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Converting Distressed Real Estate Developments: Legal and Financial Considerations Navigating the Zoning, Covenant, Lender and

Successor Liability Complexitiespresents

Today's panel features:M. Maxine Hicks, Member, Epstein Becker & Green, Atlanta

Mel S. Weinberger, Partner, Holland & Knight, Washington, D.C.David A. Barksdale, Partner, Ballard Spahr Andrews & Ingersoll, Las Vegas

Thursday, September 10, 2009

The conference begins at:1 pm Eastern12 pm Central

11 am Mountain10 am Pacific

The audio portion of this conference will be accessible by telephone only. Please refer to the dial in instructions emailed to registrants to access the audio portion of the conference.

A Live 90-Minute Audio Conference with Interactive Q&A

Converting Distressed Converting Distressed Real Estate Developments:Real Estate Developments:

Legal and Financial ConsiderationsLegal and Financial Considerations

Presented on Thursday, September 10, 2009 at 1:00 EST by:

M. Maxine Hicks, Esq.Chair, National Real Estate Practice

Epstein Becker & Green, P.C.Atlanta, Georgia www.ebglaw.com

1

I. Introduction

II. Trends and Options

III. Legal Considerations

IV. Conclusion

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I. Introduction

The financial crisis has forced developers to analyze projects in a different light to determine the product type and mix that will work in today’s market.

Developers are looking at demographics and considering the total cost of the product to the consumer. As a result we are seeing trends that include smaller homes, less expensive amenities, an emphasis on long‐term cost saving techniques, such as energy efficiency, and green building.

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II. Trends And Options

Trends we are seeing include:

1. Condominiums to Rental

2. Single‐Family to Mixed‐Use Developments

3. Office Space to Hotels

4. Restructuring of Clubs and Amenities to reflect the demands of the current market

5. Residential Condominiums to Assisted Living Facilities

6. Age‐restricted to Non‐Age‐Restricted Communities

7. Affordable Housing

8. Sustainable Development

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II. Trends And Options (Cont’d)

Planned Developments – Unique approach needed because of multiple moving parts and interests of various stakeholders.

Look Before You Leap – Understand your plan before you buy and ensure that you can implement it.

5


Some of the foregoing trends require special considerations. For example:

1. Assisted Living

• Understand the local zoning classification for assisted living facilities, for example, “medical use” rather than “multi‐family.”

• Consider applicable state healthcare regulatory licensing requirements.

• Physical changes may be necessary. For example, do hallways accommodate wheelchairs? Is there space to provide nursing stations?

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2. Age‐Restricted to Non‐Age Restricted

• The Housing for Older Persons Act (“HOPA”) of 1995

• The Fair Housing Act (Title VII of the Civil Rights Act of 1968) and The Fair Housing Amendments Act of 1988

• State laws, local laws and ordinances

• Were any permits conditioned on the project being age‐restricted?

• Consider the impact on the entire community.

For example, earlier this year the New Jersey Legislature passed a bill (A3772/S2577) to allow for age‐restricted developments to be converted to approvals for non‐age‐restricted developments.

Much of the opposition to the bill concerned the influx of school children into the local school systems that would result from the repositioned properties.

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III. Legal Considerations

Key Considerations when Acquiring Distressed Developments

1. General Acquisition Due Diligence

2. Land Sales Compliance Matters

3. Special Considerations for Club Components of Projects

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III. Legal Considerations (Cont’d)

1. General Acquisition Due Diligence. Due diligence in the acquisition of distressed property requires a careful review of the governing documents—the Declarations, Recreational Easement Agreements (“REA”), Cost Sharing Agreements, recorded easements, long‐term leases, etc. Consider:

• Who are all the stakeholders?

• Who may have standing to obstruct proposed changes?

• What rights may be acquired by a successor developer?

• Does the developer have unilateral amendment rights?

9


• What responsibilities and obligations will be inherited? Existing Infrastructure Agreements Telecommunications Provision Agreements Commitments to adjacent property owners or other entities Commitments made to local governments and zoning conditions Commitments to stakeholders—successor liability issues and

fiduciary duties Environmental considerations

• When do the developer’s rights terminate as to: The right to add or withdraw property Control of the owners association Establishment of architectural controls For condominiums, what limits exist on the Developer’s ability to

terminate the condominium? For example, to convert a distressed condominium into rental apartments?

10


2. Land Sales Compliance Matters. Land sales violations by a predecessor developer could affect successor developers.

• Ongoing HUD investigation of complaints by existing buyers could present an issue when repositioning a project.

• Sales contacts assumed by the successor developer may be open to rescission by purchasers.

• Failure to provide a Property Report opens contracts up to a 2 year right of rescission – this right survives closing.

• State land sales considerations or issues may also exist.

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3. Special Considerations for Club Components of Projects. If a distressed project contains a private club, an entirely different and potentially diverse group of stakeholders with different, and often dramatically altered expectations, need to be addressed. Rightsand issues to consider include:

• Equity vs. Non‐equity Club

• Legal right to amend the club membership documents

• Practical ability to amend the club membership documents

• Right to create additional classes of memberships

• Right to conduct promotional events/issue promotional memberships

• Right of club to establish reciprocal use agreements with other clubs

12


Hypothetical project – Lake View.

Lake View is a large second home planned development in excess of a 1,000 acres in the southeast:

• initially anticipated to include a combination of single‐family lots and condominium units;

• roads are partially constructed;

• central water and sewer service has been promised but the lines have not yet been installed;

• measures to prevent stormwater run‐off have lapsed;

• promoted as a highly amenitized property;

• there is a private non‐equity golf club available to the owners at Lake View;

• lakefront lots sold with an agreement that a permit for construction of a dock would be assigned to the lot owner;

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• a master set of covenants has been recorded and one condominium regime established;

• 75 lots out of a proposed 700 lots have been sold, others are under contract;

• no condominium units have been sold and construction has not yetcommenced;

• there is a federal interstate land sales registration covering the lots.

The successor developer of Lake View wants to reposition the property at significantly lower price points for the single‐family lots, no condominium units, scaled‐back amenities, and a club membership requirement for homeowners in Lake View.

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1. Land Use, Zoning, and Other Matters

• Assume that Lake View is in a municipality that does not have extensive zoning requirements.

• Review all permits. – For Lake View any dock permits issued for the community

and/or lakefront lots should be reviewed to determine expiration dates, requirements for renewing the permits, and any conditions on the assignment of the permits from predecessor developer to successor developer.

15


2. Environmental Considerations

• Be careful to avoid becoming strictly liable for on‐going violations from the predecessor developer simply by taking title to the property.

• Stabilize water runoff, detention ponds and other water features on the site.

– The successor developer of Lake View must immediately correct the stormwater runoff issues.

3. Governing Documentation

• Review the Master Declaration for Lake View along with the articles of incorporation and by‐laws of each owners association.

• Review any cost‐sharing and recreational easement agreements.

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• Some key provisions of the Master Declaration relevant to developing a strategy to reposition a project are:

What are the permissible uses of the property?

What is the period in which the successor developer has the right to annex or withdraw property?

What is the period in which the successor developer may unilaterally amend the Declaration and under what circumstances?

• It is important to understand what is required to amend the existing covenants.

Review the Master Declaration to determine which lots are to be counted in a vote of the owners association (e.g., are developer owned lots counted?)

17


In our hypothetical approximately 10% of the lots have been sold and the successor developer has the unilateral right to amend the Master Declaration.

This may not always be the case. If it is necessary to obtain owner consent to amend the covenants, understand the process for doing so, including the requisite owner vote, notices and voting procedures required by the covenants and applicable state law.

• At Lake View, the Master Association has not yet been turned over to the homeowners.

The successor developer will need to appoint new officers and directors to replace the appointees of the successor developer who will resign.

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4. Terminating the Condominium Regime

• The repositioned plan for Lake View does not include a condominium.

• Since construction had not yet started and no units were sold, terminating the condominium will be easier than if units had been sold.

• Terminating a condominium, withdrawing phases and/or amending the Declaration of Condominium requires an understanding of the procedures required under the Declaration of Condominium and applicable state law.

19


5. Amenities and Recreational Facilities

• A distressed project, such as Lake View, that has a private clubraises a number of issues.

• Often the expectations of the club members have been altered over time as the project has evolved.

• Identify the successor developer’s obligations to the current members of the club and the options available for restructuring such obligations.

Did club members pay a refundable membership deposit? If yes, what will trigger a requirement to refund deposits?

What incentives can be offered to current club members to make them more receptive to a changed club program?

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• Establishing a mandatory club component that touches and concerns the land and runs with title requires an understanding of the applicable state law.

• Depending upon applicable state law, the mandatory membership requirement may not apply to previously sold lots.

• Evaluate the ability to amend the club documents and any right to terminate the club.

• For the right project, especially in historically second home areas, there may be a benefit to incorporating a fractional ownership component.

Fractional ownership responds to those consumers looking for highly amenitized vacation property who may not currently be able justify the cost of a second home.

21


6. Consider Existing and Future Owners and Contract Holders

At Lake View 75 lots have been sold, thus the successor developer must consider what promises were made to owners concerning the development, for example:

• timing of infrastructure construction; and

• recreational facilities to be developed.

A. Federal Land Sales Laws

• The offer and sale, within the United States, of property is regulated by the Federal Interstate Land Sales Full Disclosure Act (15 U.S.C. 1701 et seq.) (“ILSFDA” or “ILSA”).

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• Administered by the U.S. Department of Housing and Urban Development (“HUD”).

• If a developer fails to comply with ILSA, a purchaser may have aright to cancel a sales contract

The right to terminate the sales contract survives closing.

• The successor developer of Lake View must determine whether the repositioned Lake View is exempt under ILSA.

If not exempt, a new registration for Lake View must be filed.

23


B. State Land Sales Laws

• Our hypothetical Lake View is not registered pursuant to any state land sales laws. However, many distressed projects will be registered in one or more states so it is important to be aware of this issue.

• Be aware of potentially applicable state land sales laws (i.e., the situs state and target market states).

• Compliance with the registration or exemption requirements of ILSA does not render a project compliant with, or exempt under, any state land sales laws.

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IV. CONCLUSION

Given the financial crisis, there are exceptional buying opportunities for all types of real estate. Distressed properties can be successfully repositioned. Success depends upon a thorough understanding of the current status of the development, and careful evaluation of the legal risks and liabilities related to the distressed asset.

Converting Distressed Converting Distressed Real Estate Developments:Real Estate Developments:

Legal and Financial ConsiderationsLegal and Financial Considerations

Thank you for attending!

M. Maxine Hicks, Esq.Chair, National Real Estate Practice

Epstein Becker & Green, P.C.Atlanta, Georgia www.ebglaw.com

June 17, 2009

Fractional Ownership: A Viable Exit Strategy?Critical Legal Considerations

Mel S. Weinberger

Fractionals have transformed the vacation ownership in-dustry in recent years and are quickly emerging as preferred alternatives to wholly-owned vacation homes for many con-sumers. Typically, fractionals attract consumers who could easily afford a second home but can’t justify the cost and inconvenience of whole ownership when their use of the property is usually limited to several weeks each year. This distinguishes fractionals from one-week timeshare interests that are usually sold as a hedge against rising vacation costs.

For developers confronting the incredibly tight credit market that currently prevails, coupled with decreased discretion-ary spending by the overwhelming majority of consumers, converting a whole ownership property, whether a detached single family home, townhome, hotel suite, or condominium unit, to fractional ownership might provide an effective exit strategy through the creation of a product that is far more affordable than whole ownership. There are many critical legal and practical considerations that generally confront developers and property owners considering the fractional option as a means of maximizing the net present value of their investment returns.

It is almost always less challenging from a legal, financing and design perspective to incorporate a fractional compo-nent into a real estate offering prior to the commencement of sales and, in particular, prior to the recordation of any condominium declaration or other private restrictions. How-ever, sometimes, the adage “better late than never” makes sense.

Legal Considerations

The following key issues, among others, must be satisfac-torily resolved before the economic benefits of a possible fractional conversion can be realized:

1) Zoning Is fractional ownership, which most often represents a specified percentage undivided fee simple interest as tenant in common in a particular property, permitted by the applicable zoning, subdivision, or similar ordinance? If not, how likely is it that the appropriate governmental entity will be willing to amend the ordinance to permit fractional ownership? This is obviously a threshold legal consideration.

2) Private Restrictions Does the applicable condominium declaration and/or master covenants, conditions and restrictions allow fractional interests to be created and sold? For example, in Florida, if the property sought to be fractionalized is part of a condominium regime, unless the condominium declaration as originally recorded contains certain statu-torily mandated language that expressly contemplates the creation of “timeshare” interests, fractional inter-ests, which are almost always considered “timeshare” interests under state law, cannot legally be created and sold without the unanimous approval of all of the whole unit owners. In other states (and in Florida, even if the statutorily mandated language is included in the condo-minium declaration), the issue of whether the developer may unilaterally elect to create and sell fractional inter-ests without any input or vote of the existing whole unit owners may still arise.

Hospitality Industry

Alert

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The provisions of the existing governing documents usually determine the precise underlying legal structure of the fractional regime. Sometimes, such existing docu-ments can simply be amended to add all necessary provi-sions related to the fractional interests, especially if the developer is still in control of the relevant condominium or master association. In other cases, the fractional regime must be “overlaid” on top of the existing whole ownership regime. Both approaches can be equally effective, although the latter scenario is usually more complicated from a documentation perspective.

3) Use of Resort Amenities Will fractional owners be entitled to use and enjoy the resort’s recreational and other facilities and amenities? Usually, such rights are assured via some form of re-corded instrument (declaration, easement, etc.). In other situations, leases containing non-disturbance provisions are employed. It is sometimes necessary to overcome the objections of whole unit owners who are concerned with the possible overuse of the resort’s amenities. The obvious explanation is that regardless of the number of fractions into which a particular property is divided, only one fractional owner (including family members and friends) can be in residence at a time.

4) Cost Allocation How will operating, maintenance and reserve costs be allocated among fractional and whole unit owners? Frac-tional owners typically expect a higher level of services, including, in most cases, daily maid service and concierge and other hotel-like services for which whole unit own-ers should generally not be asked to contribute. Treating all owners fairly from a cost perspective is essential.

5) Use Plan How should the use plan/reservation system be designed in order to fairly and equitably allocate occupancy privi-leges among all of the fractional owners? Will all avail-able time be “floating,” i.e., assigned each year pursuant to some type of reservation system, or will some annual weeks of usage be “fixed”? Purchasers are usually prepared to pay a significant price premium in order to ensure guaranteed occupancy rights during certain times of the year (e.g., Christmas/New Year’s at a ski resort). Many use plans incorporate a hybrid structure that offers a good balance between predictability and flexibility each year.

Will fractional owners be able to make last minute “space-available” or “bonus” reservations? How far in advance will normal reservations be required and when can such reservations be canceled without penalty? Are rentals permitted? Can occupancy be reserved in seven consecutive day increments only or can shorter stays be reserved well in advance? It’s usually a great idea to

maintain some flexibility in the legal documents to allow the developer or project manager to alter the use plan if deemed in the future to be in the collective best interests of the fractional owners.

6) Exchange Program Should the resort be affiliated with one of the reciprocal exchange companies so that owners can elect to vaca-tion at other resorts from time to time? These days, most fractional purchasers desire this option, although there are various costs associated with the privilege, including annual membership and exchange fees payable by the fractional owner and an up-front affiliation fee payable by the developer to the exchange company.

7) Existing Lender; Partial Releases of Liens Will the resort’s blanket mortgagee or other lien holder be willing to grant partial releases of its lien upon the closing of each fractional interest sale? That’s obviously the only way in which the developer can convey free and clear title to the fractional interest upon closing. Lenders that are unfamiliar with the concept of frac-tional ownership of real estate are frequently reluctant, at least initially, to agree to grant such partial releases, especially since upon a default by a mortgagor, the lender can foreclose upon only that mortgagor’s fraction-al interest, not any other fractional interests in the same unit or home. Furthermore, a developer’s existing lender must typically be willing to extend the loan’s maturity to reflect the anticipated longer sell-out period of fractional interests as compared with whole ownership (since more individual sales are needed).

8) Increased Regulation Is the developer prepared to comply with the numer-ous statutes and regulations that govern the marketing and sale of most forms of fractional interests, usually under state timeshare laws? A timeshare registration is required in most states in which offers will be made through any means, including telephone and email, i.e., not only the state in which the resort is located, unless the offering qualifies for a statutory exemption from such registration. Avoiding regulation as timeshare interests is generally desirable but not easy. In some cases, selling fewer than a particular number of fractional interests in a single property does not require registration. However, the availability of this exemption varies considerably from state to state. Can the developer advertise, and are non-binding “presales” of fractional interests legally permitted, prior to registration? How can the Internet be used to market fractional interests without running afoul of state timeshare and other laws? Contrary to popular belief, online marketing is regulated under both federal and state law.

3

In the event that the subject fractional interests do need to be registered under one or more states’ timeshare statutes, the developer will generally need to disseminate to pur-chasers a detailed disclosure document, grant purchasers a rescission period (usually seven to 10 days), include specified provisions in the purchase agreement and other consumer documents, escrow deposits prior to closing and otherwise ensure that purchasers receive all benefits promised to them.

Also to be considered is whether the existing whole unit reg-istration, if any, can merely be amended to permit the sale of fractional interests or whether an entirely new, more costly and time consuming timeshare registration is required. The fractional interests may also need to be registered under the federal Interstate Land Sales Full Disclosure Act, adminis-tered by HUD, unless the project is properly structured and the purchase agreement and other documents are carefully drafted.

Finally, there exist a myriad of other federal, state and local legal requirements, including securities, telemarketing, tax, environmental, real estate licensing and various consumer protection laws, with which any prospective seller of frac-tional interests should become familiar with guidance from an attorney experienced in the fractional area.

Practical Considerations

Beyond the foregoing legal considerations, there are numer-ous threshold practical factors that a prospective seller of fractional interests must consider, including:

1) Location Not every property fits the fractional mold. Is the property in a desirable location from a fractional perspec-tive? Fractional projects are typically most successful in locations that attract repeat visitors and where the cost of whole ownership is prohibitively expensive for most prospective purchasers.

2) Type of Resort Is the property in a regional, primarily “drive-to” resort versus a destination resort, i.e., one to which most visi-tors fly? While fractional sales at both resort types can be tremendously successful, the distinction often greatly impacts the determination of what type of use plan/reser-vation system the developer elects to adopt. Some resorts fall into both categories (e.g., Vail is a regional resort for Denver residents but a destination resort for most oth-ers). Fractional projects have also proven highly success-ful in certain urban locations.

3) Fraction Size and Price What size fractions will be offered and how will they be priced? Typically, smaller fractions, e.g., 1/12ths, are priced more aggressively as compared with whole ownership prices versus larger fractions, e.g., 1/4ths. Larger fractions typically appeal more to purchasers in “drive-to” markets who can travel to the resort relatively cheaply and on a more frequent basis, as compared with purchasers of fractionals in destination resorts, travel to which is more costly and generally requires greater advance planning. Depending upon how much “space-available” or “bonus” time is contemplated, the fraction sizes don’t necessarily correlate to the number of guaran-teed days and nights of annual usage.

4) Marketing and Sales Who will handle the marketing and sales of the frac-tional interests? Fractionals are a very unique form of real estate that can most effectively be sold by those who completely understand the product and can adequately explain it to potential purchasers. Use of a dedicated sales team is usually far more successful than relying pri-marily on third-party brokers who would generally prefer to sell property with higher purchase prices in order to earn larger commissions. Additionally, many third-party brokers don’t fully appreciate the numerous benefits of fractional ownership.

5) Financing Is purchase money financing likely to be available to fractional purchasers? In the past, many individuals financed their fractional purchasers by tapping home equity lines of credit or borrowing against their stock portfolios. The current economic downturn has rendered each of these alternatives infeasible for most consum-ers. This has required many fractional developers to at least consider offering seller financing, not a particularly attractive option since doing so results in significantly less cash being generated upon closing to pay lenders, marketing and sales costs, etc. However, there remain a few specialized lenders that still seem willing to make purchase money loans to highly creditworthy fractional purchasers, with additional such lenders likely to enter the marketplace in the reasonably near future.

6) Management Who will manage the fractional project, including any related rental program? Who will administer the fractional use plan/reservation system? These are critical decisions that often dictate whether a fractional project will be successful.

4

About the Author Mel S. Weinberger is a Partner in the Washington, D.C. office of Holland & Knight. He has focused on the representation of developers and lenders in all aspects of resort development and finance for more than 28 years. Mr. Weinberger counsels clients on a wide range of transactional, compliance, intellectual property and licensing issues regarding resort and recreational real estate as well as virtually all other forms of real estate. He also advises clients on bankruptcy-related issues, loan workouts, and represents banks and other institutional lenders.

About Our Hospitality Practice Holland & Knight’s Global Hospitality, Resort and Timeshare Group represents every segment of the hospitality industry in countries around the globe from our offices in the United States, Mexico, China, Israel, United Arab Emirates and Venezuela. Our lawyers handle acquisition, development, construction, financing, environmental, management and license agreement, condo-minium hotel documentation, golf and club membership, financing and employment matters. Clients served by the group include owners, developers, operators of, and lenders to, hotels, resorts timeshare and fractional properties worldwide. As one of the largest hospitality practices in the United States, our lawyers have in-depth knowledge and experience in this niche industry as well as an understanding of the opportunities and challenges our hospitality industry clients face.

About Holland & Knight Holland & Knight is a global law firm with more than 1,100 lawyers in 17 U.S. offices as well as Abu Dhabi, Beijing and Mexico City. Representative offices are located in Caracas and Tel Aviv. Holland & Knight is among the nation’s largest law firms, provid-ing representation in litigation, business, real estate and governmental law. Interdisciplinary practice groups and industry-based teams provide clients with access to attorneys throughout the firm, regardless of location.

www.hklaw.com888.688.8500Holland & Knight LLPCopyright © 2009 Holland & Knight LLP All Rights Reserved

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different, and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel.

Conclusion

The decision to create and sell fractional interests in real estate requires a developer to carefully weigh the potential benefits to be realized, particularly the likelihood of an ac-celerated sell-out of an otherwise troubled project, against the numerous legal and practical issues involved as high-lighted above. While a conversion to fractionals may not be the right answer for every project adversely affected by pre-vailing economic conditions, the sale of fractional interests is worthy of consideration.

For more information, contact:

Mel S. Weinberger 202.828.5009 | [email protected]

Converting Distressed Real Estate Developments:Legal and Financial Considerations

David [email protected]

The Lender Perspective

Presented on: Thursday, September 10, 2009

2

Lender Considerations

Am I going to get repaid?

How will this affect my security?

3

Existing Financing

• Nature of the loan - Acquisition and development

- Construction

- Permanent

• Nature of the project- Single purpose – lenders prefer

- Mixed use – may require multiple lenders

4

Financing Structure

• Single loan/balance sheet- Loans held (and serviced) by a single lender

- Greater flexibility in restructuring

• Securitized/CMBS- Interests in a single loan or pool of loans held by multiple lenders

- Servicing component separate

- Less flexibility

5

Status of Project

• Early stages- Greater flexibility in reevaluating scope of project and change of use

• Later stages- More likely new financing will be required

6

Relationship Between Borrower and Lender

• Does the lender have trust and confidence in borrower?- This is one of the most important factors a lender will consider in

evaluating whether to restructure

• How has the borrower performed?- Keeping the lender fully informed

- Were difficulties caused by borrower/management issues or change in the market?

7

New Financing

• Underwriting process- Stricter standards

• Value- Very difficult to establish in current market

• Comparable sales – very few transactions

• Income capitalization – difficult to estimate future net operating income

8

Plan for Conversion

• What are the factors driving the change?- Economic – both macro and micro

- Demographic

- Cultural and social shifts

• Strength of new market- How extensive is the borrower’s research?

9

Due Diligence Considerations

• Must show the lender all relevant factors have been thoroughly evaluated

• The factors will depend upon property type and contemplated use- Zoning and entitlements

- Covenants, conditions and restrictions

- Environmental

- Practical• Both physically and economically

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Lender Concerns

• Lien priority- Will additional funds contributed

be subordinate to existing liens?

- Vendee liens

- Tax liens

- Mechanic’s liens

• Environmental liability

• Lender liability

De-stressing the Due Diligence Process:

Issues to Consider When Acquiring Distressed Residential Developments

Written by: M. Maxine Hicks, Linda Ragan Warnke and Jenny A. Lipana

Epstein Becker & Green, P.C.

“Distressed properties” is a term that for some represents opportunity - a chance to

capitalize on bargain prices. A low price, however, is not always the benchmark of a good deal.

Numerous issues beyond just the dirt and the bricks impact whether a distressed property is a

good investment opportunity. If you are considering acquiring a distressed property, proper

attention to adequate due diligence will help you understand the issues and obligations you stand

to inherit and avoid costly hidden surprises.

Due diligence investigation need not be daunting. The focus of this article is to present

issues that you, as a potential successor developer, should consider when purchasing distressed

property within a planned community or condominium project (“Development”). While some of

the issues raised apply to both residential and commercial distressed properties, the primary

focus of the article is to raise issues particular to distressed residential properties.

This overview is broken down into three general categories of investigation and

understanding: (1) the land, (2) the governance, and (3) the owners and contract holders.

Understanding the Land

The acquisition of distressed property should include all of the customary due diligence

applicable to any land acquisition, but must also include consideration of issues that are unique

to the acquisition of a distressed Development, as discussed below.

Title Investigation

When considering the purchase of distressed property, a thorough investigation of the

condition of title is imperative. In addition to the standard search of recorded easements, plats,

surveys, tax assessments, and other encumbrances, pay special attention to any liens, judgments,

UCC Statements, and existing leases on the property as these may have significant implications.

For example, if a predecessor developer pledged membership interest in the developer entity, a

release of the UCC Statement may be necessary before the developer has the necessary authority

to enter into a binding sales contract for the property. Carefully review any leases and determine

whether the lease subordinates to a new owner or lender as well as what obligations and rights

you retain under the lease, such as restrictions on uses within the property, rent increases or

space renovations.

- 2 -

Land Use, Zoning, and Other Matters

Failure to adequately investigate the land use and zoning requirements can result in

unusable property. Ask whether the current use of the property is permitted under the local

zoning ordinance or is a result of a variance granted to the predecessor developer. If a variance

was obtained, be aware of any applicable conditions and confirm that each of your anticipated

uses for the property is permissible. Be aware of permits issued for the property by federal, state

or local authorities, utilities providers and others that have an impact on the Development. When

reviewing permits issued for the Development, pay particular attention to whether such permits

are transferable to a successor developer and whether there are any expiration dates,

requirements for extensions and conditions imposed in the permits.

Review any Planned Use Development Order (“PUD”) issued by the controlling

government authority affecting the property. A PUD may require that infrastructure within the

Development be completed within a certain timeframe. Evaluate the status of construction of the

infrastructure and, if necessary, whether extensions may be obtained for you to meet any

deadlines under the PUD.

Environmental Considerations

The federal, state, and local environmental laws are voluminous in number and complex

in nature. The risk of environmental liability is continual and ongoing and can result in severe

civil and criminal penalties for failure to comply. Proper environmental due diligence is

essential to minimizing your exposure to future environmental liability. Review any

environmental reports, notices of violations, internal reports or memoranda, any pending or

threatened litigation involving the Development, and any other environmental-related documents

pertaining to the Development. Inquire whether the predecessor developer is aware of any

environmental matters relating to or affecting the Development. Examine any existing permits,

licenses, authorizations, approvals, variances, and the like, issued for the Development and the

assignability of such permits. Similar to any land use permits, verify expiration dates and

renewal or extension possibilities for each permit. You do not want to purchase waterfront

property with the expectation of building docks or a marina only to discover that the permit for

doing so has expired and cannot be renewed.

Understanding the Governance Structure

Governing Documentation

Any developer considering the purchase of a distressed Development, be it a mixed-use

community, master planned community or condominium, must understand the operation of the

community governance structure. Review any documentation affecting the Development,

including, for example: (1) the declaration of covenants, conditions and restrictions and/or

declaration of condominium (including any amendments or supplements) (the “Declaration”); (2)

the articles of incorporation and by-laws of each owners association; and (3) any cost-sharing

agreements entered into by the predecessor developer or owners association for the purpose of

sharing of expenses incurred on behalf of the Development or owners within the Development.

- 3 -

Review all documents for compliance with applicable state law governing planned

developments or condominiums. Thoroughly review the governing documents to understand the

rights that may be acquired by a successor developer as well as any responsibilities and financial

obligations. It is especially important to determine whether you will retain or can assume the

development rights and special declarant rights set forth under the governing documents. For

example, review the Declaration to determine key issues such as:

(1) the period in which you, as “declarant” under the Declaration, have the right to: (a)

annex additional property; (b) use portions of the property for sales activities; (c) appoint and

remove directors, officers, and committee members of the owners association; (d) establish or

exercise any architectural controls; and (e) unilaterally amend the Declaration and under what

circumstances;

(2) declarant’s liability for assessments, any exemption from assessments or right to

satisfy assessment and other payment obligations through “in kind” contributions of services or

materials; and

(3) declarant’s right to convey property to the owners association as common area, and to

require the association to accept such conveyance and maintain such property.

Common Areas and Common Elements

Review any master plan, recorded plats, and condominium surveys of the Development

in conjunction with the Declaration. With respect to condominiums, determine how the

boundaries of each unit are defined. In addition, it is important to understand which areas have

been designated as common (or limited common) areas or elements. Assess the status of any

improvements on the common areas. Determine whether the common areas have been subjected

to the Declaration and conveyed to the owners association. If the common areas have been

conveyed to the owners association, obtain and review the conveyance documents.

Amenities and Recreational Facilities

It is also important to know what the predecessor developer previously proposed to

consumers concerning the amenities and recreational facilities (the “Facilities”) within the

Development. This is of particular importance when lots or units have already been sold or you

plan to assume existing sales contracts. Ascertain which Facilities have been promised versus

merely proposed keeping in mind that purchasers may have relied on the promises of the

predecessor developer when purchasing their lot or unit. Assess the construction status of the

Facilities and determine if any of the partially built or unbuilt Facilities should be completed.

Review all contracts related to construction, including architects’ contracts and other

professional contracts, to determine any remaining obligations or rights of the predecessor

developer that you may inherit, including whether you will be required to remedy any defaults of

the predecessor developer. Analyzing the potential liabilities that you may incur with respect to

construction defects is an important consideration.

Determine whether Facilities were intended to be owned by the owners association or as

private facilities to be owned by a club or other third party. If a club is involved, review all of

the club documents, including the membership plan, membership agreement, rules and any other

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club documentation provided to consumers or recorded in the public records. Important issues to consider include, whether membership is optional or mandated by the Declaration, the type of fee structure, and whether the club is an equity or non-equity club.

Association Matters

Essential to the operation of a Development is the owners association. Note that some Developments may have layers of associations, for example, a master association and sub-associations. Review the association’s corporate and financial records and whether control of the association has been transitioned to the owners, either formally or de facto. Obtain and review copies of all association records, including the articles of incorporation, by-laws, corporate minutes, financial and tax records, and management and service contracts.

Determine whether budgets for the association have been properly adopted. Is the association adequately funded? Has an adequate reserve fund been established? Have any required payments been collected at closing? Determine whether the predecessor developer promised any exemptions to the payment of assessments. In addition, determine whether there are any caps on assessments or if the predecessor developer has delayed the commencement of the payment of assessments. A successor developer needs to understand what obligations it may incur under the Declaration and applicable state law to finance any deficit of the association (or an under funded budget) as well as any limitations that may exist on increasing owner assessments.

Architectural Control and Builder Program

Review any architectural control provisions and procedures in the Declaration as well as any guidelines established by the predecessor developer or promulgated by the association and the ability for a successor developer to alter any such controls or procedures.

If the predecessor developer implemented a preferred builder program, any agreements with builders should be reviewed to confirm whether they may be terminated or, if desired, assumed.

Federal Housing Administration (“FHA”), Federal National Mortgage Association (“FNMA”), and U.S. Department of Veterans Affairs (“VA”)

If you want FNMA loans or FHA-insured or VA-guaranteed mortgages available to purchasers within the Development, review the governing documents to determine whether they comply with the applicable agency’s guidelines. In order for purchasers to be able to apply for such loan programs, the Development’s governing documents must comply, or be amended to comply, with the applicable agency’s guidelines.

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Be cautious of any situation where there is risk of incurring significant liability with respect to construction defects and warranty claims. Review all construction-related contracts of any completed or partially completed improvements buildings to determine what rights and obligations you may assume in the event of a construction defect claim and what, if any, recourse exists against any contractors. In addition, obtain and review copies of any warranties issued to the predecessor developer, including, manufacturers’ warranties for appliances to be acquired and warranties for work completed on the property to be acquired. Determine the remaining life of each warranty and whether the warranty may be assigned. Also, review any sales contracts you plan to assume to determine any warranty obligations created by the predecessor developer.

Terminating the Condominium Regime

You may plan to terminate a condominium regime within a Development, for instance to convert a distressed condominium into rental apartment buildings. Terminating a condominium requires an understanding of the procedures required by the governing documents and state law. Before terminating a condominium, you must also evaluate the rights of any existing unit owners and contract holders.

Considering Existing and Future Owners and Contract Holders

Contract Holders

If there are sales contracts that have not closed, assess whether such existing contracts will, in fact, proceed to closing. In those Developments where there is a high percentage of speculative buyers (e.g. condominiums), there is a significant likelihood that contract holders may default on their closings and pursue legal action to recapture any earnest money deposits.

Land Sales Laws

If a successor developer will assume sales contracts entered into by the predecessor developer, it is especially important to understand the federal and state land sales laws applicable to the Development and to each contract to be assumed. Noncompliance may result in rescissions and claims of damages.

Federal Land Sales Laws

The offer and sale, within the United States, of property is regulated by the Federal Interstate Land Sales Full Disclosure Act (15 U.S.C. §1701, et seq.) (“ILSFDA”), administered by the U.S. Department of Housing and Urban Development (“HUD”). Under ILSFDA, unless an exemption is met, property must be registered with HUD. This is particularly important to a successor developer that assumes contracts from a predecessor developer because failure by the predecessor to comply with ILSFDA may open the assumed contracts to rescission by the purchasers. The Development acquisition agreement should include representations and warranties that the predecessor complied with ILSFDA and other applicable laws. The predecessor developer should also indemnify the successor developer against claims related to the Development concerning alleged ILSFDA violations by the predecessor developer.

Warranty Liabilities and Obligations

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If the Development is registered under ILSFDA, review all documents filed with HUD to

confirm the registration requirements were fulfilled. Determine whether each purchaser received

a complete effective Property Report prior to signing a sales contract. If a Development is not

exempt from registration under ILSFDA and an effective Property Report is not provided to the

purchaser prior to signing the sales contract, the purchaser is entitled to cancel the contract for

two years after he or she signed the contract. This cancellation right survives closing. The

acquisition agreement for the Development should be clear that if any contract that the

predecessor closed is later cancelled as a result of the predecessor’s failure to comply with

ILSFDA, the liability for such rescinded contract remains with the predecessor developer.

If a Development is not registered with HUD, determine if an exemption under ILSFDA

was satisfied. This analysis is crucial to measuring the risk that past sales may be rescinded. For

example, if more than 99 lots were marketed pursuant to a common promotional plan1 and sold

in reliance upon the 100 Lot Exemption2, all of the sales that relied on the 100 Lot Exemption

may be open to rescission. Another commonly used ILSFDA exemption is the Improved Lot

Exemption3, which is available for lots or units sold pursuant to a contract that obligates the

seller to complete a home or unit within two years of the date that the purchaser signed the sales

contract. A contract under the Improved Lot Exemption may permit a delay in the seller’s two

year build period only under extremely narrow circumstances, otherwise the exemption is lost.

Contracts that relied upon the Improved Lot Exemption should be reviewed closely as there has

been significant recent litigation over specific contract provisions under this exemption.

State Land Sales Laws

Whether the predecessor developer complied with applicable state land sales laws should

also be considered. Review sales contracts to determine if any purchaser’s state of residence is a

state that requires registration of a development prior to marketing it within the state (a “Closed

State”). Review contracts with Closed State purchasers for compliance with the Closed State’s

land sales laws. If the Development was not registered in applicable Closed States, determine

whether the transactions qualified for an exemption or were otherwise conducted in a manner

that did not trigger the jurisdiction of the Closed State. Understanding the marketing activities of

the predecessor and the status of any Closed State registrations is important to measuring the

potential risk that prior sales may be open to rescission under applicable state laws.

If the Development is registered under ILSFDA or any state land sales laws, consider

requiring, as a part of the acquisition closing, that the predecessor developer terminate such land

1 “Common promotional plan” means a plan, undertaken by a single developer or a group of developers acting in

concert, to offer lots for sale or lease; where such land is offered for sale by such a developer or group of developers

acting in concert, and such land is contiguous or is known, designated, or advertised as a common unit or by a

common name, such land shall be presumed, without regard to the number of lots covered by each individual

offering, as being offered for sale or lease as part of a common promotional plan. 15 U.S.C. §1701(4).

2 15 U.S.C. §1702(b)(1) provides an exemption from registration under ILSFDA for the sale of lots (or units) in a

subdivision containing less than 100 lots that are not exempt under 15 U.S.C. §1702(a). The 100 Lot Exemption

provides an exemption from registration with HUD but not from compliance with certain disclosure and contract

requirements.

3 15 U.S.C. §1702(a)(2) provides an exemption from registration under ILSFDA for the sale of land that is

improved with a residential building or sold pursuant to a contract obligating the seller to complete such a building

on the land within two years of the purchaser signing the sales contract. Commonly used with condominiums.

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sales registrations. This may help reduce confusion with the state agencies when the successor

developer files registrations for the Development.

Prior Representations

It is important to understand the scope of the predecessor developer’s promises and

representations made to contract holders and lot or unit owners, which representations were

obligations and which were proposed plans. Review any Property Report, contracts to be

assumed, and promotional material produced by the predecessor, such as pamphlets, plans,

websites, broadcast scripts, and mailers. Understanding the predecessor’s marketing strategy

will help you understand expectations of contract holders and owners within the Development

and weigh the consequences of making changes. An analysis of the representations made by the

predecessor developer is essential to determining whether planned changes to development plans

or the governing documents may open sales contracts to rescission by the contract holder.

Conclusion

The above is an overview of many of the due diligence issues to be considered by

successor developers when acquiring a distressed Development. While this list is not exhaustive

of the matters of concern to successor developers, it provides a starting point by which to review

potential Development opportunities and to avoid unintended consequences.

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