My Blog

Housing Counsel: Foreclosures are Impacting Condominium Projects

Question: Our condominium is in trouble. Many of our owners obtained those “favorable” interest only rates a couple of years ago, and now that their monthly payment has increased, their units are being foreclosed upon. This is putting a burden on the rest of us, since those owners are no longer paying their condominium fees. We are a small association with a tight budget. The developer left us with very little reserves, and now we are struggling to keep alive financially. What should we do?

Answer: You have raised a serious question, which unfortunately not too many people are focusing upon. There has been a lot of press about the increasing foreclosure rate, and how that impacts on homeowners.

But you are describing the “ripple” effect that foreclosures have on the rest of the community.

Let's go back a few years. The real estate market was hot. Condominium developers were selling units faster than they could build them. Lenders were making what everyone perceived were very favorable loans -- namely 100 percent financing with interest only financing. And many developers not only low-balled the proposed budgets for the condominium association -- so as to keep the condominium fees low -- but also did not pay any money into a reserve account for the units which were still unsold.

Now, there has been a significant reversal. Prices of condominium units have either stayed stable or have decreased in value, especially where developers were forced to lower prices in order to sell their remaining units.

And those owners who are now faced with higher mortgage payments are being forced into foreclosure, and thus are not paying either their monthly mortgage or their condominium fees.

Every year, the Board of Directors of a community association is required to prepare a budget for the next fiscal year. They estimate the expenses which the association will have to pay, which includes such items as insurance, utility bills, management and legal fees and ordinary repairs. They also obtain a reserve analysis study which projects what costs they will have in the future to repair or replace such major items as elevators, roofs, walkways, and other common elements.

All of these costs must be offset by income, and in most cases the only source of revenues will come from the owners themselves.

Board members are elected and -- like any other elected officials -- are reluctant to raise taxes or increase association fees. So most association budgets are quite tight; they rely on the hope that all of the association owners will promptly and regularly pay their fees.

So if several owners suddenly stop paying, this will usually create a shortfall for the association. And that means that the bills which regularly must be paid -- such as utilities, insurance, or repairs -- will be deferred or not paid at all.

What alternatives are there?

First, the association can enact a special assessment, forcing all owners to pay more money, either monthly or as a one-time payment. Obviously, these funds will only come from those who are not facing foreclosure, but again the ripple effect may cause even more owners to become delinquent if they cannot afford those additional fees.

Ultimately, the association might have to “bite the bullet” and file for bankruptcy. I have been reading that more and more associations are, in fact, already contemplating such a drastic measure.

Next, the association can adopt and enforce a zero tolerance rule. If a unit owner is delinquent for more than one month, begin legal action against that owner. Don't let the amount of the unpaid fees get so high that there is absolutely no way that the owner will ever be able to repay.

I also have three long-term recommendations.

Super Lien

First, mount a strong political campaign to convince your State legislature to enact what is known as a “super lien”. This means that should a lender foreclose on a condominium unit, it would be required to pay the association X number of months back condominium fees.

In the District of Columbia, for example, if a lender forecloses on a mortgage which was recorded on land records after March 7, 1991, and if the foreclosed-upon owner was also delinquent in paying condominium fees, the lender is required to pay the association up to six months of these delinquent expenses.

The specific language in the DC Code reads as follows:

The lien shall also be prior to a mortgage or deed of trust ... recorded after March 7, 1991, to the extent of the common expense assessments based on the periodic budget adopted by the unit owners' association which would have become due in the absence of acceleration during the 6 months immediately preceding institution of an action to enforce the lien. ... (?42-1903.13(a)(2).

A similar provision has been proposed in the Maryland legislature, but the bankers have strongly -- and successfully thus far -- opposed its enactment.

If associations do not have enough money to carry on its operations, the property will go to waste and more and more owners will stop paying their association fees as well as their monthly mortgage payments. Clearly, that will only lead to more foreclosures, and more depressed areas.

The law has worked successfully in the District since 1991. Lenders have not gone out of business, as the opponents have been telling the legislators. More importantly, if a potential buyer at a foreclosure sale sees that the association is solvent, this will encourage competition at those sales, which will enure to the benefit of everyone, including the lenders.

In my opinion, the “super lien” must be enacted all over this country as soon as possible.

Escrow Three Months Condominium Fees

If you live in a cooperative, you may be obligated to put three months assessment fees in escrow. If you become delinquent, the cooperative has a cushion they can tap into, before they have to take legal action for collect or foreclose.

Condominium boards of directors should give serious thought to adopting this policy for their associations. Depending on your legal documents, the board may have the authority to do this on its own, or get the membership to vote to amend the bylaws.

Either way, this will assist in keeping the financial ship of state floating, for at least a few more months.

Right To Approve New Owners

My third recommendation is that associations should consider amending their legal documents to incorporate the right of the Board of Directors to approve potential owners. Such a right currently exists with most Cooperative housing complexes.

If you want to purchase a cooperative apartment, you usually must meet with the Board of Directors (or its Admission committee) who will determine whether you can be approved to become a member of the cooperative. The Board (or committee) will consider only two factors: is the potential owner (1) willing and capable of complying with the rules and regulations of the association, and (2) financially able to pay the monthly assessments.

Obviously, such a process if fraught with risk. If the person is rejected, they may claim discrimination, based on such issues as race, religion, sexual preference, etc. Nevertheless, over the years, since most boards (or committees) are conscientious and objective, there have been very few such complaints, despite hundreds (if not thousands) of such interviews with potential homeowners.

To my knowledge, although it is legal for a community association to adopt such an approval process, very few associations have done so. Perhaps it is time to consider this option. If the lenders will not screen their borrowers, why should a community association have to suffer by having a new owner who will not be able to meet his/her financial obligations to the association?

I fully recognize that this is a drastic and controversial proposal. I certainly do not want to restrict anyone from home ownership. But on the other hand, I cannot accept the fact that potential owners may ultimately not only hurt themselves, but the community in which they live.

It's food for thought.

Looking Forward with Fixed Rates

Instead of throwing up their arms in financial frustration, borrowers in droves are trading in their ARMs (adjustable rate mortgages) for less risky fixed rate mortgages (FRMs).

In many cases, the new FRMs come with lower rates than their old mortgages, which has adjusted beyond homeowners' financial comfort level.

Freddie Mac said 89 percent of borrowers who originally had a 1-year ARM chose a new FRM when they refinanced and 84 percent of those who had a hybrid-ARM did likewise during the first quarter this year.

A 1-year arm adjusts after the first year, a hybrid remains fixed for several years or more and then adjusts.

In the current market, most adjustments push rates up, forcing homeowners to pay ever larger monthly mortgage payments.

Interest rates are lower than they were last year, but they've recently risen to their highest levels this year.

The average FRM rate for 30-year conventional mortgages was 6.37 percent the week ending May 24 this year, compared to 6.62 percent at this time last year. In July last year the average FRM rate peaked at 6.80 percent, according to Freddie Mac.

"In one year, the fully indexed rate that these ARM loans will adjust to exceeds the 30-year fixed mortgage rate by a wide margin, so borrowers are choosing more and more to take the security of a fixed-rate loan when they refinance," said Amy Crews Cutts, deputy chief economist for Freddie Mac.

Unfortunately, while prime borrowers may have the option to refinance, tighter credit standards for subprime loans and nontraditional mortgages means the option is much less available for lower income borrowers as well as second home buyers.

On a scale of fear where 1 is a sort of "pshaw" and 10 is your life flashing before you, the fear of buying foreclosures should be right up there with the out-of-body experience.

Be afraid. Be very afraid.

No doubt a foreclosure purchase can be a good way to save money on buying a home or investing in real estate, but if you don't know what you are doing the ordeal can smother you under a shroud of financial losses.

There's simply too much risk for most financial portfolios and there are easier ways to make a buck in real estate.

The American Homeowners Foundation (AHA) says with more and more homes facing foreclosure, some home buyers are considering acquiring foreclosures -- or they are being led by the nose to the "deals."

RealtyTrac, an online foreclosure marketplace said April's 147,708 foreclosure filings -- default notices, auction sale notices and bank repossessions -- represented a rate of one foreclosure for every 783 U.S. households, up 62 percent in the past year.

"Whenever the real estate market shifts, there's always this tendency to say, 'Hey. It's a good time to buy,' perhaps to cash in on those who maybe didn't understand what that really means, to cash in on the shifting market, to cash in on a returning or new trend," says Newport Beach, CA-based consultant Danielle Babb. Babb, with Corona, CA-based mortgage banker and investor William Nazur, is co-author of the yet-to-be-published "Finding Foreclosures: An Insider's Guide to Cashing in on This Hidden Market" (Entrepreneur Pr, $21.95).

"Foreclosures are already shaping up to be the next 'good time'," says Babb.

That's provided you have the time.

AHA president Bruce Hahn says the foreclosure market is dominated by real estate professionals who specialize in the market because it's a full time job, not an on-the-job-training opportunity.

"Buying a home at a foreclosure sale requires a lot of work and due diligence and is fraught with risks. You can end up spending a lot of time and money doing your homework, only to learn at the last minute the auction was canceled because the borrower filed for bankruptcy protection (which temporarily suspends the auction). Even if the sale proceeds, you may not be the successful bidder," Hahn says.

Hahn says you should not initially venture into foreclosures without competent assistance, a real estate attorney, investor or other professional familiar with local laws. That point person should also be endowed with ample connections to other savvy professionals you may also need on the way, among them, perhaps, a home inspector, appraiser and real estate agent.

"Establish a relationship in advance," Hahn advises.

Given the many unknowns associated with buying foreclosures, you'll also have to be endowed with the right financial stuff that gives you a tolerance for risk.

"Those who venture into the area should have solid equity positions in their primary residencies, they shouldn't be up to their eyeballs in credit card or revolving debt, they should be able to afford to take a little risk and they should be considering this an investment; perhaps diverting some of their investment dollars to this endeavor as a replacement for others," says Babb.

After the necessary prerequisites, the approach to buying foreclosures is a timing game. When you buy is as important as what you buy.

Preforeclosure

The period after a homeowner goes into default (misses one payment or more) and the lender files a public default notice to that affect (Notice of Default or Lis Pendens) is the period when the foreclosure process begins.

You can find the notices in your local public records office or, for a fee, get them, with varying levels of detail, from on- and offline firms that track the data.

This is one of the best times to buy foreclosure properties, experts say, because you'll have more time to get a comparable market analysis, research the title and have the home inspected.

It's also a time when the seller may be most accommodating, especially if he or she can walk away with something to show for any equity and if he or she can avoid further ruining his or her credit standing, says Babb.

During preforeclosure, the home likely isn't up for sale, so you'll avoid competition that comes with listed homes. That means, relatively speaking, there's a greater chance you can offer a price that's less than market value but more than the amount owed the bank.

"People should know that foreclosures are not always in the best of shape and they should always hire an inspector who is very detailed that will give them not only the list of items that needs to be fixed, but bids to fix it (or at least a contractor that can do that). Repairs, as well as real estate agency fees (if you aren't selling by owner, which is what I would recommend doing to avoid the fees) are all going to come out of the purchaser's bottom line and need to be considered.

Hahn suggests, whenever possible, selecting homes with substantial equity. That's often evidenced by the owners' tenure.

"Normally only consider houses owned by people who have lived there for a minimum of two years. However, appreciation stopped in most areas two years ago, and in many areas prices have dropped since then. Make it four years in this market. The longer someone has lived in a home, the more equity will be built in, even if they made interest-only payments," Hahn said.

Auction

The next phrase, the lender's auction, can represent the highest potential return, but, wouldn't you know it, also represents the greatest potential for risk.

"We don't recommend waiting until the auction. Usually bigger investors or institutions will buy these homes and the equity position is lower," says Babb.

Foreclosure auctions vary from state to state and may be held on the courthouse steps, in a county office or at the foreclosed home.

Unless you met the home in its preforeclosure stage you can't inspect it, you won't have time to run comparables or do a title search, but you'll have to pay in cash, usually with a cashier's check.

Auctions typically attract hard core investors looking to flip the property (sell within a short period for a profit) and others who've been around the foreclosure block a few times.

If you buy and things get nasty, you may have to evict residents reluctant to leave their lost home. That gives them plenty of time to trash the place or otherwise strip it for their own financial gain.

"Even if the foreclosed-upon family took care of the property, which is unlikely; the property probably has not been lived in for some time," said Dane Hahn broker/owner Exit 11 Real Estate in Stratham, NH.

"Expect the (homes) to be really dirty, maybe without appliances (even without toilets and sinks), probably without acceptable carpets, and in Northern states, showing the damages of ice and water. It's very easy to get swept-up in the potential future profits of a flip and to ignore the out-of-pocket expenses required to make the property whole," Dane Hahn added.

Real Estate Owned (REO)

Banks repossess homes that aren't auctioned off, say if the highest offer is less than the homeowner owes the lender.

Banks aren't in the business of holding and selling homes, but don't expect to land an REO for a song.

"When banks offer the property for sale, they are not necessarily pricing the property fairly. Often, they are trying to get top dollar based on what was owed, not what's based on a fair appraisal that takes condition and location into account. Just because it's bank-owned, don't expect a bargain," said Dane Hahn.

At least there's time to arrange for an inspection and a title search, removing some of the risk from the cost.

Babb says no matter what strategy you take, there's an inherent risk in the current market that property values will decline.

"It is possible that you could be in an upside down position even on a foreclosure,which is why doing real comparative analyses and knowing your equity position up front is absolutely crucial in this market. Remember that excessive foreclosures in an area can reduce property value, so it doesn't hurt to also check and make sure that a lot of the neighbors aren't in notice of default status, Babb said.

Exit Strategy

Then there's the exit strategy, which you'll have to consider at the onset of your decision to buy a foreclosure.

Why are you buying the foreclosed property? As your primary residence? To flip? As a rental?

"You basically have to know a little bit about every aspect of investing to include, contracts, financing, negotiating, acquiring, rehabbing and distributing these properties," said Richard James, owner/investor of New Home Investment Group in Lorton, VA.

"Distribution is the key in any real estate investment. You must have a good exit strategy. In the meantime, you must be prepared for some holding costs. It's a lot to juggle for a seasoned investor. A novice would really be gambling. Foreclosures aren't for the novice," James added.

If you are feeling financially fatigued and fearful about losing your home, spend a few hours in a bankruptcy-required class, or one like it -- even if you aren't filing for bankruptcy.

The simple step could save your assets.

As foreclosures and other mortgage defaults rise unabated, bankruptcies -- nearly half of which are mortgage related -- have been on the decline since the most significant overhaul of the bankruptcy laws since 1978 took effect more than a year and a half ago -- about the same time the housing boom began to go bust.

Since October 2005, the new law made it more difficult to get through bankruptcy court and that certainly has reduced the number of bankruptcies.

Also, those who rushed to file under the old law skewed statistics by pushing the number of bankruptcies higher than they may have been during the final period before the new law took effect.

But other provisions of the new law are specifically designed to reduce the number of bankruptcies before they reach court and to prevent consumers from returning to bankruptcy court later.

There's some indication the provisions are working.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) contains provisions that require that all individual bankruptcy candidates undergo credit counseling in an individual or group session within six months (180 days) before filing for bankruptcy relief. Another provision says bankrupt debtors must complete a more involved course in personal financial management before debts can be discharged.

The courses are only available through U.S. Bankruptcy Court-approved credit counseling agencies or course providers.

In the first study to measure the new law's effectiveness, the National Foundation for Credit Counseling's (NFCC) "Consumer Counseling and Education Under BAPCPA," found that fewer than four percent of consumers who turned to NFCC agencies for mandated pre-filing counseling actually opted to enroll in voluntary debt management programs (DMPs) instead of filing for bankruptcy.

However, related testing revealed consumers improved their financial knowledge by 10 to 40 percent.

They accomplished that task after only a few hours of education in bankruptcy-mandated counseling. Most consumers also said they plan to apply their new knowledge by setting budgets and making more prudent decisions about spending in the future.

Chances are, they've also seen the inside of a bankruptcy court for the last time and have a better chance of holding onto a home.

Based on more than a half million bankruptcy-related counseling sessions, conducted by 107 NFCC agencies, 11 months after the new law took effect, the NFCC study found:

• Consumers filing for bankruptcy were typically "upside-down" financially. Average unsecured debt exceeded average annual income by more than $12,000.
• Mortgage delinquency was prevalent for consumers filing for bankruptcy. Among those agencies reporting, 42 percent indicated that between 26 and 100 percent of their pre-filing clients were delinquent with their mortgages. This is higher than reported for non-bankruptcy counseling clients.
• The No. 1 reason consumers intended to file for bankruptcy was "poor money management/excessive spending."

While bankruptcy-mandated counseling can be conducted over the phone, Internet or in person in a few hours, the lessons are not the kind of no-brainer courses some college students take to pad elective requirements.

Bankruptcy law requires:

• Credit counseling agencies must provide approximately 90 minutes of counseling that includes a budget analysis and credit counseling designed to consider all the alternatives -- not just bankruptcy -- to resolve a client's credit problems. That includes an analysis of the client's current financial condition, a discussion of the factors that caused the condition and information on how the client can develop a plan to respond to future problems without defaulting on debts.
• Before debts are discharged, more exhaustive information in a minimum two-hour financial management course is necessary. In the study, the classes lasted more than 2.5 hours, on average. The information is broken down into four categories: budget development, money management, the wise use of credit and consumer information. Each category comes with minimum curriculum requirements.

Those requirements include:

• Budget Development -- Consumers learn how to set short- and long-term financial goals and to develop skills necessary to achieve those goals. Lessons include calculating gross versus net monthly income and identifying monthly expenses as fixed, variable, or periodic.
• Money Management -- Information includes the importance of keeping adequate financial records; developing decision-making skills to distinguish between wants and needs; comparison shopping; maintaining adequate insurance coverage and saving for emergencies, for periodic payments and for financial goals.
• Wise Use of Credit -- The session should provide information on the types, sources and costs of a variety of credit and loans; identifying debt-trouble warning signs; appropriate use of credit; alternatives to credit and how to check one's credit report.
• Consumer Information -- The final session provides clients with resources for consumer assistance; information on related consumer protection laws and regulations and protection against consumer fraud.

Time and again, studies prove consumers properly schooled in financial education retain home ownership longer and with fewer financial problems, they have higher credit scores and generally live a less financially-stressed life style.

The sooner in the consumer's financial life the education begins, the better.