High Demand for High-Rises Gives Way to a New Finance Model Buyer-Financed Development Becomes the New Normal
By Andrew C. Hall
With demand for high-end residential condominiums quickly outpacing supply, developers are moving swiftly to introduce new inventory to the market. Recovery is certainly underway, but financing challenges continue, and some developers are turning to the buyer-financed model to help fund the pre-construction and construction phases of a project. Not only does this method reduce the risk of financial loss, it also results in greater profits since it avoids interest expenses, substantial bank fees, and internal costs associated with the construction draw process. While the benefits to the developer are abundant, certain risks do remain for the buyer and should be assessed before entering into a contract.
Purchaser financing is a contract right that typically appears in a single line within a condominium purchase agreement. That line provides that the developer may use all deposits in excess of 10 percent toward the soft and hard costs of development. Deposits are increased during construction. If the project proceeds as planned, this model provides buyer financing for an interest-free loan without recourse.
The buyer faces larger risks in this financing model. Because a condominium can only come into existence with the state’s approval of the appropriate declaration of condominium and related condominium documents, after construction of the building, usable deposits lack the character of either an interest in the property or a secured loan. While a prospective purchaser retains the right to rescind a contract whenever there are material changes in the condominium documents, the contract purchaser will still remain at risk for refunds of deposit installments already used by the developer during the construction phase of the development.
The risks to a buyer are increased when developers also 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 provides that a contract purchaser has no liens against the condominium to be built with his or her money and, under all circumstances, will be inferior to lending obtained by the developer. The absence of any lien right puts the purchaser at the bottom of the lists of creditors to be paid.
While the benefit for developers to use deposits for construction is apparent, protections for a purchaser are both limited and ineffective. For example, if a 40-story condominium building is under construction, a contract purchaser of the unit on the 39th floor will find himself significantly behind the economic eight ball if the building fails to be completed. 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 provide this type of protection.
While the real estate market is strong, properties may be built with buyer financing. On occasion, there may actually be a benefit for purchasers if the developer passes 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 affect 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 Bankruptcy Court or in routine litigation to complete an otherwise failing building. Therefore, the risks relating to this tool are grave and should be considered by a buyer and his or her attorney before entering into this type of agreement.
The Florida Supreme Court has rescinded condominiums from the economic loss rule except in product liability cases. Condominiums are not traditional products. Therefore, if litigation develops over failed condominiums, lawsuits for fraud as to the ability to complete 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 real estate professionals and lawyers who do not identify and inform their buyers of the risks of this development model.
Andrew C. Hall is the managing partner of Hall, Lamb and Hall, P.A., a Miami-based law firm specializing in complex corporate, business and securities litigation.
South Florida Legal Guide Midyear 2013 Edition