Berding | Weil - Attorneys At Law

The Condo Conversion Budget

How do you learn the Truth?

by Tyler P. Berding

We have written on these pages before about the economic crisis that can befall the buyers of condominiums converted from old apartment buildings1. Buyers wake up to find that the home they thought could be owned and maintained with an attractively low monthly assessment turns out to be a nightmare of hidden expense. Understandably, they want to know the truth, and the truth is that a 25 to 30 year-old building just cannot be evaluated with the same criteria that you would use for a new one, and the financial plan used to maintain it also cannot be the same as one used for new construction.

Unfortunately, that is precisely what the State of California and many local municipalities did when they permitted thousands of old apartment units to be sold to consumers. The California Department of Real Estate requires that certain disclosures be made to prospective buyers. These include the monthly maintenance assessment and the budget upon which it is based. Unfortunately, the DRE does not usually take into consideration that the building is old and allows the maintenance budget and reserve accounts to be computed as if the project had just been completed.

The California Civil Code requires that the budget for long term reserves be based on a “visual inspection of the accessible areas” of the project.2 The purpose of this inspection is to identify all of the “major components that the association is obligated to repair, replace, restore, or maintain that, as of the date of the study, have a remaining useful life of less than 30 years.3 That's all well and good as long as we are talking about new buildings. There, just the usual components found in a reserve budget (e.g. roofs, paint, and asphalt) have a service life of less than 30 years. Also, as you walk around the project, you can be pretty sure that if it looks good on the outside, it's probably ok on the inside (within the walls, under siding, beneath the roof membrane, etc.)

But with an old apartment house, those presumptions are unreliable. First, over the course of 25 years, many things can happen to the inner areas of an essentially all-wood structure. Water leaks can cause dry-rot in framing and roof decking. Constant exposure of such wood components as balconies, staircases, and railings to the weather will allow those components to rot if not adequately sealed or flashed. Plumbing can literally wear out. Electrical lines and fixtures can fail. None of these components are likely to be noticed if the “visual inspection of accessible areas” is too casual and limited to a surface inspection.

Those components, when new, probably had a service life exceeding 30 years, and hence would not have been required to be part of the reserve budget. But if we have a building that is itself that old, it is unrealistic to expect that those same components will last another 30 years, especially if they have already begun to fail. Of course, if you were to include all of the components of a 30 year-old building that are wearing out in the reserve budget as the statute requires, the monthly assessments that would have to be paid by the owners would jump appreciably from those based on a new-construction budget, and few owners could afford that.

And the intersection of those two issues states the problem of condominium conversions in a nutshell: underfunding of reserve and maintenance budgets due to unrealistic expectations and inadequate inspections--most often to facilitate the sale of the units by keeping assessments artificially low.

So what do you do if you are on the board of directors of a condominium project that was converted from an old apartment house of say, 20+ years of age? Here's a step by step outline:

1. Scrutinize the financial plan.     The association's budget can be very revealing if it is understood. There are two parts of an initial conversion budget that relate to the condition of the buildings: Operating budget funding for annual maintenance and reserve budget funding for long-term replacements and repairs.

If the operating budget has categories that provide funding for gradual repair or replacement of components like wood siding, for example, in some cases that might be an acceptable substitute for wholesale replacement at some future time. For example, if, there is an operations line item called “miscellaneous carpentry” which is intended to replace portions of the exterior siding and trim, either as needed, or in conjunction with re-painting the project, that might be enough to stay even with gradually deteriorating siding, assuming sufficient funds are provided.

A similar line-item could also be found in the reserve budget itself, perhaps as a portion of the painting reserve, and would accomplish the same purpose--gradual replacement of deteriorating wood products on the buildings. Or, using a more traditional approach, include a line item for the complete replacement of exterior siding and trim at some future time. The calculation for that is, roughly: Calculate the quantity of the component to be replaced; determine the cost of replacement; estimate the remaining service life of the component; calculate an annual contribution to that component's reserve fund that will fund replacement at the end of the component's service life.

Looking at that formula suggests a number of ways that it can be underestimated. First, the component can be completely missing from the budget. In other words, there is no line-item for this component at all. It was overlooked and not included when the budget was prepared. Second, the component may be included, but the quantities to be repaired have been understated. Third, the estimated cost of repair is wrong or fourth, the estimated remaining life of the component is overestimated. Any of these, or a combination, will deprive the association of adequate funding.

Of course, most board members are not experts at estimating which components should be included or an adequate budget to fund their replacement. In fact, many of the components that we have discussed here are not even visible to a casual observer or even an expert one when the deterioration is beneath the siding. And that's why we hire an expert to do more than the usual reserve study. But first, here's a way to tap into another valuable source of information.

2. Prepare a questionnaire to the owners.    The owners are a ready source of information on the condition of the project. They will, of course, direct management's attention to active leaks or other obvious maintenance or repair issues, but they also may observe less obvious symptoms of decay or other failure that will help to guide the investigators. A written questionnaire is usually used to gain this information. Questions relating to, for example, a history of leaks into their individual unit might suggest locations where hidden damage has occurred. A report of cracks in patios or foundations could identify a soils problem. The responses to the questionnaires are then compiled into a report which is provided to the experts who will conduct the study below.

3. Commission a “super” reserve study.    As stated above, reserve studies, as required by the code are usually limited to areas that are visible and accessible. For an older building however, this often will fail to uncover problems that can be expensive to repair. An architectural firm or general contractor, who is skilled at inspections of this type, should be hired to perform the association's reserve study, and to include in the scope of that study some limited destructive testing. What's “destructive testing?” It's not as bad as it sounds--basically some of the exterior skin of the building is removed to allow access to inner areas where the effects of water leaks can be noted, if they exist. This is done on a random basis unless there is evidence of leaks in a particular area, and if so, that area is included. For wood-sided buildings, some of the siding would be removed. On stucco buildings, the trim around windows would be removed, but unless there was evidence of leaks into the interior, the stucco would usually not be cut.

Balconies, decks, and exterior stairways would be examined for signs of deterioration and portions removed, especially adjacent to the building, if it appeared that water had access to the interiors. Roof openings would depend upon the type of roof, the history of any leaks, and whether access to the underside of the roof is available through an attic. If owners report plumbing leaks, one or two small sections of pipe should be removed to examine them for signs of deterioration. Components that are missing from the budget altogether will usually account for the greatest percentage of underfunding. This is why some destructive testing is often necessary in older buildings to uncover their true condition.

A proper study will identify those components that should have been included in the initial reserve funding, determine the costs of their repair and replacement, and establish the likely remaining service lives of each of those components. That information can then be compared to the funding plan provided by the seller of the project.

4. Compare the reserve study findings to the original budget.    The initial budget is the basis for the monthly assessments paid by owners. The amount of the monthly assessment is relied upon, not only by prospective buyers in determining affordability, but also by lenders in deciding whether the buyer can qualify for a loan. If the assessment is kept artificially low, for whatever reason, the buyer and the lender will be misled. When the results of the new reserve study are compiled and compared to the calculations used in the initial budget, it may indicate that the initial budget accurately anticipated the cost of operating and maintaining the project--or not.

If the projections in the initial budget are within, say 10-15% of the findings of the new reserve study, we would probably not be too concerned. However, if the funding gap is greater than 15%-20%, then over time that will amount to a significant shortfall.

5. Get legal advice on whether the findings of the study justify a claim against the seller of the project.     If a significant shortfall exists, the seller may be liable for the difference between what was disclosed to potential buyers and the true cost of ownership. Recovery of this shortfall usually takes the form of a claim asserted by your attorney. If the gap is large enough, and negotiations to close it fail, litigation may be recommended. It is also a good idea if your attorney is consulted before the questionnaire or the reserve study is undertaken so that he or she can guide the association.

Conclusion

Condominium conversions are not a new concept--we have seen this form of housing created and sold many times over the years. But what is new in the most recent round of conversions is that they seem to be more and more undertaken with older buildings. Buildings which are almost entirely built of wood (siding, decks, stairways, etc.) are especially bad candidates for conversion since their need for maintenance and repair is usually more acute. When you add the ravages of 20-30 years of exposure to the weather, the odds of finding hidden damage that will negatively impact your reserve budget are greatly increased.

Condominium converters have three choices: (1) they can rehabilitate the buildings and put them in a condition that justifies the monthly assessment that they disclosed. (2) Instead of rehabilitating the buildings, they could put the cash into the association's reserves so that the rehabilitation can occur over time or, (3) not do either, but instead set monthly assessments high enough to raise the cash necessary to repair the buildings. What they can't do is none of the above. And unfortunately, we have seen “none of the above” more times than not.

In their search for truth, the buyers of a conversion may find that a monthly assessment, kept artificially low, was used as a means to promote the project. The incentive to set monthly assessments low also arises from the need to qualify the maximum number of buyers. If a low monthly assessment seemed too good to be true, it probably was, and there may be plenty of reasons to be suspicious about what was sold. In the case of a condo conversion, the truth isn't that hard to find.

1 Berding, “Condominium Conversions: Owner Equity at Risk” ECHO Journal, June, 2006

2 California Civil Code Section 1365.5(e)

3 California Civil Code Section 1365.5(e)(1)

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