Buyers say rental restrictions create disadvantage

Benny L. Kass
Inman News

Q: We just bought a condominium unit in a new 50-unit complex. Although the developer will not tell us how many units have been sold, we have recently learned that it is starting to rent some of the unsold units.

This seems unfair, especially since our contract specifically states that we cannot rent for at least one year after settlement.

Can the developer rent those units?

A: This is a hotly debated issue, especially in areas where condominium sales have dramatically slowed down. Just a few years ago, prospective buyers were lining up on the doorsteps of the developer’s real estate sales office, clamoring to buy those condo units. And in many cases, the prices were not cheap — often ranging between $700,000 to more than $1 million per unit.

In fact, many speculators entered into the picture, hoping to make a financial killing by buying low and flipping to a third party even before the units were ready for sale. Others wanted to buy solely to be able to rent the units.

As a result, many developers started to impose rental and resale restrictions. The most common were requirements built into the purchase and sales contract that limited a purchaser from renting the unit out for at least one year. Other provisions in the contract either prohibited a purchaser from flipping the contract, or if that purchaser really wanted to sell within a period of time (usually one year) the developer had the right of first refusal at the original purchase price.

But times have changed. Now, developers are stuck with many unsold units, either because there is no longer a great demand or because contract purchasers are just walking away from the deal — often forfeiting their earnest money deposit.

Developers argue that they are required to pay the condominium fees on these unsold units, and thus there is no harm to those who have already purchased. On the other hand, the current owners claim this is unfair because it is often difficult to get good financing when there are too many renters in a condominium complex.

It should be noted that the secondary mortgage market (such as Fannie Mae and Freddie Mac), as well as the Federal Housing Administration and the Department of Veterans Affairs, have regulations making it harder to get a mortgage loan when the percentage of renters in a building is too high. These percentages range from 40-60 percent.

Owners also complain that having too many renters in a building changes its complexion. It is no longer a condominium, but an apartment building, where tenants will not be as concerned about its upkeep and maintenance.

More importantly, the owners point out, they now have to compete with the developer when they want to sell their units. The developer can offer many more perks and benefits than can an individual owner.

Because I was unable to find any legal cases in the Washington, D.C., metropolitan area, I researched other states and found an interesting case — 511 W. 232nd Owners Corp v. Jennifer Realty Co. — from New York. In 2002, the New York Court of Appeals held that the developer of a cooperative complex breached its contractual obligation to create a “fully viable cooperative within a reasonable time by refusing to sell a majority of the cooperative shares.”

That developer planned to sell 66 cooperative units. However, after selling only 25 units it stopped marketing them and instead kept more than 62 percent of the shares in the building. Indeed, the plaintiffs in the case alleged that the developer had rejected bona fide purchase offers from prospective purchasers of vacant apartments.

The public offering statement (POS), which the developer was required to provide to prospective purchasers, made no reference to the fact that it would not sell all of the units. However, while the POS cautioned potential purchasers as to numerous investment risks, it did not mention the risk that the developer would keep more of the units for itself and rent them out.

The high court pointed out that in New York, “All contracts imply a covenant of good faith and fair dealing in the course of performance.” According to the court, this is particularly true in cooperative conversions whose sponsors must meet “high standards of fair dealing and good faith toward tenants” because “purchasing tenants and sponsors do not deal as equals either in terms of access to information or business acumen, and thus tenants often lack equal bargaining power.”

Accordingly, the court held that the plaintiffs had stated a valid cause of action for breach of contract. It should be pointed out that this opinion was on a technical legal point of law. The developer had filed a motion to dismiss the case claiming that the plaintiffs did not state a valid claim, but the court ruled to the contrary. The court did say, however, that it was not getting to the merits of the contract claim, and sent the case back to the lower court for trial.

However, the New York attorney general, having reviewed the court opinion, issued regulations effective Dec. 6, 2006, which impacted on both condominiums and cooperatives. Basically, so long as a developer fully discloses to potential purchasers that it may not sell all of the units, and further discloses certain risks — such as that purchasers may never gain control of the board of directors — developers are permitted to rent out any unsold units.

Clearly, this ruling was disheartening to many New Yorkers who find themselves in a condominium where possibly a majority of the units are rented.

But this does not leave you unprotected. First, as stated earlier, the developer is probably required under the terms of the legal documents to pay all of the condominium fees on the unsold units. Potential homeowners must read the public offering statement very carefully, because in many situations the developer will pay only its share of the operating expenses, but will not be contributing anything toward reserves.

More importantly, when the developer is in control of the board of directors, he wears two hats: developer and board member. In the latter capacity, he has a fiduciary duty to all owners to act appropriately and reasonably. In the words of the New York court, the developer has an obligation to “deal fairly and act in good faith.” This concept is not limited to New York; it is a basic concept in American law.

Here is a suggestion that you should consider: Find out who the current owners are. If the developer will not divulge this information, you can search the land records in your jurisdiction to get this information. It is a matter of public record. You can also go door-to-door and make inquiries of the occupants.

Once you have a list of the current owners, hold a meeting in your apartment and try to organize them. Explain the problems associated with having too many rental units in your complex. Your group may want to retain legal counsel, so that all legal avenues available to you will be explored and implemented. For example, as owners, you have the absolute right to periodically inspect the books and records of the association. You have the right to insist that the developer obtain and circulate an annual financial audit. You may also be entitled — pursuant to the condominium laws in your state — to have one owner elected to the board of directors. And even though that owner will always be outvoted by the developer board members, at least you will have access to all of the decisions that the board makes on your behalf.

In preparing for this column, I spoke with a number of attorneys. The lawyers who represent developers informed me that they always include in the POS language that protects their client against situations such as this.

The bottom line: If you really want to purchase a condominium unit in a newly built project, read the condominium documents very carefully. Consult your financial and legal advisors before you are legally committed to go to settlement. Too many people have told me “those documents are over 100 pages and I just did not have time to review everything.”

It’s your investment; don’t take chances.

Copyright 2008 Benny L. Kass