Robert Braverman, Braverman Greenspun
With a challenging real estate market, owners in newly built or recently converted condominiums may be wondering when they will ever get control of their buildings, and will they be ready when they do? Can you share some insights on how to have a smooth transition when the sponsor has to relinquish control?
There needs to be a smooth relationship leading up to the transition. And that period of time prior to the transition – from the time a condominium opens to the day the sponsor relinquishes control – can typically be up to five years, which is a long time. With the upcoming marketplace that we're probably about to experience due to the pandemic, I don't think we're going to be seeing situations where buildings that come online are sold out immediately. We're probably going to be seeing a trend where sponsors do maintain control of the condominium board for the full period of time that they are allowed to under the offering plan.
When you say the full period of time, you mean an end stop to their control?
There's always an end date, and there are different permutations and different structures contained in offering plans. Typically, what you see is relinquishment of control five years after the first closing. We can take that as kind of a baseline. There are differing structures, but that is a fairly typical one. So a sponsor could only own one unit in the building and still be in control of the board for up to a period of five years.
And let me just clarify, when you say control of the board, there are representatives from individual owners on that board, is that correct?
Well, there could be, yes. But let's say it's a five-person board and a five-year control period. For the five years after the first closing, at least three of the board members will be affiliated with and designated by the sponsor, which means that the sponsor is really in control of the building because they control the board.
As I was saying before, most likely we're going to see control periods strung out all the way, and when that happens, there are often issues that arise. Because as time goes by and unit-owners occupy the building or live in the building for a significant period of time, they justifiably want to have some say in the operation of the building. But it's important for unit-owners to understand that when you're buying in a new condo, that's not necessarily going to be the case for at least a five-year period, and you have to understand if you're coming in in year one, there's a good chance that the board is going to be sponsor-controlled for up to a period of four or so years.
And I think if you understand that and you're willing to work with it, you're more likely to come out of that initial control period with a smooth transition, whereas if you battle it from day one, there's going to be acrimony and discord from day one. It surprises me when I'm representing boards of new construction buildings that there's often bewilderment as to why the sponsor is in control for such a significant period of time. But it's in the offering plan. It's always listed as a special risk in terms of the duration of the initial control period. So people buying condominium units should really walk into that facet of their investment with their eyes wide open.
I don't want this to take us off on a different tangent, but often you hear in newly constructed condominiums that there are construction defects, and the unit-owners want to address that once it comes to the fore sooner rather than later, but the sponsor is in control of the board. Is that a conflict?
Absolutely. And it's a conflict that is very difficult to resolve because, on the one hand, there are often construction-related issues of different magnitudes in new construction buildings. There are unit-owners who are eager to see those issues resolved, but there's a sponsor that is in control of the board and isn't necessarily motivated to perform an investigation, and certainly is not going to be motivated to bring claims, in essence, against itself.
However, there are ways to assuage the concern of unit-owners who are worried that limitation periods might expire or claims might be waived during the initial control period, and that is through what's known as a tolling agreement, where the condominium and the sponsor enter into an agreement that, in essence, says timeout on all claims related to construction until a period following the expiration of the initial control period. With that type of agreement in place, unit-owners can at least have some sense of security that if there are claims to be brought, they'll still be able to be brought at the time when the unit-owners take control of the board.
So maybe one of the strategies for a smooth transition is to try and get this agreement beforehand?
Yes. When I represent sponsor-controlled boards, even if there is time left on the various limitation periods, it's always prudent in my view for the sponsor to say, "Okay, we get it. We understand that we're not going to be particularly motivated to do an investigation of the building at this particular time. And again, we're certainly not going to be motivated to bring an action, but we'll do the right thing and we'll make sure that when we do give up control of the building, that the condominium association is not prejudiced in any way because we had control of the board for that period of time."
So talk to me about another strategy.
A second strategy which I've seen work in a couple of instances — and one I'd like to see more sponsors be amenable to — is a gradual handoff of control. Sponsors have very good and justifiable reasons to maintain control of the board for as long as they're permitted to. It might be that the building doesn't have a permanent certificate of occupancy and the sponsor wants to control the ability as best as possible to obtain that certificate of occupancy, which is one of its many obligations under the offering plan. It may be that there is commercial space that needs to be sold and the sponsor will feel that it's in a better position to sell that space while it controls the board.
But that period is going to come to an end. Very often, particularly in high-end new construction condominiums, we're talking about projects that are approaching a billion dollars with sophisticated building systems, large staffs and lots of different types of amenities, from movie theaters to gyms, pools and spas. And if the sponsor waits until the very, very last day of the initial control period and then calls an election, I analogize that to giving the keys to the Ferrari to the kid who just got their learner's permit and has never been behind the wheel of a car.
Sponsors can do a lot of good for themselves and for the long-term health of their project by giving up control in a gradual way. So for example, if it's a seven-person board, the sponsor is going to want to maintain four seats on that board until the end of the initial control period, but there's no reason why, in the last 12 months, you can't start to gradually bring residential unit-owners onto the board, whether it be by way of a sponsor representative resigning and the remaining sponsor representatives appointing a unit-owner to the board, or whether it be by a special election of the unit-owners for the one spot on the board. The latter is preferable because then the unit-owners right from the get-go are picking their representatives. And on the day the sponsor hands over the keys, you've now got one person who's been on the board for probably a year, a second person who's been on for nine months, and a third who's been on for three or six months, and they've learned how the building operates. They’ve learned the interaction between the board and the managing agent. They have an idea of what, if any, construction and punch list items remain to be completed in the common areas. It's a much smoother transition and it doesn't hurt the sponsor's reputation to say, "Hey, we want to make sure when we do walk away from this, it runs as efficiently as possible going forward."
And why would a sponsor object to this? It seems so reasonable.
I think it's just been done the other way for so long that sponsors are saying, "Look, this is what we bargained for. We're going to control the building for as long as we can." There are intermediate things that sponsors can do if they don't want to go so far as to have these special elections or to start to dilute, if you will, their control. So for example, and I see this all the time, what does a sponsor-controlled board really care about the hours of operation of the gym or how many people at one time can use the playroom? We're talking, of course, pre-COVID times. Sponsors are well suited and I think well served to at least have a committee of interested unit-owners. And there are always interested unit-owners who want to get involved in the day-to-day quality of life operations. So at least form a committee of unit-owners to advise you on what's working in the building and what's not working as well. And at that point, let the unit-owners have at least a say, if not control, over those types of quality-of-life issues.
Okay, so now we're in a transition time and there is a reserve fund in the condominium, and unit-owners may be concerned that the sponsor has used these funds for their own ends. Is there a strategy for dealing with this?
So when it comes to conversions of existing properties – either a conversion from a rental building to a condominium or co-op, or the rehabilitation of an existing building to a condominium – very often there's what's known as a statutory reserve fund, where there is a specified formula in the offering plan where the sponsor is required to make a contribution to the reserve fund upon each sale of a unit.
This is only in a conversion building, not a new construction.
Correct, this doesn't apply to new construction. In conversions, that reserve fund is earmarked for capital repairs, the theory being that it's not a new building but an existing structure, and it's going to need capital repairs and improvements earlier on than a new construction building would. So the sponsor leaves a reserve fund to take care of those types of repairs. What can sometimes happen is during the course of the sponsor's work, capital repairs to the building need to be done, and there are instances where the sponsor is permitted to draw down on that reserve fund in order to make repairs to the building while it is in control of the board or still in the sales process.
In my experience, sponsors are well served to sit down with an incoming residential board or at some point prior to there being the handoff and go through what the expenditures were. I've seen lots of instances where a board comes in for the first time and they haven't really been given a background as to what's been transpiring in terms of payment for capital expenditures. They sit down and they look at their ledger and they see that the reserve fund has been depleted by the sponsor for making capital repairs. Sometimes it's perfectly legitimate and appropriate that the sponsor used the money. Other times, it might be more of a gray area, and somewhat infrequently, there are improper uses for these reserve funds. A board in a converted or rehabilitated building coming in and having that conversation with the sponsor very early on will, in my view, lead to a smoother transition than leaving the board to try to just figure it all out.
Would it makes sense, whether it's a new project or a conversion, that a group of residents approach a sponsor at the beginning of the five-year process to say, "We want to be somehow involved so when this building is on our hands, we're not ignorant about what goes on," so that they try and have a collegial spirit from the beginning?
Absolutely, which brings things full circle to what we had discussed early on. That is, you want to plant the seeds for a smooth transition at the beginning of the process by having the sponsor and concerned unit-owners engage in a healthy, grownup dialogue about how this building is going to evolve over the first five years of its life, understanding that there might be varying interests and goals. But if you have that conversation early on and the sponsor recognizes that these unit-owners, while they might not have control for quite a while, are going to be the ones living in the building, you develop a culture that's healthy and non-confrontational, as opposed to an unhealthy, acrimonious one.