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

If you are the first buyer in a multi-unit project, and the developer files for Chapter 11 bankruptcy protection, there is some protection. Whoever ultimately will own the rest of the units will be obligated to pay the assessments for those units.

While this sounds good in theory, as a practical matter it can be disastrous. The bankruptcy court may take a long time before deciding on the disposition of the unsold units, and there will be no money in the association to pay monthly expenses such as insurance, utility bills and maintenance.

Here is where lender protection comes into the picture. Most mortgage loans are sold in the secondary market, through such organizations as Freddie Mac or Fannie Mae. And these entities have established pre-sale requirements that originating mortgage lenders theoretically are required to follow. Pre-sales should ensure that the developer has some money coming in.

For example, the Fannie Mae guideline for conversion projects states, "At least 70 percent of the total units in the project must have been conveyed (or must be under contract to be sold) to owner-occupant principal residence or second home purchasers."

For new construction projects, Fannie Mae says, "We do not have a standard presale requirement. . . . Instead, we establish varying presale requirements based on local market conditions or the developer's track record. Generally . . . the presale requirement can be satisfied if [at least 70 percent of the units] have been conveyed to the unit purchasers or if the units are under contract for sale."

The Fannie Mae guideline goes on to state that this "70 percent requirement applies in most cases, although we will determine a specific presale requirement for each project based on its feasibility and marketability."

It has been my experience that most developers will not allow any unit to go to closing until there are a decent number of units under contract. This number, however, may not be consistent with the secondary mortgage requirements.

In a hot market where property values are appreciating, it makes sense to be the first buyer in a condo project. In fact, in the past few years, many speculators were signing up to buy condos at start-up prices, solely to flip the unit -- or even the contract -- to make a quick buck or two.

This practice became so pervasive that developers imposed a number of restrictions in their contracts to curb this speculation. Many developers required potential buyers to agree that they would not rent the unit for a period of at least one year. If they sold the unit within the year, the difference between the initial purchase price and the resale price would go exclusively to the developer.

But we are no longer in a real estate bull market. Condominium prices are either flat or decreasing. Developers are offering all sorts of incentives, such as reduced prices, free plasma televisions sets, and prepaid car rentals, to entice buyers.

This may be a good time to buy. No one knows when this sluggish market will rebound, and for a reasonably foreseeable time, mortgage interest rates are still at a comfortable level.

However, to protect yourself, here are some suggestions: