Examining Economic Curability of Condominium Construction Defects
In recent years, following the housing market collapse, there have been an increasing number of local condominium Home Owner Associations (HOA’s) discovering wide spread construction defects impacting the common areas of their complex, as well as unit interiors. This is reasonably the fallout of the unsustainable and unmanageable housing boom over the last decade.
The housing boom was a primary driver of growth in multi-family and condominium style ownership, especially for first time home buyers. Consequently, the organization and management of homeowner associations has become a big topic for all market participants, including buyers, sellers, banks, developers, and even politicians. Washington State passed a law in 2007 requiring associations to perform replacement reserve studies to ensure potential buyers have better information into whether there is a need for special assessments and/or other large capital projects that may impact their decision to buy. This was just one of many steps taken from a legal standpoint to add transparency and accountability to association management. In addition, the appraisal industry is beginning to recognize the importance of inquiring about reserve accounts and investigating the soundness of an association’s board.
In cases we’ve analyzed, construction defects have had a tremendous impact on a properties marketability and highest and best use, often resulting in a diminution in value. In one case, an entire high-rise apartment building in downtown Seattle was demolished as a result of physical defects being so great that they were beyond repair. In most cases, defects can be cured, yet associations are forced to act quickly to correct imminent problems at their own expense, and can end up in drawn-out litigation cases with the builders to collect damages. This is when the appraisers get involved.
The style of appraisal required to solve a construction defect problem is similar in nature to a partial taking in a condemnation case. The before, or as unimpaired, value of the property is estimated assuming the improvement was constructed in strict adherence to the building specifications and all applicable building codes. The after, or as impaired, value of the property is then estimated with the improvements in their “as is” condition. The difference between the before and after values is the damage suffered by the property owners.
In general practice, the loss of value caused by a construction deficiency is measured by the cost to cure the deficiency, as long as the cure is “economically feasible”. Determining the economic feasibility of a construction defect project that impacts a condominium association is more complex than projects that involve a single property held in traditional fee ownership. A condominium is a form of fee ownership of separate units in multi-unit buildings that provides for formal filing and recording of a divided interest in real property. The condominium owner possesses a three-dimensional space within the outer walls, roof or ceiling, and floors and, along with other owners, has an undivided interest in common areas; (e.g., the land, the public portions of the building, the foundation, the outer walls, and the spaces provided for parking and recreation). The owners of units in a condominium project usually form an association to manage commonly held real estate in accordance with adopted bylaws. The expenses of management and maintenance are divided pro rata among the owners, who pay a monthly fee.
Therefore, issues relating to common area elements are under the authority of the association board, and its members through voting rights. It is reasonable to assume a prudent HOA will require that any common area construction defects be cured to ensure the safety of the community and the durability of the association’s assets.
Through legal recourse, the association can attempt to recapture monetary damages to pay for the necessary replacement of deficient components. However, if litigation is not successful, or the property is under imminent physical duress, the association will be required to rely on reserve accounts or levy a special assessment against the homeowners. The cost of a large-scale renovation project is likely well beyond the cash held in a typical reserve account. As such, most associations will borrow money through conventional lending institutions, in turn, each unit will have a lien placed on the title until the assessment is paid in full.
Large special assessments and property liens may create a financial hardship on individual unit owners and/or interfere with sales of units. In distressed situations, special assessments can lead to increased foreclosure activity through the inability or unwillingness to pay. What is more, an association simply entering into a legal dispute is grounds for FHA (Federal Housing Administration) to withdraw financing options within the complex. FHA is the largest loan issuer in the country with federal government guarantees. By guaranteeing the loans, the government shares the risk that a private lender would normally shoulder alone. This makes it possible for private lenders to be able to offer loans to clients who may be considered “higher risk”. A borrower who may be considered “higher risk” does not necessarily have credit issues; it may just be someone with a lower income or a limited down payment. This form of financing is prevalent with lower-end housing product. Without this financing tool, a primary pool of potential buyers can be excluded, which is proven to have an adverse impact on value.
As supported by comparable data in the Greater Seattle market area, complexes under heightened distress (projects in litigation, projects that have lost FHA approval, or projects with an abundance of foreclosures) are experiencing value trends well below the market norms. This is substantiated when comparing aggregate sales price trends of units within distressed complexes to sales within unimpaired complexes. This event is based on adverse public perceptions (stigma), and exacts a penalty on the marketability of a property and hence value. This component of loss should be accounted for when determining the feasibility of performing the cure, and in some cases, is substantial relative to the cost to cure itself.
In sum, when examining the diminution in value resulting from construction defects in condominium complexes, it is necessary to analyze the economic feasibility of performing the cure. A property is economically curable, if spending money to fix the item will generate a value increment equal to or greater than the expenditure, or allow the property to maintain it’s value, the item is normally considered curable.
In light of recent laws affecting FHA approval for associations in litigation, coupled with changing public perception, the loss can be measured in two forms; the cost to cure the physical deficiencies; as well as the additional market reaction (stigma) resulting from a distressed complex. It is reasonable to conclude, if the physical condition is made whole, then the market stigma will begin to alleviate. Considering the alternative, of not curing the defects, may lead to escalated losses in value over an extended period that can far outweigh the cost to fix the problem today. Thus, as long as the cure is physically possible (i.e. demolition is not mandatory), fixing the defect is feasible, and reasonable damages “at a minimum” will equal the cost to cure.
