Thanks to the economic downturn, condominium prices are dropping across the country. But if the homeowners association is in the red, a condo that looks like a steal can quickly become a money pit, leaving buyers on the hook for a lot more than they had bargained.
Here’s how buyers can protect themselves before they sign on the dotted line.
Why knowing your HOA matters
Buying a condo isn’t like buying a home, says attorney Roger Winston of Ballard Spahr’s Bethesda, Md., office. Where individual homeowners must deal with costs associated with their property, condo owners delegate that duty to a homeowners association, or HOA, which has the power to collect dues, make special assessments and spend money for routine upkeep and special projects.
Of course, the money in the HOA’s coffers belongs to those who own units in the condo, and how that money is managed should be just as important to a buyer as the asking price.
“You see a lot of great deals on condos right now,” Winston says. “But given the current financial environment, you have to do your due diligence on the HOA to make sure you aren’t buying into a situation you can’t afford.”
What can go wrong?
According to Winston, buyers can find themselves paying for a lot more than they expected if the HOA is unable to maintain the building. Expenses can include covering dues for unsold units, shared utilities and special assessments to fix faulty construction. Those are real possibilities in cases where the developer went broke and a bank took over the building.
In other cases, when banks foreclose on condo owners during a recession, and there are fewer unit owners paying dues, solvent owners might catch their HOAs reducing services in the building, such as pool maintenance and janitorial work, to cut costs.
Ideally, an HOA’s reserve fund would cover the deficiency, but the wave of undersold buildings, individual foreclosures, bank-owned buildings and personal bankruptcies has left many condo owners with larger than expected HOA dues and special assessments.
What a buyer is entitled to
While the terminology and procedures vary by state, virtually every jurisdiction provides a mechanism for giving the buyer access to an HOA’s financials, whether the buyer gets it directly from the HOA or via the seller. Typically, that information will include the HOA’s balance sheet, yearly revenue from HOA dues, the reserve fund balance, notice of any pending lawsuits and information on recent assessments, as well as what percentage of units are behind on their dues.
Getting that information isn’t hard, says Winston. The trouble is that most buyers don’t fully understand what they find.
“There isn’t a Good Housekeeping Seal of approval for condos,” Winston says. “And unfortunately, there’s no easy, economical way to look at the financials and figure out if the HOA is in good shape.”
But there are warning signs, says Allison Scollar, a real estate lawyer at Guzov Ofsink in New York.
“Buyers should be looking for a steady financial picture,” Scollar says. “Big yearly spikes and dips in spending are good signs the building is in trouble.”
Scollar says that emergency borrowing by the HOA and frequent special assessments are huge red flags. She also says a building with a high percentage of renters is a bad sign because the owners of those units don’t have the same incentive to maintain the building.
Another good indicator is whether the HOA has done a study to determine if its reserve fund is adequate, says Brendon DeSimone, a Realtor Associate at Paragon Real Estate Group in San Francisco. Such surveys are a hallmark of well-run associations, he says.
But whether you’re an expert or a novice, reading financial documents can only get you so far. Winston advises that buyers take time to talk to as many people in the building to get a sense of how well the HOA is run.
HOAs dealing with foreclosed units, a bank-owned building and owner bankruptcies face an uncertain cash flow, placing a huge burden on other owners. Depending on state law, banks may or may not be required to pay dues on foreclosed units. But even if they do, the payments are frequently delayed, says attorney Martin Bearg of Livingston, N.J. So it’s a good idea to familiarize yourself with the building’s delinquency rate and the HOA’s accounts receivable — mainly the dues it is owed — to understand a building’s financial status.
Unfortunately, while a financial disclosure will tell you how many units are in arrears, it can’t predict the future. So buyers will want to ask the seller and other residents questions that will give them a sense of the financial stability of those living in the condo. They might include: Are bankruptcies in the building on the rise? Are more foreclosures likely? These aren’t easy questions to answer, and at best, it’s only going to be a snapshot, says Winston. But if a buyer believes that several owners are in financial trouble, it would be a good idea to walk away, no matter how low the asking price is.
To be sure, buyers may not be the only parties to walk away from a building with a high delinquency rate. Potential lenders may steer clear of a building with a delinquency rate above 15 percent, says DeSimone. In some cases, buyers may have to increase their down payment or pay a higher interest rate. More likely, they’ll simply lose the loan because it doesn’t conform with the guidelines of Fannie Mae and Freddie Mac, the government-sponsored enterprises.
In practical terms, the disclosure should be the same whether you’re buying from a developer, a private party or a bank. But full disclosure isn’t the same as full accountability, and to avoid getting stuck with a larger share of the HOA’s liabilities, Winston says that buyers should be wary of bank-owned buildings and failing developers.
Typically, buyers will get some protection because lenders won’t fund loans until more than 70 percent of the building is sold. But it’s not the total number of units sold that matters so much as the assurance that you won’t be the last buyer for the foreseeable future.
“What you’re looking for isn’t all that concrete,” Winston says. “But what you want to see (when the bank or developer is selling the unit) is a financial commitment to attracting other qualified buyers and to standing behind the construction of the condo should the need arise.”
In the case of a distressed building, Winston says that commitment is actually more important than getting the highest price because the long-term success of the HOA depends on a building populated by owners who can maintain it.
Buyers should also be wary of a bank-owned building or a struggling developer, says Winston, because banks and developers may lowball the cost of major repairs or improvements. When a building is in trouble, banks and developers will work quickly to minimize their financial obligations, meaning their estimates for major repairs may come in low and their strategy may be to avoid dealing with the building in the long term. When that happens, individual owners may find themselves being asked to pay special assessments to cover those costs.
“If a bank has foreclosed or a developer is overextended, they typically want to get out in a hurry,” Winston says. “That means buyers shouldn’t have a lot of faith in the bank (or a cash-strapped developer) to aggressively market the building, make improvements or fix defects in the construction.”