Condominium Termination: A Potential Path for Repurposing and Redeveloping Aging Condominium Buildings

The tragic collapse of the Champlain Towers in Surfside, Florida, in June 2021, was a wake-up call for owners of units in aging condominium projects throughout the country, as well as associations, property managers, state regulators, developers, lenders, and others involved in the condominium industry.

Many of the factors that may have contributed to the Surfside collapse–including an aging structure, substantial deferred maintenance, and inadequate reserves–are present at many other condominium buildings.

In the months since the tragedy, we have seen increased scrutiny of condominiums from lenders, regulatory bodies, insurance carriers, and potential unit purchasers. Fannie Mae and Freddie Mac have added more stringent requirements for condominium loan approvals. (See Ben Eisen, Surfside Tower Collapse Makes Buying Condos More Complicated, Wall Street Journal, (Feb. 20, 2022). Florida regulators have increased inspection periods and made it more difficult for condominium associations to defer needed repairs. See S. B. 4-D, 2022 Leg., Spec. Sess. (Fla. 2022). Maryland now requires more frequent reserve studies, and obligates associations to comply with certain reserve funding level recommendations, see H.B. 107, 2022 Leg., 444th Sess. (Md. 2022) (effective Oct. 1, 2022). It is expected that other states will consider similar measures.

Buildings constructed during the condominium boom of the 1970s and 1980s are now entering their fourth or fifth decade, and may have reached the end of their useful life, particularly in harsh coastal areas. The same factors burdening the broader economy–the threat of recession, inflation, and supply chain obstacles–raise the costs of keeping up with the maintenance requirements of an aging building, which often are managed by volunteer association boards which lack the expertise required to undertake major capital improvements. In the face of these challenges, some condominium projects will be unable to continue to operate according to the status quo, and may seek alternatives, including termination of existing condominium regimes.

Termination has been a component of condominium law from its inception, but has been pursued only in limited circumstances. It is unfamiliar ground for many associations and practitioners.

In addition to the economic situations discussed above, there are many circumstances in which it may make sense to consider a condominium termination, including when significant deferred maintenance exists, following a substantial casualty or condemnation event, or to pivot the project to a better use, such as student housing or higher density affordable housing. The authors expect to see a rise in the number of condominium terminations in coming years. This article reviews the basic mechanics of termination, identifies some common pitfalls, and discusses some broader issues related to condominium termination.

The Mechanics of a Condominium Termination

Termination of an existing condominium regime is governed by state law and typically is accomplished by recording a termination agreement. This negates the Condominium Declaration that established condominium units and returns the property to a single unified parcel of real estate with one owner (or one group of owners). Following termination, the property may be sold free and clear of the ownership interests created under the condominium regime. This makes termination an attractive path for an owner or developer wanting to repurpose or redevelop the entire property.

The rules and procedures for a condominium termination can be found in two main sources: (a) the applicable state condominium act (State Act) and (b) the recorded Condominium Declaration. State Acts generally set forth the minimum standards and requirements for termination, including the percentage of owners required to vote in favor of termination. The Condominium Declaration may provide additional requirements beyond the minimum standards in the State Act. In instances where the terminated condominium property will be sold, parties also may need to consider additional requirements imposed by the buyer’s title insurer and lender. State Acts vary widely in their requirements for termination. This article considers the Uniform Condominium Act (UCA), a version of which is in effect in 14 states, as well as some other notable State Acts that deviate from the UCA.

Approval of Termination

State Acts set the minimum threshold of owner votes required for termination. A Condominium Declaration may increase this required threshold, but generally cannot lower it, except in limited circumstances for non-residential condominiums. UCA § 2-118(a). The UCA requires the “agreement of unit owners of units to which at least 80 percent of the votes in the association are allocated, or any larger percentage the Condominium Declaration specifies.” The 80 percent threshold is widely used, but this varies by state. Colorado has the lowest threshold at 67 percent, Colo. Rev. Stat. § 38-33.3-118(2)(c) (2022), and a few states require 100 percent approval, see, e.g., 765 Ill Comp. Stat. 605/16 (2022) (requiring all unit owners for approval), which in practice makes termination of a large residential condominium with many owners nearly impossible and gives a single unit owner veto authority. Some Condominium Declarations also impose requirements for approval by lienholders.

In Florida, where the condominium market plays an outsized role and the State Act is well developed, the termination threshold has been modified several times during the last 20 years.  Prior to 2007, the State Act required consent from 100 percent of owners and mortgagees, a nearly impossible task. Pursuant to legislation enacted in 2007, the threshold was lowered to 80 percent, with the caveat that no more than 10 percent of owners could affirmatively object. This change was followed by a series of high-profile stories about unit owners losing their homes to termination. In response, in 2015 the objection threshold was lowered to 5 percent, and additional consumer protection elements were added to reduce abusive practices and protect homeowners. See Fla. Stat. § 718.117(3) (2022). Most other states do not have a similarly well-developed termination act and could face the same problems previously seen in Florida if terminations become more widespread.

The termination threshold is generally met in one of two ways. First, an interested buyer may approach the condominium association and offer a buyout. The association can vote to accept the offer, contingent on obtaining approval from the requisite number of owners. This approach may be successful in condominiums that are otherwise struggling financially or have costly deferred maintenance obligations on the horizon. If the buyer can offer a premium over the market value of the units, this may be a compelling exit strategy for condominium owners. This approach may fail, however, if the governing body of the association is not interested in selling the property. Second, a buyer may purchase individual units until it controls enough votes in the association to vote to terminate the condominium unilaterally, and then sell the property to itself or an affiliated buyer. Some states have consumer protection laws that protect against abuses by “bulk owners” who own a large percentage of units in a condominium and may be able to act against the interests of other owners, but many states do not.

The Termination Agreement

The termination agreement, once ratified by the requisite threshold and recorded in the land records, is the instrument that actually terminates the condominium regime. The requirements for the termination agreement are based in state laws and are not universal, but they generally require only a bare minimum of information. The UCA provides very little detail:

An agreement to terminate must be evidenced by the execution of a termination agreement, or ratifications thereof, in the same manner as a deed, by the requisite number of unit owners. The termination agreement must specify a date after which the agreement is void unless it is recorded before that date.  A termination agreement and all ratifications thereof must be recorded in every county in which a portion of the condominium is situated, and is effective only upon recordation. . . . If, pursuant to the agreement, any real estate in the condominium is to be sold following termination, the termination agreement must set forth the minimum terms of the sale. UCA§ 2-118(b)-(c).

Sale of the Condominium Property

A condominium may be terminated with or without an agreement in place to sell the property. Under the UCA and many State Acts, the termination process varies depending on whether the property will be sold.

Under the UCA, an agreement to sell the condominium property may be entered into by a condominium association prior to a vote by the unit owners (subject to any restrictions in the condominium bylaws) but does not become effective until it is ratified by the requisite number of owners. The owners vote on the proposed sale and termination according to their bylaws and applicable law, and they indicate approval of the sale and termination by executing the termination agreement, which includes the terms of the sale. In the interim period between termination and sale, the association holds the condominium property in trust for the unit owners, and each unit owner may retain the right to occupy its unit.

Termination without an agreement to sell the property is much simpler, and usually occurs only when a single owner already holds 100 percent of the units and wants to eliminate the condominium ownership structure. Upon termination, the unit owners become tenants in common with interests allocated according to their respective ownership interests in the former condominium, and each owner has an exclusive right to occupy its former unit. Given the practical difficulties in managing a property with multiple occupants under a tenancy-in-common structure, this approach likely only makes sense in very limited circumstances.

Allocation and Distribution of Proceeds

Upon the sale of a terminated condominium property, the unit owners and their respective lienholders are each entitled to a share of sales proceeds. Under the UCA, the value of each unit is determined according to an appraisal undertaken by the association. The appraisal report must be distributed to the unit owners, and is deemed approved unless objected to by at least 25 percent of the unit owners. The proportionate interest of each unit owner is determined according to the fair market value of the owner’s unit, allocated interests, and any limited common elements, and each owner is assigned a proportionate share of the sales proceeds based on their proportionate interests. Sales proceeds are held initially by the association as a trustee for the owners and lienholders and distributed according to their respective interests. In practice, this distribution can be complex, as the buyer and seller must account for adjustments, prorations, and payoffs both at the property level and at the individual unit level, including the payment of liens and delinquent assessments, accounting for property taxes and transfer taxes, adjustments for rent and utilities, and all of the other complexities that accompany a real estate closing.

Potential Pitfalls

Termination of a condominium is a complicated and delicate process. In some cases, it may result in the termination of ownership rights against the wishes of a unit owner, or at a price that the owner doesn’t think is fair. State Acts often provide only minimal guidance, and do not anticipate or address many potential pitfalls and points at which aggrieved owners may object to the process, including the following:

Conflicts of Interest. A “bulk owner” of units above the required threshold may have the unilateral right to terminate the condominium over the objection of other owners and to sell the property to itself or an affiliate, which can lead to actual or perceived conflicts of interest at each step of the termination process. The Florida State Act has some consumer protection elements to prevent abuse, but many State Acts do not. In this scenario, terminating owners should be careful that they are following all termination procedures to the letter, and are providing a fair purchase price backed up by an independent appraisal.

Valuation of Units. The UCA and many State Acts require that a separate fair market value must be determined for each individual unit. The appraisal can be an expensive and time-consuming undertaking, and may require the consent of each unit owner to access the owner’s unit. If a unit owner does not agree with the results of the appraisal, there is no path for appeal unless at least 25 percent of the owners object to the appraisal.

Cooperation in Closing Process. Conveying clean title may require cooperation from outgoing owners. Although the termination agreement eliminates a unit owner’s interest in their individual unit, a title company may impose some or all of the requirements that a seller typically would be required to follow, including filing state tax withholding certificates, paying and allocating property taxes, obtaining payoff letters from lenders, and providing title affidavits.

Mechanics of Transition in Ownership. Some State Acts are silent on important points about how possession is transferred upon a sale. Under most State Acts, occupancy can continue after termination, but the occupancy right expires upon the conveyance of the condominium property. Some states, including Florida, provide an outgoing owner with a preemptive right to lease back its unit at market rates for a limited time, but many State Acts do not address this point at all. Another unsettled question is how existing leases are treated upon transition, including whether leases survive and remain binding on the new owner, and whether there are any limits on a unit owner’s right to enter into a new lease that may survive termination.

Changes in a Post-Surfside World

We already have seen many changes in the condominium industry after Surfside, including sky-rocketing insurance rates. We also expect to see the additional changes described below, which may affect the calculus of whether to continue or terminate a condominium regime:

• Updating state laws. Florida passed new laws in 2022 strengthening condominium regulation and requiring additional inspections for certain buildings. Other states are reviewing their own requirements, and we expect a flurry of activity in the next few years to include new standards for inspections, resale disclosures, periodic recertification, and reserve requirements, all of which may have the effect of increasing costs of ownership and making termination a more appealing option. In addition to changes targeting safety, many states could benefit from updates to their condominium termination statutes to eliminate some of the uncertainty and pitfalls identified above. A clarification of the procedures for termination would give developers more confidence to proceed with a termination when it makes economic sense.

• Insurance. Increases in insurance rates have been one of the most tangible and immediate aftershocks of Surfside for both unit owners and associations. In Florida, some report that premiums have nearly doubled, or that coverage is not available at all to some buildings. States may face increasing pressure to limit or subsidize insurance rates.

• Underwriting. Lenders have always imposed additional underwriting standards on condominium projects, addressing matters such as reserves, deferred maintenance, and potential litigation. Both Fannie Mae and Freddie Mac, which provide essential liquidity to the market by purchasing residential loans, issued bulletins to lenders after the Surfside collapse imposing stricter standards that made some condominium unit loans ineligible for resale to the agencies, and require burdensome certifications from associations as a condition to new loans. As many as one in four condominium projects in Florida may now be ineligible for Fannie Mae and Freddie Mac loans. Difficulty financing or refinancing unit loans can send a condominium project into a “death spiral,” as more units go into foreclosure and more assessments go unpaid, further depleting reserves and making the project ripe for termination.

Conclusion

The Surfside tragedy accelerated and highlighted ongoing trends that make responsible maintenance of certain aging structures such as condominiums an increasingly difficult proposition. In the face of these challenges, many owners and associations may make the rational calculation that their condominium is not sustainable, such that termination and sale to a developer is a desirable alternative. If termination becomes more commonplace, owners, developers, and practitioners alike would be well-served by a condominium termination process that is more understandable, transparent, comprehensive, and as fair as possible to all parties involved.

Ballard Spahr’s Distressed Assets and Opportunities team draws on attorneys with specific skill and experience in real estate and corporate lending, bankruptcy and restructuring, distressed M&A, distressed real estate, public and project finance. We also handle secured and unsecured commercial lending, tax, municipal recovery, loan servicing, and corporate trust services, litigation, and other areas of practice. Our Real Estate attorneys cover all aspects of commercial real estate law and transactions, including permitting, title, environmental issues, acquisitions and dispositions, site development and construction, project financing, loan workouts and acquisition of distressed assets, and leasing. Please contact us for more information.

Originally published in Probate & Property: Volume 36, Number 6, ©2022 by the American Bar Association. Reproduced with permission. All rights reserved.

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