December 11, 2008

The pitfalls of renting out condo projects

  • Developers considering an interim rental strategy for their condo projects must first understand the legal issues of doing so.
    Schwabe, Williamson & Wyatt


    Developers of recently completed condominium projects have come face-to-face with a very challenging sales environment. Due to the down economy, many are contemplating interim unit rental programs as a market-bridging measure.

    Condominium sales have dropped dramatically in the Seattle metropolitan area. The just-released PricewaterhouseCoopers/Urban Land Institute study, “Emerging Trends in Real Estate 2009,” confirms the falloff in local sales. At the same time, apartment rents are increasing and vacancy rates are falling, making Seattle a strong residential rental market.

    However, condominium developers considering a rental strategy need to move carefully to avoid serious missteps that could threaten the ultimate success of their projects. The economics are tempting, but understanding the legal issues raised by an interim rental program is essential to risk management and investment protection. Here are some of the key legal issues that condominium developers need to understand before embarking on an interim rental program.

    Rental restrictions

    The declaration document creating the condominium often includes restrictions on renting units. The developer should confirm that the project’s declaration permits leasing under the terms of the anticipated rental program. If not, and if any units have already been sold, then the amendment process provided under the declaration may require obtaining the consent of the owners of such units and potentially their lenders.

    Risk of conversion

    A condominium project can become a “conversion condominium” under the Washington Condominium Act if any unit is rented as a residence before the condominium is legally deemed created. This can also occur if the unit is occupied within a year before its sale, regardless of when the condominium is created. Conversion status can be avoided in both instances by the timely delivery to the tenant of written notice that the unit is part of a condominium and subject to sale.

    If the project is a conversion condominium, the law requires that each tenant receive 120 days’ notice to vacate and a first right to purchase his or her unit before it is sold. Compliance with these requirements can significantly slow the developer’s unit marketing and closing process.

    Conversion status may also impose other burdens on the developer, including requirements to pay relocation assistance to tenants and to make additional disclosures regarding the property’s condition to prospective unit buyers.

    Warranty liability

    Condominiums are subject to certain construction warranties created by state law. These warranties run to purchasers, and are not enforceable by renters. For the individual units, the warranty period under the Washington Condominium Act runs from the date of purchase. For common building elements, which are the focus of most warranty claims, the warranty period usually runs from the date the first unit is conveyed to a bona fide third-party purchaser.

    One strategy to get the clock ticking on the warranty applicable to common elements, despite the interim rental program, is to sell at least one unit to a bona fide third-party purchaser.

    In any event, an interim rental program is likely to have some impact on the warranty period, at least as to the warranty applicable to the individual units. This should be accounted for through extension of completed operations insurance coverage and other prudent risk management measures.

    Additional insurance

    Many developers are insuring condo projects through owner-controlled insurance programs, known as “wrap-up” policies. Completed operations coverage under the wrap-up policy may be insufficient to cover the additional warranty period resulting from the time a developer holds the units for rental. The “owned property” exclusion to the policy may also preclude liability coverage during the rental period. These are key risk management issues requiring close attention.

    Threats to financing sales

    Sometimes renting units can negatively impact financing for the development. The terms of a project’s construction financing may require a minimum number of unit pre-sales before the project lender will release its secured position on individual units and permit sales to close. An interim rental program will necessarily delay the sale of units and the ability to meet this requirement.

    A similar issue arises in connection with the lender who is financing unit purchases. Developers typically arrange prospective purchaser access to a preferred lender, offering terms that facilitate sales. These lenders are often keen to meet minimum owner-occupancy standards for federal loan programs. Most preferred lenders expect active marketing of the units for sale. Renting a significant number of units within the condominium project may threaten lender objectives and, in some cases, could be viewed as a breach of preferred lending agreements.

    While each situation is unique, the economic decline is forcing some lenders to be open to accommodations that may include an interim rental program.

    Careful planning

    Flexibility and initiative are always key to successful entrepreneurship. Condominium developers need both in these challenging market conditions. An interim rental program is one potential strategy. Prudence demands that such a program include proactive legal risk management. It is only by doing so that developers can fully enjoy the benefits of a win-win situation: rental income in a landlords’ market and higher sale prices for units when market conditions improve.

    Dennis Ostgard is an attorney with the Seattle office of Schwabe, Williamson & Wyatt. Schwabe attorneys Anne Tiura and Elizabeth Vielbig helped research and draft this article.

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