Residential Magazine

The Condo Conundrum

These homes appeal to millennials, but they also pose risks for the mortgage industry

By Jacob Channel

Millennials buying their first homes are increasingly looking for lower-cost options that get them closer to the city center. Condominiums are a popular choice in these situations. Nearly half of all mortgage applications for condos now come from this generation, according to a CoreLogic report.

While the appeal of condo living is clear, this shift in demand poses very real risks to the mortgage industry that originators should know about. These risks have only grown more evident after the tragedy of the Surfside condo-building collapse in South Florida earlier this year.

Poor financial management can cause condo properties across the country to suffer from disrepair and put a lender’s investment at risk. The situation could grow even worse as climate change threatens coastal areas in particular. These risks are worth understanding as you handle the increased demand for condo purchases.

Financial health

When you’re reviewing a loan application for a condominium purchase, you must consider more than your potential borrower’s finances. You’ll need to evaluate the financial health of the condo community as well. You’ll also need to uncover the following information:

  • Determine what percentage of units are delinquent on homeowners association (HOA) dues. No more than 15% of units should be 60 days or more past due.
  • Does the condo community hold enough of its annual budget in reserve? This amount should be at least 10% of the budget.
  • Find out whether enough units are owned by different individuals. In large buildings of 21 or more units, no one entity should own more than 20% of the units.
  • Confirm that there is adequate insurance coverage. There should be a master insurance policy that covers the full replacement cost of all units and improvements.

A condo association will have to pass all of these tests to determine whether a condo unit is warrantable, or eligible for conventional mortgage financing through the government-sponsored enterprises Fannie Mae and Freddie Mac. If it’s nonwarrantable, the only option will be alternative financing that your company may not offer.

Because individual condo units are part of a larger property, their values depend on what shape the entire building is in — not just a single unit. If other people who live in the building don’t pay the HOA fees or default on their loans, then the values of the condos owned by even the most responsible owners will suffer.

Mitigating risk

Concerns about a condo community’s finances being in poor shape are increasing. A Fannie Mae survey of senior mortgage executives last year found that 60% identified the financial stability of HOAs as a top risk to their business, making it the most-cited consideration and the fastest-growing concern during the previous year.

Requirements for condo reserves vary widely by state. In states like Ohio with the most stringent rules for condominium associations, a board is required to set aside 10% of its annual budget for long-term needs. Other states require that condo associations put money in reserve but don’t specify a minimum amount. States like Florida require condo association boards to annually set aside in money for items that will cost more than $10,000, such as roof replacements, paving and painting. But neighboring Georgia has no requirements for reserves.

In fact, most states have no legal requirements for condo associations to keep money in reserve, according to a survey of state laws by the Community Associations Institute. Only nine states require condo associations to conduct a formal reserve study to ensure that the community’s savings are adequate for future maintenance, repair and replacement of systems such as roofs and common facilities.

Fannie Mae and Freddie Mac guidelines are a reasonable way to mitigate risk, but lenders and originators may consider looking deeper. There are established best practices that condo associations should follow, regardless of the state.

A reserve study is an important component. The condo association should do a physical inspection of major systems, including roofs and common areas, to determine their age and condition, then estimate how long they will last while determining the replacement cost. Every condo association’s needs will be different. The important thing is that the community is planning ahead for long-term expenses, avoiding the need for costly special assessments or loans.

Deferred maintenance

These financial issues can lead to serious problems with a condo community’s condition and safety. This past June, the 12-story Champlain Towers South condo building in Surfside, Florida, collapsed and killed nearly 100 people. Inspection reports released later showed that a ground-floor pool deck had major structural damage while support columns and beams in the parking garage also were cracked.

Infighting among condo association board members and pressure from homeowners to keep dues low can sometimes lead to maintenance needs piling up. About one-third of condo communities around the country are behind in saving for big-ticket repairs, Association Reserves CEO Robert Nordlund told The Seattle Times. His company consults with communities on their reserve funds.

 This is certainly a cause for concern for lenders. Deferring maintenance until it requires an immediate and pricey repair can lead to the need for a large special assessment — a charge passed by the condo association board for all homeowners that can amount to tens of thousands of dollars on top of regular dues. As a result, homeowners may not be able to pay their bills and missing payments make it harder for lenders to recoup costs on foreclosed homes. Structural damage also may raise issues related to the ethics of originating a loan on a housing unit that may be unsafe to live in.

 Fortunately, the type of catastrophic building collapse seen in Surfside is relatively rare in the U.S. Still, you should look for a detailed condition report of all major systems in a condo community as part of the reserve study. Associations should have a preventive maintenance plan for all components listed in the reserve study to prolong their life.

 In the wake of the collapse in Florida, lenders and borrowers alike should continue to put pressure on condo associations to properly inspect and maintain their buildings. This not only ensures that condos are worthwhile investments but, more importantly, are safe.

Emerging dangers

Climate change could put additional pressure on the maintenance needs and financial stability of a condo association. Today, nearly 40% of the U.S. population lives in coastal areas at risk for rising sea levels, storm damage and erosion that accompany climate change, according to the federal government. By 2100, best-case projections show that sea levels could be a foot above their 2000 levels — and by 8 feet or more in the worst-case scenarios.

The results of this trajectory are stark. About $135 billion in U.S. real estate could be underwater by 2045, according to the National Oceanic and Atmospheric Administration. This number could reach $1 trillion by the end of the 21st century. At the same time, hurricane damage is expected to increase significantly and top more than $35 billion per year by 2050. Coastal cities have a high concentration of condos that could be at risk from both hazards.

These perils may be hard to quantify in the short term. But if your client is considering a mortgage on a condo in a high-risk area, it might be worth asking the condo association board about its plans to mitigate the risks of climate change and keep the community protected in the years to come.

Complex investment

If your client doesn’t make their payments on a single-family home, there’s a straightforward process for a mortgage lender to recoup its investment via foreclosure. The prospects of reselling a condo, however, are a lot more tricky.

Some condominium communities put restrictions on who can buy a property in their building. By limiting the pool of buyers, it may take longer to offload a property through foreclosure. Shoddy financial management or pending litigation can scare some mortgage lenders away from financing a resale.

Litigation can arise from all manner of issues within a condominium community. In some cases, homeowners may sue the condo association board for failing to repair items that a resident believes should be covered by the board. Other times, litigation may involve disputes between neighbors.

Fannie Mae states that it will not purchase loans for condo units in communities involved in major litigation. This includes lawsuits that allege major issues tied to the safety, livability, structural soundness or functional use of the property.

A lender can move forward with a warrantable condo loan if the litigation involved is minor — for example, if the lawsuit deals with damage in a small area of the property or with noise complaints. It’s the responsibility of the lender to determine whether the litigation is major or minor.

Growing demand

Condos make up only 8% to 10% of the mortgage origination market, but they comprise a larger proportionate share of the risks. That’s why condo lenders tend to require a downpayment of 10% or more, compared with a 3% minimum on single-family homes. Interest rates tend to be higher, too.

Lenders and the originators who work with them should keep in mind that as cities become denser, home prices rise and the number of homes for sale declines, more buyers are likely to look to condos in lieu of traditional single-family homes. In last year’s Fannie Mae survey, the majority of mortgage executives reported that they expect demand for condo loans to grow or stay the same in the coming years.

Remember, however, that the trends for condo sales do not always follow the larger housing market. While single-family home prices rose quickly across the country last year, the average condo sales price actually fell in places like Seattle, Boston and Queens, New York, according to data analytics company Black Knight. In cities like Washington D.C., Los Angeles and Charlotte, condo prices rose much more slowly than the prices of single-family homes.

Lending on condos can be a profitable business. There’s a reason why more than 85% of lenders surveyed by Fannie Mae issue mortgages for condos. Lenders that are thinking about offering condo loans can better protect their money by making sure that the condo unit is in a well-maintained building and that the owners of other units are up to date on items like association fees. ●


  • Jacob Channel

    Jacob Channel is a senior economic analyst for LendingTree, where he conducts studies on a wide variety of subjects related to the U.S. housing market and provides general macroeconomic analysis. His work has appeared in major publications including The New York Times, Bloomberg, Forbes and CNBC. He earned a bachelor’s degree and a master’s degree in economics from The New School, and he is based out of New York City. 

You might also like...