With demand for high-end residential condominiums quickly outpacing supply, developers are moving fast to introduce new inventory to the market by proposing more than 150 new condo towers with nearly 20,000 units in each of the counties of South Florida. Recovery is certainly underway, but financing challenges continue. Lenders, for the most part, are still reluctant to make large construction loans, opting to only fund projects that bring a significant amount of hard equity and credible ownership.
So, developers are turning to the buyer-financed model to help fund the pre-construction and construction phases of a project. The model — also known as purchase financing — is beneficial to developers. It reduces the developers’ risks of financial loss and results in greater profits by avoiding interest expenses, substantial bank fees and internal costs associated with the construction draw process. But it can be riskier for the buyers and they should assess that risk before entering into a contract.
Purchaser financing is a contract right spelled out in condo purchase agreements that allow the developer to use all deposits in excess of 10 percent towards the soft and hard costs of development. The problem is that deposits used during construction aren’t considered either an interest in the property or a secured loan. So, the contract purchaser will be at risk for refunds of deposit installments already used by the developer during the construction phase. The buyer would still retain the right to rescind a contract whenever there are material changes in the condominium documents but that person may have a hard time trying to get all of the deposit back.
The risks to a buyer also increases when developers retain the right to borrow money from lenders for use in the acquisition, development and construction of the condominium. The deposits that are used would convert into unsecured debts inferior to mortgages created in favor of lenders and mechanics liens for unpaid labor and materials furnished to the project. At closing, the amount owed to lenders and/or to lien claimants must be paid to deliver clear title to a contract purchaser. However, a failed developer may not have adequate resources to achieve this result much less refund any deposits already used.
Typically the purchase agreement expressly deprives buyers the right to file a lien against the condominium to be built with his or her money. The absence of any lien right puts the purchaser at the bottom of the lists of creditors.
The buyer-financed model provides limited and ineffective protections to buyers. While a purchaser should request some form of protection in the form of a completion bond or other third-party assurances to mitigate against a developer’s financial failure, this is unlikely. Developers will not provide this protection voluntarily and individual purchasers lack the economic power to compel the developer to do so.
While the demand for condos remains strong, properties may be built with buyer financing. On occasion, a developer may pass any of the savings of interest, bank fees or other expenses avoided to the purchaser in the purchase price. However, the monitoring role that banks play during the construction draw period is an intangible benefit that may outweigh any savings actually passed on.
If the market softens and a financial crisis reappears, it is unlikely that contract purchasers will be able to identify each other rapidly enough or have enough of a consensus to act in concert either in U.S. Bankruptcy Court or in routine litigation to complete an otherwise failing building. Therefore, the risks to this new method are very serious.
A Florida Supreme Court opinion stands to complicate things for Realtors and lawyers who do not identify and inform their buyers of the risks of this development model. If litigation develops over failed condos, lawsuits for fraud as to the ability to complete a condo-project will be a primary litigation vehicle against officers and controlling shareholders of developers and against realtors. Because developers may not be able to respond to judgments in a failed real estate market, the litigation will shift to Realtors and lawyers.
Andrew C. Hall is founding partner at Miami-based Hall, Lamb and Hall. He focuses his practice on complex commercial litigation, professional negligence, securities litigation and arbitration, family law, personal injury and wrongful death. www.hlhlaw firm.com