By Benny L. Kass
Saturday, October 14, 2006; F04

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.

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:

· Ask the developer how many units are under contract.

· Insist that the developer and your mortgage lender strictly adhere to a requirement that at least 50 percent of the units be under contract before you are obligated to go to settlement.

· Try to get the developer to agree that should comparable units in the project be discounted more than 10 percent below your sales price, you would be allowed to either match that lower price or get your money back. This may not be possible, but it is worth asking.

Whether you are considering buying in a new building or in a conversion, after you sign a sales contract, you will receive a lengthy document called a Public Offering Statement. You will have several days in which to unilaterally terminate the purchase contract. The number of days varies depending on the jurisdiction.

The offering statement contains such matters as the legal documents, the proposed budget and any warranties provided by the developer. It also includes the rules that will govern your conduct as a condominium owner.

Read this document very carefully. If you have questions, ask the developer to answer your concerns before your time limit expires. Go to the project over a weekend or early in the evening and try to discuss the building condition with some of the new owners. And have your lawyer and your financial advisers review the legal documents and the proposed budget to determine if they are in order.

Buying a condominium is a serious matter. Buying in a slow market requires even more attention.

Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers may also send questions to him at that address.