Berding | Weil - Attorneys At Law

The Uncertain Future of Common Interest Developments

by Tyler P. Berding

OBSOLESCENCE THEORY

Everyone knows that certain consumer products become "obsolete." The phrase "planned obsolescence" applies to a manufacturer's scheme to insure profitability by building into a consumer product the seeds of its demise, and thereby create future demand for its replacement. Obsolescence also happens to real estate. Neighborhoods can become "obsolete" when the condition of the property no longer supports the use for which it was originally intended. Residential neighborhoods that gradually industrialize become ill suited as a location for homes. Similarly, ranch land that is developed into suburban enclaves usually can no longer support viable agricultural operations.

Traditional downtown shopping districts can reach obsolescence and deteriorate when a modern mall is built on the outskirts of the city. Property that has become obsolete may languish in value and use until such time as a city or private developer chooses to "re-develop" it into a more appropriate use.

Virtually all urban property reaches obsolescence if given enough time. Obsolescence concepts are equally applicable to common interest developments. The idea that a project will last forever in its original form is no truer for common interest developments (CIDs) than it is for any other kind of real property. In most cases, physical obsolescence follows a loss of economic value due to the changing conditions of the neighborhood. In the case of a CID, however, it is usually a combination of physical and political factors that leads to loss of economic value. And it may be this political factor, e.g. the inability to reach group consensus on such important issues as funding for major repairs, as well as the natural "cycling" of ownership interests in common interest developments that hasten a CID's demise.

Ten years ago, we wrote an article entitled "No Plan for the Future." It was essentially a warning about the hidden costs of maintaining common interest developments. We stated that reserve accounts might be seriously underfunded, especially for the unexpected costs of replacing some of the major building systems. That article broke new ground. It suggested that the budgets for reserves recommended by the California Department of Real Estate were inadequate since the DRE format did not take into consideration many building components that were found to be actually failing. Our firm's experience with failed building systems made us realize that the light-frame wood construction employed in most common interest developments was so lacking in quality that many components that were assumed to last the life of the building would not. Our conclusion then: inspect the project very carefully and assume nothing.

In the years that followed that article's first appearance, the concern over component longevity has not lessened. In fact, as we have learned more, our concern has increased. It is now clear that many common interest developments will not live up to the expectations of their owners or the governing document provisions that assume the project's "perpetual" life. However, while a project's failing physical systems are certainly cause for concern, they are only a symptom of larger problems affecting the future of common interest developments.

COMMON NEEDS VS. INDIVIDUAL RIGHTS

There is no modern analogy to a community association. It is more than a quasi-governmental agency. It is more than an investment. It is more than a social organization. A common interest development is a unique blend of law, business and sociology. It is a multidimensional mix of principles of real estate law (restrictions on the use of private property), corporate law (the community association), business and economics (project management and funding), sociology (communal living) and psychology (individual interests and expectations), all marinating in an active political environment. The closest historical comparison is to a small village where the rules and politics were largely internal matters and the main concern was protection against the forces of nature. The survival of the village depended on the resourcefulness of the relatively few inhabitants. The impact of failure was the loss, not only of economic interests and basic shelter, but of the social system as well.

America's brief experiment with "communes" in the Sixties provides a comparison only insofar as they demonstrate the predominance of individual will. Regardless of the high-minded ideals upon which a group living situation is founded, individual self-interest will eventually decide the fate of the community. For communal living to succeed, the welfare of the group must prevail over the rights of the individual. That concept is completely at odds with the instincts of most of us. In America, individual self-determination usually prevails, and that basic truth illuminates the fundamental flaw in the common interest development concept. In CID living, the success of the group is wholly dependent on the voluntary contribution of capital by each owner. As we will see, the inability to reach consensus on the need for such contributions is the reason that many common interest developments will eventually fail.

OPTING OUT

If a small business fails, the owner can declare bankruptcy, shut the door and walk away. A governmental agency can simply draw on a broad base of taxpayers to provide funding. An investor only loses his capital. A community association in trouble cannot simply close the doors and walk away. The "village" has to pay the utilities, remove the garbage, and maintain the buildings if the owners are to have shelter. This cannot be effectively done without a consensus of the owners, because without owner approval, the association cannot raise sufficient funds to operate. More importantly, without consensus, the social system that binds the community begins to break down. Once the social and political breakdown begins, the "community" ceases to operate as one. In other types of communities, social and political breakdown does not necessarily doom the community. Individuals can prevail over a failed social or political system by turning inward and using their individual resources to enhance and protect their property and provide shelter for their families.

This ability to exercise independent judgment on matters relating to the care and maintenance of property, however, is essentially denied to owners of property in attached housing communities. An individual owner, in most cases, cannot act independently to preserve his common interest property. Both the physical configuration and the legal restrictions of many common interest developments make independent action virtually impossible. An owner of a condominium cannot repair "his" roof if the community association falls to do it. An owner of a condominium cannot act independently to reconstruct the project in case of a natural disaster. The concept of an attached housing common interest development is that all such actions shall be taken by the community. It takes consensus for a community to act.

THE LOSS OF CONSENSUS

As long as the community can raise sufficient funds to maintain and repair the property adequately, the restrictions on individual action are unimportant. Adequate funding, however, requires the continued willingness of the community members to assess themselves to pay for required maintenance and repair. This continued willingness depends on the reasonableness and affordability of the maintenance assessments. Once the assessments are perceived to be unreasonable or unaffordable, consensus is lost.

When projects are new, they require little maintenance, and most of the assessment dollar is devoted to operations and reserves for future repairs. Assessments then do not represent an inordinate percentage of the owner's cost of housing. Owner agreement with board decisions is founded on the affordability of the cost of living in the development. Consensus can be lost, however, once the assessments begin to increase as a percentage of the owner's housing cost. Lack of consensus translates into political instability. In a community association, that often can translate into uncomfortable confrontation. Therefore, in many community associations, political instability is avoided almost literally "at all costs." This avoidance takes the form of resistance by the governing board to creating the confrontation that occurs when they try to raise assessments. An unwillingness to raise assessments then deprives the community of a revenue stream adequate to deal with known maintenance and repair requirements. A failure to maintain and repair the property properly brings loss of value, difficulty in selling or refinancing, higher non-owner occupancy percentages, and accelerated deterioration of not only the physical plant but also of the quality of life enjoyed by the residents.

This dynamic, therefore, is a vicious cycle. The threat of political instability or lack of economic sophistication brings about resistance to raising revenues, which results in inadequate maintenance or repair, which then brings about a loss of quality of life which then results in political instability, ad infinitum. This cycle can continue for many years and the conditions it fosters can be gradual, or not, depending on many factors including the original quality of the buildings; the business acumen of the board and the association's manager; and the willingness of the ownership to fund the project adequately. A large number of positives in that equation will usually mean an extended period of reasonable stability in the condition of the project. More negatives, however, will usually mean an accelerated move toward obsolescence.

The individual owner is trapped in this cycle. He cannot "opt out" of the system. His only choice is to vote for increased assessments or not, or to sell. If he sells, his successor will be given the same choices. If the community fails, the owner's interest will be lost. There is no present means by which an owner can salvage his separate interest in a failed community.

EXCEPTIONS TO THE RULE

There are means by which the project's obsolescence can be postponed, but it is most probable that there are no means by which obsolescence can be permanently avoided. Illustrated below are the four stages of an association's evolution toward eventual obsolescence. These stages can be lengthened or shortened, depending on the general quality of the project, the wealth of the owners, its geographic location, the past fiscal practices, and the competency of its board and management. A high-end, well-located project, such as a high-rise condominium on San Francisco's Nob Hill, may never become obsolete because of its high intrinsic value and because its owners have both the ability and the willingness to pay whatever the cost of reconstruction may be. On the other hand, a low-end condominium project, perhaps one converted from an old apartment complex fifteen or more years ago will almost certainly become obsolete.

Postponement can be achieved if a sophisticated board or manager strives to educate the membership to accept the burden and the benefits of sound fiscal management, which includes creating a reserve for future repairs that acknowledges the probable failure of some major building systems traditionally not considered appropriate for a reserve budget. Examples include siding systems, most external structures constructed of wood, like entry stairs and balconies, as well as plumbing components. Having adequate reserves means having the funds to partially or totally replace major building components many years into the project's life when failure will most likely begin to occur. A very good professional manager can anticipate future needs and has the persuasive powers to encourage owners of even modest means to save for the future.

However, these exceptional circumstances run against the tide. Most projects are not high-end or located in the most upscale sections of the city. Most projects are built in locations that are easily duplicated elsewhere and therefore possess no particular intrinsic value. Many projects exist through a succession of boards whose degree of sophistication in business and finance is highly variable. Most projects do not obtain the benefits of highly sophisticated management throughout their existence. The owners of most projects cannot be counted upon to agree to contribute whatever is necessary to stay even with the growing cost of repairs. This is especially true with the many buildings that were not built from the highest quality materials or with the patience and skill provided by custom builders. Most common interest development projects were built under the time pressures of mass-market production, using generally unskilled labor that was not adequately supervised.

Some of these inadequacies are caught early enough in the project's life to be the subject of a claim against the developer so that recompense is obtained and repairs instituted. However, there will be in almost all instances, other examples of deterioration that will not be found until later in the project's life, no matter how good or how competent are the inspections. Inspectors cannot be expected to tear the buildings to the ground to ferret out all examples of defects, nor do they enjoy the ability to see into the future to determine what the weather cycles over ten or twenty years will do to the buildings. Therefore, other than in exceptional cases, it is inevitable that many multi-family common interest developments will evolve through the following stages. The only real question is how long that evolution will take.

THE FOUR STAGES OF EVOLUTION

The First Stage

A brand new project enters the first stage. The duration of that stage depends on many of the factors outlined above. Generally, during the first stage, the regular assessments will appear to cover all projected maintenance and repair costs without resort to special assessments or outside sources, and with only modest annual increases. Non-owner occupancy is at the lowest percentage it will ever be, usually 10 percent or less. Board members and professional managers are easy to find, the political climate is benign and the members are generally supportive of the board. The project looks and feels new and exciting. The membership's attitude reflects these qualities. Re-sales are brisk and values stay high with modest appreciation reflecting general market trends.

The Second Stage

In a project's second stage of evolution, regular assessments will be insufficient to satisfy mounting maintenance and repair costs. If a competent board using professional management has identified the true costs of repair, the members will contribute to capital by means of a special assessment on at least one occasion during this stage. If required maintenance and repair has not been identified, the project will appear to be within its budget. There may have been a discovery of defective construction conditions that will demand a remedy. Non owner occupancy has increased beyond 25 percent. The board of directors will begin to face political issues, which emanate from the increasing percentage of non-owner occupants. There will be an increasing number of complaints from residents about the general condition of the project or about the necessity for specific repairs. Recruitment of board member candidates may be necessary. If true repair costs are identified and brought to the members, there will be general resistance to the request for a special assessment, but the members will ultimately support the board's request if the costs for repairs at this stage of the project's evolution remain affordable. This will be true if deferral has not postponed needed repairs for too long. Sales of units are comparable to the market generally. Government backed mortgages and refinancing is still obtainable.

The Third Stage

In the third stage of evolution, those associations (and there are thousands) that have failed to store enough nuts away for the winter, will have to appeal to the membership for emergency funding and/or apply to a bank for a loan. Bank financing of large reconstruction projects is becoming quite commonplace, but most financial managers will argue that borrowed capital is not an adequate substitute for capital that is contributed by the owners. This is especially true if the repayment of the borrowed capital prevents the association from adequately reserving for the next round of reconstruction. Borrowed capital for reconstruction should only be considered as a temporary means of achieving solvency for the association. The assessments for repayment of the loan should be in addition to contributions to reserves adequate to fund future repairs. In this stage, non-owner occupancy has increased beyond 35 percent. Government-backed mortgages become difficult to obtain. Management costs increase due to the additional workload presented by the many complaints from residents about the physical condition of the buildings. Political strife within the association increases as the demands upon the residents for funding, coupled with a decreasing quality of life, increase. Board members resign rather than be subjected to the increasing volume of the owners' demands. Recommendation for current repair now includes several building components that were not anticipated with the requisite reserve accounts. The price of such repairs is beyond the association's financial ability. The economic and political climate of the association begins to be reflected in the sales price and turnover of units. The project begins to show the effects of deferred maintenance. Painting is delayed, landscaping deteriorates, and resident complaints about maintenance and repair issues further increase, putting added stress on the board and management.

The Fourth Stage

Given that many, many associations have failed to anticipate the full extent of eventual reconstruction costs, they will, sooner or later, exhaust both contributed and borrowed capital sources. This includes such one-time influxes of capital as that provided by insurance recoveries or litigation settlements. Once all outside sources of capital are exhausted, the ravages of obsolescence will be hard to forestall. By this Fourth Stage in the project's evolution, the owners have long since refused to provide meaningful contributions of additional funds; lending institutions have refused further advances; and the projection for immediate or future repairs is well beyond any projected accumulations in the reserve accounts. Non-payment of assessments begins to climb to the point where the association's ability to pay for essential services, including utilities and management, is fading fast. Essential repairs are being deferred to the extent that the basic habitability or safety of the buildings is coming into question. Non-owner occupancy has risen beyond 50 percent, and refinancing or mortgage lending by most traditional lenders is precluded. Behavioral problems increase, vandalism to the property becomes more than just occasional, and political problems within the association make recruitment of board members and management very difficult if not impossible. The ship is rudderless and sinking.

Beyond the Fourth Stage, a project's fate is hard to predict. Certainly if the deterioration of the physical condition seriously affects habitability, health, and/or safety, local jurisdictions will be forced to intervene and will demand that those conditions be repaired. Given that the lack of ability to reach consensus on funding is the reason that these conditions have been allowed to develop, it is unlikely now that the owners, mostly absentee, will see any point in throwing "good money after bad." Their cash flow and equity may be nonexistent or negative, and the condition of the project makes a sale impossible. They continue to hold their interest in the property only because they receive rental income. The local jurisdiction may condemn some or all of the buildings, accelerating the onset of obsolescence. Absentee owners, deprived of rental income, will simply walk from the project and abandon the property. Resident owners without alternative housing will stay as long as the local jurisdiction will permit occupancy. Criminal activity will make if difficult for anyone to continue to occupy the premises. Redevelopment or other government-backed programs might be called upon in rare cases to rehabilitate the property. However, in most cases, the project will be valueless, uninhabitable and unsellable. Continued ownership will become a clear liability to the remaining investors and wholesale abandonment will ensue. In most cases, legal title to the separate interests will default to various lenders.

An example of such a project was observed in San Bernardino, California a few years ago. It consisted of fourplex condominium buildings, approximately 35 years old, now gone beyond a Stage Four. Units were boarded up or burnt out. Whole buildings had been bulldozed and only empty lots remained. There were a few inhabitants, possibly squatters. The surrounding neighborhood was in only slightly better condition, but fully occupied, lessening the chance of a municipal redevelopment project. The varied condition of the units suggested that they remained under separate titles. The complexity of titles, including the interests of lenders, most likely prevented any uniform scheme to convert the property to a better use.

LESSONS

The modern CID had its birth about 50 years ago. The average project is probably now about 20 to 30 years old. The four stages of evolution can occur over a life span of up to perhaps 40 years, but more likely, signs of obsolescence will begin to appear much earlier. These statistics suggest that the beginnings of a serious problem of CID obsolescence are just now upon us, with the greatest impact to be felt over the next ten to fifteen years.

What lessons are there to be learned? Other than the obvious, prudent financial and business management of each common interest development, this situation also suggests that quick financial fixes may be illusory. It also suggests that owner equity may often be a lot less than believed, especially if there has been insufficient attention paid by the board or management to periodic inspection, including intrusive testing where appropriate.

The most important lesson may be, however, that the concept of communal responsibility for complex residential real estate is fundamentally flawed. Assessments are essentially voluntary beyond certain basic minimums. Homeowners tend to view increases or special assessments through a veil of self-interest. A first-time buyer may not intend long-term ownership and hence be unwilling to contribute to reserves that may not be used for repairs until well after his expected departure. Owners on fixed incomes have obvious limitations on their ability to pay for repairs. Since they have no ability to negotiate for more affordable repairs, they may simply veto the funding request altogether. Other owners will view the repair funding request with varying degrees of enthusiasm, or lack of it, depending entirely on their individual circumstances and the extent of their understanding of the problem.

OWNERSHIP CYCLE

Reservations about further investment in the property are exacerbated by the ownership cycle. The average length of ownership of an interest in a common interest development is seven to eight years. Since reserve budgets for long-term repair of such items as roofs and siding frequently project actual repair of those items 10 to 20 years in the future, the average owner can see little advantage to investing in reserves since they won't likely be around to spend it. Further, since the lack of adequate reserves is a difficult problem to appreciate, it is difficult to disclose. A prospective buyer, unless he is very well informed, will not be able to analyze the financial condition of the reserve account. Therefore, an inadequate long-term reserve may not play any role in a purchase decision. If that is the case, owners will not be motivated to improve that "asset." From their point of view, they are better off investing in new carpets and drapes.

In short, one of the very circumstances that makes single family detached homes such an attractive and perennially solid investment, individual judgment and action on maintenance and repair issues, is conspicuously absent in attached dwelling situations. In the detached situation, the individual owner assesses cost and risk and can act in a manner appropriate to his self-interest. In attached situations, the owner has no such right and is often distrustful of the decisions made by others. Government action of any sort is inherently suspect, but even in a post-Proposition 13 era; governments still have the right to impose most of the taxation necessary to carry out their legislative enactments. Community associations, with responsibilities not unlike other governments, have no such right and must seek voluntary funding for necessary projects. "Voluntary" taxation is largely unworkable. It is not surprising therefore, that community associations are chronically underfunded.

This challenge to the viability of the voluntary assessment concept will no doubt draw the fire (and the ire) of many in the community association industry. Those who object to our assertions are encouraged to take a closer look at the evolving physical and financial conditions of community associations and project those conditions ten or fifteen more years. We have interviewed many industry professionals on this subject over the past ten years. Not one has expressed doubt about the inevitable obsolescence of many community association projects. Those who manage and service these projects, as well as the boards who govern them, know that raising the necessary funds to deal with both expected and unexpected repair costs is their single greatest challenge. Since individual members will usually vote their self-interest, a collision with community interests is often the outcome. When that collision results in under funding, the project will likely deteriorate over time.

AN EXIT STRATEGY?

While our discussion of this problem might suggest it, we do not support the notion of legislating mandatory assessments or mandatory "full" funding of reserves, or any other way of taking voting rights away from homeowners. For one thing, that would materially change the nature of what the owners bought. For another, "mandatory" funding of reserves requires that there be developed an objective criteria for setting the amount of the reserves. The legislature has not yet shown an ability to write laws that can detect and preserve the unique nature of each common interest development, and therefore could not be counted upon to propose a formula which would have universal application. Finally, enforcement of such a provision would be extremely difficult. Our purpose here is to simply point out, that given the present system, the obsolescence of many common interest developments is likely.

Changing the current financial structure is not the answer. Many older projects have accumulated such a large unfunded liability for future repairs that a legislative edict of "thou shall" fully fund reserves would have no practical effect and compliance would be unenforceable. Too many years of under funding reserves leaves a gap that owners cannot afford to close. Imposing the large special assessments that would be necessary to close that gap would merely force many owners into abandoning their interests. (That is not to say, however, that we should not consider changes that would strengthen funding requirements for future common interest developments.)

The challenge is not in finding ways to impose mandatory funding requirements or to eliminate individual rights, but rather in formulating an appropriate exit strategy that will protect the individual's investment when the inevitable occurs. At present, no appropriate strategy for preserving individual interests in the face of an obsolete community exists. It should be a legislative priority to find one.

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