Canada: Common Ground: Retail & Commercial Condominium Financing

The condo real estate market, both retail and commercial, is hot. But condo developers and unit buyers need funding. Here's the legal foundation of condos and the special risks – and risk mitigation steps – for condo lenders.

CONDO FOUNDATION

According to CMHC in 2013, between 1981and 2011, owner-occupied condos increased from 171,000 to 1.154M plus 461,000 rented condos, a growth rate nine times faster than owner-occupied homes and quadrupling its share of the home-ownership market. Condos are particularly popular with seniors and young adults:

• 19% of condo owners are under 35 (11% of homes).
• 29% are 65 or older (23% of homes).
• 42% of condo owners live alone.
• 28% are couples without children.

Here's what condos are, how they're created and governed, the basics of condo corporations and condo unit ownership and common expense funds.

Defined. Condominiums are a type of ownership – not a type of building: they can be any type of housing (units in buildings, townhouses, even detached houses within a development) or use (commercial, residential or mixed), in phased developments and can even be "bare land". Condo ownership has two main characteristics: title to a defined area, known as a unit, within a specific parcel of land; together with a common interest in shared areas of the land and/or buildings with all other unit holders. People typically buy condos because expenses are shared, the cost is lower than fee simple ownership and maintenance and repairs are more efficient.

Condo Creation. Each province has its own condo legislation and specific approval processes. The legislation has been updated in recent years in some provinces to better protect consumers and to bring some consistent to the laws (though this wasn't achieved so much in PEI). In a nutshell, the process is for the developer (called the "declarant") to begin the process and design of its intended condo on lands it owns; prepare the paperwork required by legislation; and prepare its declaration and description:

• Declaration. The declaration is the "how" of the condo development. A legal document that creates the condo units to be bought and sold under provincial law, it is the condo corporation's "constitution" or charter document. The declaration is the first – and the last – reference point for how the condo operates: it details the ownership rights of unit owners, transfers land from the declarant and sets out how condo governance will occur. Lenders, however, should particularly note that the consent of registered encumbrancers to the creation of the condo development is required – but once land is transferred to the condo corporation, mortgagees can't enforce against the land – so prudent lenders will seek and rely upon legal advice before giving consent.
• Description. The description is the "what" – so there are no surprises for anyone. It includes the plan of survey, construction plans and details of the unit boundaries.

Condo Governance. Upon final approvals, the condo corporation comes into being. When the condo is created, the Declarant appoints a temporary Board of Directors of the condo corporation; as units are sold, unit owners are elected to form a permanent Board. The directors act on behalf of the condo corporation, which can make by-laws governing the condo corporation and rules governing use of common elements.

Condo Corporations. A condominium corporation is essentially a management company owned by all condo unit owners collectively. It is a legal entity created pursuant to the relevant provincial Condominium Act. The declaration is its charter, and its role is to manage the condo's property and business affairs. Both members] (the condo unit owners) and mortgagees have voting rights on matters relating to condo governance.

Unit Ownership. An owner owns a "unit" and a specified percentage interest in the common elements as set out in the declaration; the precise allocation depends on the condo structure and declaration. Areas designated as "common" in one condo corporation might belong to a unit in another, but common areas generally include halls, elevators, pools, land, exterior walls, windows, outside doors, and so one. However, owners may have an exclusive right for some common property (such as balconies, parking spots, storage and driveways).

Common Expense Funds. The condo corporation is required to have a reserve fund for major repairs and replacement. Unit owners pay condo fees for regular maintenance of common areas and for expenses such as snow removal, and contribute to the reserve fund, in the proportion the declaration specifies. Unit owners cover shortfalls by way of "special assessment", and prudent lenders will inquire about the nature of reserves, and some provinces/territories require reserve fund studies. Insurance is one such common expense. Legislation requires condo corporations to carry insurance to their replacement value of the common elements and units, and provides that the condo corporation has an insurable interest even though it doesn't own the property. It's up to the unit owner to insure any improvements made to the "standard" unit. Like any other mortgage, lenders should confirm that appropriate insurance is in place.

FINANCING A CONDO DEVELOPMENT

Financing a condo development is similar to financing a subdivision. The lender starts with a mortgage on the freehold land to be developed. If no condo is declared, the mortgage is unaffected and the transaction can proceed as normal. The lender is paid by the developer through the sale of units, and the charge lies upon the units, not the land, once the condo is declared.

LENDING TO THE CONDO CORPORATION

The risk in lending to the condo corporation is that there's no hard security: the condo corporation owns no land and can grant no mortgage. And it's unlikely that the condo corporation has the right to assign its lien rights to the lender, just as a municipality can't assign to its lender the right to levy taxes, so the loan transaction proceeds based on a covenant to pay. As a result, care and due diligence are key for the lender. In particular:

• Legal opinions will be necessary.
• Authorization to borrow must be clear in the declaration and by-laws.
• The lender must ensure that the loan documents don't contravene the provincial
• Use of the funds should be carefully directed / sequestered to the intended use and notice/voting requirements must be met.

In terms of payment and default, the condo corporation can levy special assessments to pay the loan (provided it follows all necessary procedures). On default, the lender can sue and obtain judgment; by legislation, a judgment against the condo corporation is a judgment against all unit owners in proportion.

FINANCING A CONDO UNIT

Condo mortgage financing isn't radically different from fee simple mortgage financing. The main types are office space and retail (e.g., shopping complexes and hotels). However, it does require the lender to take some due diligence steps and obtain security documentation in addition those it would take or obtain in the case of a standard mortgage.

Additional Due Diligence & Security Documentation. The lender should undertake the following due diligence in addition to those it would take for a standard mortgage due diligence: determine ownership percentage; review the condo declaration, rules & by-laws; review the relationship between the condo's common elements & the condo unit; confirm insurance of the condo development, not just the contents; obtain any assessment reports respecting potential repairs & maintenance and the longevity of capital items; and Estoppel Certificates. In addition to standard loan documents, the lender should obtain Estoppel Certificates, an assignment of material agreements, consents and non-disturbance and an assignment of insurance.

Estoppel Certificate. Issued by condo corporation or its management company, an Estoppel Certificate outlines common expenses, arrears, voting rights, reserve fund balance, planned expenditures, debt, status of insurance and other matters. It is in the nature of a warranty and representation binding on the condo corporation and assists lender's assessment of financial condition and health of condo development. The condo corporation has a lien on each unit to recover outstanding fees, special assessments, arrears and so on, payable by the unit owner to the condo corporation pursuant to the declaration of the condo by-laws; the condo corporation can enforce this lien in the same manner as a mortgage, including the power of sale; the lien is even a "super" priority in some provinces.

Security Documentation. A condo mortgage should also include special covenants to: assign voting rights; assign insurance; observe and perform the condo declaration, rules and the by-laws; pay any contributions levied by the condo corporation; pay the common expenses; and forward to the lender any notices, assessments, by-laws, rules and financial statements of the condo corporation.

MANAGING LENDER RISK

The three hallmarks of managing lender risk in the context of condos are early and ongoing:

• Engagement with the developer.
• Due diligence/ information review
• Legal advice.

It's key to remember that condos are creatures of statute, so there are numerous legislative requirements for each of the developer, the condo corporation and owner. Understanding those obligations as well as the rights and obligations of unit owner / borrower to shared and essential services necessary for the use and enjoyment of the unit is key to managing the risks. Here are five specific risk management tips for lenders: 

• "Go behind" the budgets presented.
• Look for pre-sales of units at the development stage.
• Paay close attention to reserve fund studies and projections.
• Understand your market and demographics.
• Communication, communication...communication.

Lenders financing commercial condos have some special considerations to take into account to mitigate their risks.

ENFORCEMENT AGAINST CONDOS

The legal process to enforce a mortgage against a condo is generally equivalent to enforcing a conventional mortgage, with a few adjustments. The mortgagee acquires voting rights in the condo corporation when in possession; mortgagees in possession should ensure that condo fees and special assessments are paid lest the condo corporation lien kicks-in. The mortgagee in possession must give notice to the condo corporation to exercise the voting rights it's acquired, and notice to third parties to non-disturbance agreements.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.