium project as just an old apartment building we miss the point. A condominium conversion is a collection of apartment units bound together and rendered salable as condominiums only with the addition of the financial means to maintain them. And while it may not be new construction, the development is certainly a new product, created and put into the stream of commerce for the first time by the converter, and one which carries with it all of the warranties that any new product should provide. Representations of fitness, in the form of the proposed funding plan among others, were made.


To conclude otherwise would be to render meaningless all of the statutory law and regulations of the California Department of Real Estate which are intended to insure that every condominium project sold--regardless of whether it is new construction or converted from an old apartment house--can be properly maintained by its new owners. Unfortunately, neither the statutes nor the regulations provide an administrative process by which the community association of a newly converted condominium can require the converter to provide an adequate funding plan. That’s usually left to lawyers and the courts. Not exactly the “carefree living” new buyers were hoping for.


How can a prospective buyer be sure that all of the “parts” of this new condo product are adequate? It’s difficult. The average person, and even most real estate professionals, cannot usually tell if the funding plan, the “budget” prepared for this condo conversion, will provide enough cash to operate and maintain the project. That requires construction experts who can analyze the condition of the entire building, not just those areas which are visible and accessible, and accurately project future maintenance and repair costs. Most converters don’t go that far and cost estimates for repair of hidden issues are not provided, or are based upon the expectation that certain components will be brought to an “as new” condition during the conversion process, which for one reason or another doesn’t happen. Also, the desire to keep assessments low--to qualify the greatest number of potential buyers--is a natural conflict and one which legislators have been unwilling to correct.


The best protection against the faults in a condominium conversion is not to buy it. Developers of conversions are not like traditional developers of new construction. They are usually single purpose legal entities structured to protect the real seller from liability. They also commonly lack adequate insurance to protect buyers from defects and inadequate funding. But after the sale, the community association can hire appropriate experts to examine its reserve and operations budget in light of the age and true condition of the building, and amend the funding plan accordingly. To the extent that uncovers a significant shortfall, the seller should be asked to correct it. The buyer should expect a new product to perform like one.


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