Preparing for the Big Chill

The economic forecasters agree that we’re in for a long, chilly winter. Possibly, a long, chilly spring, summer, and fall, too. Possibly, even a few chilly years. With the global economy cooling and credit suddenly tight, New Yorkers who are buying into new or not-yet-finished condominiums need to be aware of the perils lurking amid the construction cranes and freshly drafted mortgages. One of the most chilling is the very real prospect of a coming rash of defaults by condo sponsors.

While no one can say for sure if defaults and bankruptcy filings will increase as the economy cools, there are a number of steps condominium boards can take to protect their buildings from the coming chill.

In real estate, as in medicine, prevention is often the best cure. And while it may be impossible for condo boards to prevent a sponsor from defaulting, it is important that they remain alert to signs of trouble so that damage to their investments can be averted or kept to a minimum.

The most common and obvious sign that the sponsor is in dire straits is, of course, that it suddenly stops paying common charges and defaults. One way to gauge the sponsor’s financial health is to study the offering plan, which must be amended periodically as long as apartments are selling. The amendments will include a financial disclosure, which will tell a board the amount of rental and common charges collected monthly, whether there’s a surplus or shortfall, and whether or not sponsor apartments have been pledged as collateral for loans. Boards can also run a credit check on the sponsor.

“That [financial disclosure] gives you a way to evaluate the sponsor’s cash flow,” says Steven Wagner, a co-op and condo lawyer and partner at Wagner Davis. “It tells you how much is coming in and how much is going out.”

Above all, veteran real estate observers agree, this is a time for condo boards to get aggressive. A “this-too-shall-pass” attitude is not an option. “Every condo board in the world should be checking several things right now,” says attorney James Samson, a partner with Samson Fink & Dubow. “The first thing to do is find out what kind of mortgage the sponsor has, who holds it, how big it is, and if you can buy it. Also, find out if the real estate taxes are being paid. If not, that’s real trouble. And find out if the sponsor’s defaulting at other properties.”

While there’s no end to potential sources of financial strain on sponsors in these chilly times, the most likely cause of a reduced cash flow is that unsold apartments are suddenly having a hard time finding buyers. Without income from sales, the sponsor is suddenly squeezed. This can have a snowball effect.

“Developers who are having difficulty selling apartments still have to pay their construction loans and other expenses,” says Wagner. Sometimes, he adds, even when the sponsor is able to keep up with his debts, the lending institution may have a change of heart – or cash flow problems of its own. “If the lenders want out,” he says, “they’re going to have to give the developer time to find a new lender. That can be a big problem.”

It can be a challenge because borrowing money – even for something relatively small, like a car – is no longer the breeze it used to be, even a few months ago. In the case of getting new financing for something as big as a half-finished condo tower, it can be downright harrowing.

“Of course,” Wagner adds, “if the sponsor is in default [on a bank loan], the lender is under no obligation to give the sponsor time to do anything.”

Under the state attorney general’s Policy Statement No. 6, passed in the aftermath of the last major stock market crash – the monster in 1987 – co-ops and condos began receiving “special treatment” that expedites their takeover of a financially troubled sponsor’s stake in a property. But the foreclosure process works much more slowly for condos than for co-ops.

Even if a condo board is able to purchase and sell a troubled sponsor’s apartments at a profit, there are limits to what Policy Statement No. 6 can do. The attorney general cannot, for example, force the sponsor to meet his financial obligations. And if the board has not done its homework and foreseen the coming financial crunch, there is a strong possibility the lending institution will start foreclosure proceedings and begin collecting rent on the sponsor’s units.

“Aggressively fight the bank for the rents,” Samson advises, noting that a sponsor is in default when he fails to pay common charges. “File the lien for the [sponsor’s] unpaid common charges as soon as they stop showing up. Then you can start collecting the rent from the sponsor’s units. Even if you can’t get the rents, you can go to court and apply for reimbursement for the cost of providing essential services, such as heat and elevators.”

In the opinion of attorney Stuart Saft, a partner with Dewey & LeBoeuf, it’s usually wise to try to negotiate a settlement before hauling the sponsor into court. “A full-scale litigation against a sponsor will drag on for five years or more,” he says. “It will cost hundreds of thousands of dollars – and you have no guarantee you’ll be successful or that the sponsor will have any money to pay you.”

Even if negotiations prove unsatisfactory, Saft believes boards should file a complaint with the enforcement bureau of the attorney general’s office before filing a lawsuit. A lawsuit, he believes, should be a last resort.

Bottom line, “boards have to be vigilant and prepared to act quickly,” says Saft, because this chill is big and it’s for real. “Do your homework,” adds Wagner, “and don’t discount the rumors. They may be true.”