When a Condo Developer Goes Bankrupt, It Can Mean Trouble for Early Buyers

Q: What happens to your investment if you buy one of the first units in a condominium and the project goes bankrupt before a significant number have been sold?

Could you possibly lose all you invested? This is a concern for people who are retired and can't afford to lose such a significant sum.

A:This is a concern for anyone, young or old, especially in today's soft condominium market. To some degree, condominium buyers are protected by lender pre-sale requirements, but for all practical purposes, it is caveat emptor -- let the buyer beware.

To understand this rather complex issue, we have to go back to basics, namely how a condominium is created. There are two important legal documents involved with a condominium: the declaration and the bylaws.

The declaration serves as a deed that establishes and defines the condominium and that recites the manner in which the "declarant," or the developer, desires to convert or construct the property as a condominium. The declaration describes specifically the various components of the property, which generally include common elements, limited common elements and units.

The bylaws contain the rules for self-government of the condominium by an association of the unit owners. The association directs the affairs of the condominium, administers policies outlined in the bylaws and generally oversees the upkeep and administration of the project.

Whether this is a newly constructed condominium or a conversion from rentals, the developer generally must obtain some form of government approval of the legal documents. The requirements will differ from state to state. Once the association documents have been approved, they are recorded among the land records in the jurisdiction where the property is located.

When these documents are recorded, the condominium association springs into being. And since the developer owns all the units, the developer has another role: to serve as the initial board of directors of the association.

All legal association documents require that every owner must pay his or her share of the condominium assessments. The percentage will be spelled out in the declaration. When the developer owns all the units, it must pay the entire condominium fee to the association.

As units are sold, the developer's obligation for these assessments will diminish. When the last unit is sold, the developer will no longer be obligated to make these payments.

It should be noted that this is the generally accepted practice. Some developers and some state laws permit variations. For example, some developers will agree to pay all the association expenses, whether that is more or less than the obligation to pay all the fee assessments. In other situations, a developer will pay the condominium fee for the units it still owns, but will not pay any money into a reserve account.

Especially in a converted condominium project where the infrastructure is not always completely modernized, this latter arrangement is not in the best interest of the new owners. They will find themselves without adequate reserves should problems arise. They will have to significantly increase the monthly assessment to bring the reserve account up to a reasonable level.