The Great Foreclosure Debate
Should Community Associations use Alternatives to Foreclosure to Protect Their Cash Flow?
There is currently raging a great debate. This one has nothing to do with national health care, war in the Middle East, or the future of the Washington Redskins. No, this debate is over whether community associations should have the right to use foreclosure as the ultimate delinquent assessment collection tool. Foreclosure is the enforcement device that allows a creditor, in this case a homeowners association, to force the sale of an owner's condominium or single family house to collect a delinquent association assessment.
The practical arguments among the various participants in this debate go back and forth something like this: Assessments are a community association's cash flow lifelineif owners fail to pay, the association cannot keep its commitments. Foreclosure is a radical remedyit costs associations more than they can possibly recover, so why do it? Foreclosure for failure to pay delinquent assessments is the only enforcement mechanism that works.
The legal arguments include: There is really no contract between owners and their association that gives the board of directors the right to foreclose because the owners weren't parties when the association was created. The CC&Rs are recorded against the title of the owner's interest and provide for lien rights and hence the right to foreclose. State legislatures have not clearly provided for an association's right to foreclose.
And finally, the moral arguments: A home is a sanctuaryhow can we allow it to be taken away just to satisfy a small arrearage in assessments? We should not allow owners who do not pay their assessments to live on the backs of those owners who do. Everyone should pay his or her own way. Foreclosing on someone's home is immoral and community associations should have no right to do it. It just supports a large number of attorneys, property managers, and collection companies.
Anyone who has paid any attention to the articles, blogs, websites, and water cooler conversation about community associations and the recession has heard these arguments, or others like them. Can't be missed. And the underlying problem is realthousands of community associations have real cash flow problems because owners are falling behind in their assessments. Enforcement activity is up, and that often means an increase in the number of properties entering the foreclosure process. People are losing their homes for a variety of reasons, but there has been an outcry over whether community associations should be able to enforce delinquent assessments through foreclosure. But we're getting ahead of ourselves. Let's back up and look at how we got here.
Community associations are creatures of statute. Unless you decided to have a mass Tenancy in Common (no legally recognized separate titles; few rules and no simple way to legally enforce them) or a Partnership of hundreds of individuals with no easy way to market your individual interest, a different statutory scheme of some sort was necessary to allow individual owners to share ownership of stacked or attached real property and to maintain it. And maintenance requires regular funding, so some means of obtaining regular owner contributions was also necessary. With a diminishing amount of land or availability of government services, the creation and perpetuation of community associations made sense for many reasons. By giving associations 'municipal functions', they had to also be given the power to tax to perform those functions and so state legislatures gave associations the power to levy and collect assessments.
But what exactly are these assessments? Are they really like a property tax, and if so, should they be collected by public entities? Are they like a charitable contribution, voluntarily made? Are they a payment for services renderedmanaging and maintaining the property? Community associations do many of the same things that local public entities domaintain streets and parks and community swimming pools. But they also do what private homeowners dopaint the buildings, put on new roofs, and pay the water bill.
Clearly homeowner associations are not cities, counties, or community service districts and municipalities have no interest in using their taxing powers to provide cash flow to homeowners associations. Community associations manage private property with ongoing obligations that require a steady stream of cashso unpredictable voluntary contributions would be an unacceptable, not to mention, naïve, system of funding. No, what's left is what we've gota legal obligation with a means of enforcement to insure that obligation is fulfilled. Regardless of anyone's position on funding priorities (roof then paint, or paint first?) the facts are inescapablewithout a reliable means of funding maintenance, repair, and various other obligations, the physical plant of community associations would deteriorate and fail at a rate much quicker than we see today. There's no room in this debate for arguments that cash flow isn't necessary. And cash flow means owner assessments that can be relied upon.
What any rational version of the debate centers upon is not whether we should enforce these obligations but rather the means of that enforcement. Any argument that contends that community associations could survive without a mechanism to enforce owner financial support is simply not credible. But because enforcement today often means using some form of foreclosurejudicial or non-judicialenforcement is under the microscope and very hotly debated because people are losing their homes at rates not seen in years.
Foreclosure is shorthand for the legal process used to enforce a creditor's lien rights. This can be done using the courts as required in some states, or using non-judicial foreclosure as permitted by many states. By either method the obligee of a debt, in this case the homeowners association, is given a contractual or statutory right to secure payment of the debt by recording a lien against the real property of the obligor, in this case the individual owner of a lot or condominium in a community association. The lien will be senior to the rights of most other secured creditors whose rights accrue after the lien is recorded and, in some ways, the lien right is senior to that of the owner (since the lien must, if equity exists, be paid before the property can be sold). Foreclosure is the process by which the creditor protects its rights by compelling the sale of the property securing the debt, in other words, by foreclosing the rights of any other parties with more junior interests.
Associations are thus given the status of secured creditor that is, the obligation of the owner to the community association is secured with a lien on the owner's interest in the real estate. This is the same security given to a mortgage lender. As such, it may choose to enforce delinquent assessments by exercising these lien rights in a proceeding that ultimately would foreclose the owner's interest if the obligation were not satisfied. Keep in mind, however, that any mortgage lender would likely have rights that are superior to those of the community association, and if the owner were delinquent with assessments, they could likely be delinquent in mortgage payments and/or property tax payments, either of which would take precedence over the association's lien in most states. If the association pursued an actual foreclosure in that instance unless the equity in the property was sufficient to cover all of the outstanding obligations, the association would end up with nothing.
But that's not the issue herewhether or not the association ends up with its past due assessmentsthe issue is why should associations be given a secured right in an owner's separate interest in the first place? Why should the association be allowed to foreclose the owner's interest to enforce its claim for delinquent assessments and perhaps deprive the owner of his or her home? The answer to that is actually another question--what's the alternative?
In the forefront of the debate is the assertion that rather than being given a secured position which permits enforcement through foreclosure, the association should be relegated to the status of unsecured creditor. This would mean that for an association to recover it's assessments from a delinquent owner, the association would have to chase the debt just as any other unsecured creditor wouldin a lawsuit in small claims or higher court. We've seen this argument many times but its basis remains unclear. If the reasoning is that chasing the debtor in a civil action will somehow protect the owner's home, that's a false premise, because it won't.
Any civil judgment once obtained can be enforced against any of the debtor's assets, including, of course, their home. In some states there exists what is known as a homestead exemption which exempts a certain amount of the owner's equity should the property be sold to pay debts, but it isn't an all-inclusive exemption. If the equity exceeds the exemption amount, the home can still be sold to satisfy a judgment. And of course, any other asset can be similarly seized and sold by the sheriffand the judgment will, by that time include all of the collection costs as well, including attorneys' fees and the fees of the sheriff.
So what has been accomplished by taking this alternate route? For one thing, it will cost the association a great deal more to collect its assessments, which probably means that the average delinquency wouldn't be pursued. This in turn would mean that the funding shortfall that the other owners would have to cover would be greater. In the meanwhile, the bank and/or the local municipality may be pursuing foreclosure anyway if the debtor's obligations are substantial.
But let's step back and compare how similar situations are dealt with. What if this wasn't a community association but rather a rental property? The apartment rent a tenant pays covers a number of things. It covers a return on the landlord's investment. It covers the landlord's maintenance and repair expenses. It also covers certain utilities, taxes, insurance, and other costs of servicing the property. These are, by the way, many of the same services provided by a community association. What happens if a tenant fails to pay the rent? Eviction. Yes, they lose their home.
We haven't heard anyone argue that landlords should not be able to evict tenants who fail to pay the rent, so why do we argue differently in the case of a community association that is providing the same maintenance, repair, insurance, utilities, and management services? Maybe it's because a homeowner possibly has more invested in the property than a mere tenant. But should we discriminate against someone just because they haven't been able to afford to own their home? Or maybe we are just more sanguine about owned homes than we are about rentalsthat emotional issue again.
The same thing is true for tax liens. If an owner fails to pay the property tax, the local municipality or the county will evict the owner eventuallythis time through the foreclosure process known as a tax sale. And property taxes often pay for some of the same services provided by a community associationstreet and landscaping maintenance, and recreation facilities. Again, if we are going to permit cities and counties to invoke foreclosure for failure to pay taxes, why should the community association be treated differently?
And what about the company that puts a new roof on your house? If you fail to pay for the roof, the contractor is given what is known as a Mechanic's Lien in the amount of the payment owed. That lien can also be the subject of a foreclosure proceeding with the property being sold to satisfy the lien. No one has yet said that they believe that contractors should not be able to foreclose their liens to recover the value of the material and labor that they put into your house. And consider thisa roofing contractor can put a new roof on a condominium, and if the association does not pay for the work the contractor can place a lien on all of the separate interests in the project with the right to foreclose on those interests if payment is not made. Should the association not have a similar right when it is relying on owner assessments to pay the roofer? The mechanic's lien doesn't discriminate between those owners who have paid their association assessments and those who have not. Would it be fair to jeopardize the equity of the performing owners in order to be fair to those who are in default?
Of course these are isolated hypotheticals, but they are offered to prove a pointthat we cannot take one situation and condemn it as unfair without considering the legal treatment of similar circumstances. To do so is shortsighted, if not intellectually dishonest. We also realize that these are mostly logical, rather than emotional arguments, and sometimes we have to indulge our feelings with something more than just cold facts. So here goes.
A home represents a number of things that apartments do notpride of ownership; an investment; a long-term commitment, often to one's family. Much of this cannot be calculated or compared to such things as the short-term interest a tenant has in an apartment. But are they important enough to support shifting the delinquent owner's obligations to the other owners in the complex, or to the public at large in the case of property taxes? What about their interests? Some of the most emotional arguments we have heard are by owners who are not delinquent in their assessments and who are angry that the association is not doing more to collect from those who are. Weigh these competing interests. Who wins?
Also obscuring the debate are the accusations of self-interest against the community of professionals that services community associationsparticularly those collection agencies that utilize non-judicial foreclosure. Their job is to induce the owner to pay the debt. In that regard they are no different than any other collection agency. The fact that they can ultimately cause the home to be sold for the debt undoubtedly gives them more leverage than that enjoyed by an unsecured creditor, but only a very small percentage of cases pursued by such companies actually result in taking the home. As we said above, long before most of those cases reach that stage, someone, a mortgage company or a local municipality has asserted its more superior liens. And like every business, there are good guys and bad guys in the collection game. But what most of the self-interest arguments lack is an explanation of how doing without this particular mode of enforcement would promote more orderly and predictable collections, not to mention promoting fairness across the entire spectrum of owners, not just to those in default.
None of this should be interpreted as being apologetic for any professional. But it also should not be seen as promoting any alternative collection methods for the simple reason that we have yet to see anything else that will insure adequate cash flow, even in good times. To have to use any collection method is unfortunate and results in few winners on either side of the struggle. This current recession has exaggerated the losses on all sides. It has not been fun. But the problem is now, and always has been, maintaining the already inadequate cash flow necessary to meet the needs of the project and the owners. How does a board of directors discharge its obligations to its members if it cannot protect the association's income stream? The answer is that it can't. When your delinquency rate is approaching 10, 20, or 30 percent so that expenses have to be cut dramatically, the board has to consider every possible way of raising cash, and since virtually all of the cash comes from owner assessments, we ask again, what is the alternative?
To insure that we are covering all parts of this debate, what follows are some possible funding and enforcement alternatives, but be aware, most would require a complete re-structuring of the economics of a community association, and are not available in the short run, and maybe not available at all to existing community associations.
One idea is rather than collecting assessments annually, the developer of a new community would provide the association with five years of maintenance and expense funding to serve as seed money. The association would have a lien on every property, but would only collect assessments from equity when a property was sold. Certain retirement communities already do this. The problem, of course, is predictability. There would have to be a provision for supplemental income if, for example, properties were not selling, as is the case now.
You could also limit foreclosure actions to amounts above a certain thresholdsay $5,000 or $10,000. In other words, only use that remedy when the amount in default was significant. That would work to limit foreclosures, but it would also likely insure that many defaults would continue until just before they reached the magic threshold. But perhaps such a rule could be coupled with a lien that allowed the association to collect at the time of a sale, which of course, they could do now, if they wanted to, by simply forbearing from collection actions. But the effect of this would undoubtedly have a negative impact on the income stream as owners simply looked at this as a way to defer expenses until their unit was one day sold.
Another idea that we have discussed before would apply to high-rise buildings. A developer would retain title to the common areas, and lease them to the owners on a long-term lease. The developer would be more like a landlord, and would maintain and repair the property in exchange for the lease payments. This would eliminate much of the construction defect litigation, but would not eliminate monthly or annual payments from the owners. In this case, owners would be more like tenants, with the landlord having the same right to evict non-paying owners. Not a very satisfactory alternative if we are trying to keep people in their homes.
Then there is the concept of creating special districts, or maintenance trusts that would be more regional, and possibly more governmental in nature. The assessments would be more like property taxes. The good news would be that perhaps those taxes could receive the same income tax treatment that municipal property taxes do now. The bad news is that public entities would still be able to force someone from their home for non-payment. There are probably other funding mechanisms that have not been thought of yet, but any of them will and do require some manner of enforcing the obligations they create.
It is useful to go through an exercise like this if it will inspire a closer and more dispassionate look at the problem. What we believe most careful observers will note is that one way or another, in most debtor-creditor relationships, not to mention in the collection of most debts related to real estate interests, there is likely going to be recourse to an individual's home for non-payment of assessments, taxes, mortgage payments or similar debts which are of and concerning the real property. The need for revenue is too great to give up all meaningful methods of collection. And any enforcement method that works will most likely provide eventual recourse to the home. Oh, yes, you might have to try garnishing wages, selling off someone's possessions, their car perhaps, but if you strip them of their remaining income and transportation do you honestly believe that is necessarily better than forcing them to sell their home?
Nothing about debt collection feels good given the personal circumstances that cause debtors to default in the first place. But community associations, like any enterprise, need a predictable, adequate income stream to survive, and to get that they must have the means to protect it. Every owner relies on it and every owner should understand and appreciate why strong measures are sometimes necessary to achieve it. The populist argument that allowing community associations to enforce the assessment obligation through the foreclosure process is less just than that same remedy used by a myriad of other creditors for similar purposes cannot be sustained if we are to have any respect for practical, legal, and yes, even emotional consistency.
We welcome any and all reasoned arguments about or suggestions of practical solutions to the assessment enforcement dilemma, and if we get some we will enthusiastically print them in this space and include them in our ongoing discussion of this very important topic. What we reject, however, is any debate that refuses to recognize the practical realities and condemns current practices without considering and suggesting workable alternatives. Send your ideas to the author and we'll continue this conversation.