Life's Not Fair--More About Purchasing From a Sponsor
April 12, 2010
The Financial Shake Out
When I first wrote about this topic a number of years ago, the landscape of a purchase from a sponsor was remarkably different. Brand new apartments, with high end features, were coveted by potential buyers and folks literally lined up to sign purchase agreements. Sponsors were unwilling to negotiate the terms of the purchase agreement and many sales were made on a “take it or leave it” basis. Well, things have changed. Yes, there are still many situations where high end developers will not materially change the terms of the offer as stated in the Offering Plan (the document by which sponsors offer apartments for sale). On the other hand, there are many, many developers out there who are sitting with an enormous amount of inventory and they are ready to make deals. A year or two from now, things may change, but for the moment, it is still a strong buyer’s market. There are a number of factors to consider when purchasing an apartment from a sponsor.
Start with the Offering Plan
The sponsor's disclosure document is long, complicated and usually not easy to understand. The purchaser's attorney, at least in theory, will review the document and report back on issues that the purchaser should contemplate before making a decision on whether or not to go forward. Most purchasers do not actually review the Offering Plan, but rely on their attorneys to explain the relevant issues disclosed in the Plan. Nevertheless, there are several sections of the Plan, at a minimum, that a purchaser should review:
"Special Risks" At the beginning of each Offering Plan, there is a section entitled Special Risks, in which the sponsor discloses all of the material aspects of the Plan and possible risks to ownership. These disclosures are discussed in greater detail within the body of the Offering Plan, but the Special Risks section will disclose the most important issues that the purchaser should consider. It is essential that the purchaser review these disclosures and understand how this information might affect ownership of an apartment and the future of the development.
"Description of Property" Attached to the Offering Plan as an exhibit, is a document that describes the technical aspects of the construction of the building in great detail. If possible, a purchaser should have the property description reviewed by an engineer or architect to insure that there are no design or construction issues that might be a cause for concern.
"Rights and Obligations" Each Plan has a section describing the rights and obligations of the sponsor, the unit owner, the condominium and the Board of Managers of the condominium. These provisions give the potential owner of a unit a better sense of what to expect from the sponsor when it comes to completion of the amenities, the obtaining of a permanent certificate of occupancy and liability for construction defects. Again, it is essential that a purchaser understands the rights and obligations of each party, so that there are no surprises down the road.
No one expects a purchaser to plow through every page of an Offering Plan. That being said, taking the time to at least review the sections referred to above, will provide the purchaser with a wealth of information.
Be Alert to Hidden Costs
One fact of life that will become immediately apparent is that sponsors like to pass along costs. From the sponsor's perspective, since the sponsor has just laid out many millions of dollars for construction, once units start getting sold, recouping costs is of major interest. Ordinarily, the seller pays the New York City and New York State transfers taxes in connection with the sale of an apartment. For New York City, this tax amounts to 1 percent of the purchase price for apartments under $500,000 and 1.425% for apartments priced at $500,000 or more. The New York State transfer tax is .004 percent of the purchase price (which equals $4 per $1,000 of purchase price). In sponsor sales, the sponsor attempts to pass those costs along to the purchaser. If you were buying an apartment for $1,000,000, that would add approximately $18,000 onto the purchase price. It's actually a greater cost, because when you sell your apartment, those transfer taxes won't be paid by the purchaser. In addition, you will also be paying the sponsor's legal fees for closing on the purchase of the unit which can add up to another $1,500 or more, when high-end law firms are handling the closings. In the old days, the sponsor would not even consider picking up these costs, and the burden of the transfer taxes and sponsor’s attorneys fee were foisted on the buyer. In many cases, these costs are now items for negotiation. With sponsors holding so much inventory, a deal won’t be lost because a buyer does not want to pay the transfer taxes. You may not always get the sponsor to go along, but under current financial conditions, it would be foolish not to ask.
The All Cash Contract
It may be too extreme to say the “all cash” contract has gone the way of the “Edsel” or maybe I should say “Pontiac” these days, but in many cases, a buyer can negotiate, and should negotiate a mortgage contingency into the purchase agreement. Earlier in the decade, sponsors would insist that a contract not be subject to financing. In other words, if a buyer needed financing, whether or not a buyer could obtain a loan was the buyer’s problem. Today, with banks cranky and unwilling to lend like they used to, there are a number of new developments that will not qualify for financing because too few units have been sold. Accordingly, it is essential that a buyer insist on a mortgage contingency and a funding contingency, to insure that the financial problems of the sponsor are not transferred to the buyer. Again and again, parties to real estate transactions learn:
“If You Don’t Ask, You Don’t Get”
For more about mortgage and funding contingencies, see "The New Normal".
In new construction condo offerings, the sponsor is not required to maintain a "Reserve Fund" for future capital repairs and replacements. Nevertheless, Offering Plans usually provide for one or two month's common charges to create a "Working Capital Fund". Since you're dealing with new construction, significant repairs should not be necessary, but in many cases, construction issues do arise soon after the building is occupied. When repairs are required, unless the sponsor funds the repairs (which does not always happen), the units owners can be faced with significant increases in common charges or special assessments. Until a condominium has an operating history of at least three years, there is no way to predict whether the construction is sound or whether the unit owners will discover shoddy workmanship either in common areas, apartments or both.
Adjustment for Real Estate Taxes
When you purchase a condo, you will be purchasing a separate unit which will be separately assessed for real estate tax purposes by New York City. When a condo is first completed, sometimes the apartments have not been separately assessed. As a result, the sponsor will make an allocation of taxes based upon (i) the current tax bill for the entire building and (ii) your pro rata share of ownership interest in what is known as the common elements of the condo. Hopefully, your unit will be separately assessed by the time of your closing, so that the taxes allocated to your unit will be known with certainty. Unfortunately, there is no assurance that such allocation will be completed prior to closing. In addition, if the sponsor is applying for a real estate tax abatement (which can last for many years), that abatement may not be in effect at the time of your closing and you will be obligated to close on the higher unabated tax. Very often, the sponsor’s estimate of the taxes is lower than the actual assessment of taxes imposed by New York City. Sponsor’s now go to great lengths in the Offering Plan to disclaim any liability if their estimates are incorrect. It can be a significant financial shock when the numbers you have been relying on, are just plain wrong.
The Elusive Closing Date
One of the most anxiety provoking aspects to buying in a new condo, is that you will be agreeing to purchase an apartment which will be completed some time in the future. Exactly when the sponsor will be ready to close will depend greatly upon whom you ask. The sales department of a developer is there for one thing and one thing only--to get the units sold so the sponsor can close units and get rid of its construction debt. It's not exactly like the sales office in "Glengarry Glen Ross", but let's just say that there is a lot of pressure to get the units sold. As a result, you will most likely be given the most optimistic dates possible for when you will be closing and moving into your new home. Invariably, these projects take longer to complete than expected, so be prepared for delays. Many buyers who signed contracts over a year ago and were counting on easy credit, are now finding that banks lending to new developments are few and far between. Many buyers are trying to find their way out of deals and some are even walking away from deposits. In my view, an open ended purchase agreement that does not place any hard time limitation on the sponsor to complete the project and close on the sale of a particular unit, is a mistake. Buyers should insist on a contractual obligation to complete the closing by a specific date. Without that commitment, the buyer can wait around for a very, very long time.
The “Out Clause”
In most sponsor sales involving a building to be built, the Offering Plan will provide that the construction has to be completed within twelve months from the date the sponsor anticipates that the construction will be completed. This watered down obligation is just not sufficient to protect the buyer. To enforce the sponsor’s obligations, a sponsor will reluctantly give the buyer an "out date" by which the buyer can cancel the contract and get his or her money back. In other words, the contract would provide that if the closing didn't take place by a certain date (usually many months after the expected date of closing), the purchaser could cancel the contract and get out of the deal. In almost all cases (with the exception of situations where the construction is about to be completed, or is completed), the purchaser's attorney should request an out date. If the sponsor runs into financial problems and can't complete the construction, an out date is your best shot at a peaceful termination of your relationship. Don't bet the ranch on a precise closing date. Hedge your bets with an “out clause” that requires the sponsor to close on your unit within a reasonable time after your sign your purchase agreement.
The "Punch List"
The Offering Plan will always address what constitutes completion of the apartment. Invariably, the Offering Plan will provide that the apartment will be deemed completed if the only things remaining are minor (like wall dinks and paint marks). These items will be noted on an "inspection sheet" when the purchaser does his or her walk through and will theoretically be completed within a reasonable period of time after closing. The speed with which the sponsor fulfills its "punch list" obligations post-closing can depend on many factors. If there was ever a time when the squeaky wheel concept came into play it would be with the completion of punch list items. Stay on top of the construction people who are handling the post-closing items. Feed them, clothe them, promise them vacations. Do whatever you can to get the work done as soon as possible. Most developers lose interest in a project once it's completed, so tenacity about getting the punch list promptly handled will serve you well. The sponsor contract will specifically provide that no escrows or abatements will be taken for punch list items so there is no way to reduce the price or delay the closing to get the items handled. Expect to see painters, plumbers and tile guys floating around your building for many months after closing. Many sponsors got a “pass” in the old days and had watered down punch list provisions that gave the sponsor significant control of what constituted a punch list item and what became a frustration for the buyer. Although sponsors are still unwilling to go beyond the Offering Plan in terms of how a punch list will be handled after closing, buyers should ask for everything and get as much as they can.
It's Not Exactly Win Win
Historically, sponsor deals have been unbearably one-sided. Because construction costs in New York can be extraordinarily high, sponsors couldn’t afford to have any margin for error in getting their deals completed. That profile has changed dramatically and buyers are finally getting the negotiating power and respect they deserve. In many cases today, negotiating hard and not settling for unreasonable terms, will pay off for the buyer of new construction condos.
Residential Reality--Do Your Homework
You really have to do your homework when buying from a sponsor. Who are these guys? Who are their architects and builders? Who is handling sales for the sponsor? Do any of these people have a track record? Do you feel comfortable with the way you've been ushered through the sales process? There will be great time pressure on you to get your check and contracts back to the sales office. Sometimes that pressure is real because other parties may want your unit and sometimes it's just the sales people blowing smoke. You can never really be sure. Nevertheless, do what you can to educate yourself about every aspect of the project so that you can keep the post-closing surprises to a minimum. There is a carpentry expression that works well went it comes to signing the purchase agreement and tendering your down payment: Measure twice and cut once.