Developing strategies for distressed condominium projects.

The business of rehabilitating distressed condominium assets has changed dramatically this past year.

In the "good old days," projects were failing financially because they were encumbered by liens, complex legal issues, construction defects (or unfinished construction), poor design, bad marketing, or a combination of several factors pertaining to the initial developer's inability to execute.

All too often, the developer's lack of probity added combustible fuel to the financial conflagration facing distressed projects.

I dealt with a project in Boston where the developer literally ran off with the insurance money from a tire (that some suspected he set himself) and another developer in Chicago who denuded nearly $4 million in earnest money from the escrow account holding buyers' deposits.

Today, we have more residential developers who are new to the business. Execution issues still abound, more so today because of the inexperience of many developers.

And because developers are human, many promoters still exhibit moral lapses.

However, what is truly different today is that in many areas of the country fixing execution, legal or physical problems or repositioning an asset alone cannot create a market for a development when it is the market itself that is in distress.

In order to assess and solve problems in failing developments, every issue must be addressed seamlessly. In a good market, you can off-times get away with mistakes. In a post bubble market, these mistakes take on a steroid quality and grow unhealthily--and can harm and even kill the best intended plans.

This change in market dynamics makes us pause now, even before we try to determine how to best restructure or reposition a distressed condominium development. Instead, we first need to determine whether the condominium process should proceed at all. Apartment rents are rising due to a variety of factors, but they are not yet high enough in some markets to justify new construction. Potential home or condominium buyers, no longer able to secure easy credit, are renting longer. So supply will keep tightening. Meanwhile, debt is aggressively pursing apartment product, as is mezzanine and institutional equity. All this has led to improved apartment performance coupled with cap rate compression, the recent hiccup in the CMBS markets notwithstanding.

Consequently, a careful analysis needs to be undertaken as to whether leasing is a better alternative to the continuation of the condominium process. The decision is easier in a condominium that has yet to start its closings. It is a far harder decision when some units have already closed. A project that has started closing units is "fractured" until sold units can be repurchased or the condominium marketing is restarted.

It is the fractured deals that require considerable thought and pose the greatest risk, and some argue the best opportunity for "reward."

A developer who is looking at a fractured deal needs to study three things: What is the value of the property as a fee simple apartment? Can the remaining units be rented and the deal cash flow as a fractured condominium?

In doing so, should a developer accept the legal risk of managing this cash flow when time constraints on developer control imposed by the condominium documents may cause management issues and fiduciary liability in the future? All these questions must be weighted against the cost and difficulty to re-image a property in order to successfully conclude the sellout of the property as a condominium, as well as the costs and practical difficulties in buying back previously sold homes.

The strategy that one chooses to employ on a fractured development requires a different mindset, and implementing a plan to reinstate the property as fee simple, or managing the deal as a fractured condominium is complex and fraught with practical and legal difficulties.

Continuing with a condominium sales regime also needs more thought, finesse and excellent execution in a slowing marketplace.

David Tufts, one of the best condominium marketing experts I know, has said that if a new marketing campaign is undertaken in this environment, it is incumbent for a developer to "fake it till he makes it."

Projecting a positive outlook in this market is a priority, and it is more difficult to do with a cynical public and media searching for bad news.

No matter what strategy the developer employs to continue with a sellout of a fractured condominium it is clear that the days of the developer as a "gatherer" of sales is over. In this market, only a "hunter" will survive. Unfortunately, so many developers and their sales staff have never sold in a "hunter" marketplace.

The problem of dealing with fractured condominiums will take on added dimension as their numbers grow and markets soften.

Clearly, taking on the challenge is not for the faint of heart. Yet, a developer who masters the fractured condominium will have ample opportunities as this marketplace disgorges distressed condominiums in greater numbers.

BY NORMAN RADOW, PRESIDENT

RADCO DEVELOPMENT SOLUTIONS