FEATURE ARTICLE, SEPTEMBER 2007

UNDERSTANDING CONDO LAW
High-rise, mixed-use and other condominium developments mean opportunities for Texas lenders.
Lorin Williams Combs

Historically, the construction of high-rise and mixed-use condominiums in Texas has been financed by out-of-state lending institutions as early condominium developers encountered skepticism and resistance from Texas banks. The result is that, in Texas today, the majority of such developments are financed by out-of-state lenders. Financing high-rise or mixed-use condominiums is a challenge that should be met with anticipation, not trepidation, especially if lenders understand the nuances of condominium law.

Lien Priority

It is customary that the lien of a deed of trust is subordinated to the condominium declaration, and consequently the assessment lien, in favor of the condominium association in order to preserve the condominium regime if the lender’s lien is foreclosed. The Texas Uniform Condominium Act (the Act) protects construction lenders by providing that an association’s assessment lien does not have priority over a first lien deed of trust that is recorded prior to the date on which an assessment that the association seeks to enforce becomes delinquent. Therefore, as long as the deed of trust is recorded before the developer has conveyed any units, the lender will be protected because the association will not yet have levied any assessments. 

Casualty Proceeds

Many construction lenders are unaware that the Act dictates the use of casualty proceeds if the project has a residential component. The Act states that all claims for property loss on common elements must be submitted by, and adjusted with, the association and that these proceeds must be payable to an insurance trustee or the association but not to any lienholder. Once the insurance trustee receives the insurance proceeds, the proceeds must be disbursed for repair or restoration of the common elements unless the condominium is terminated, repair is illegal under a health or safety code, or at least 80 percent of the units owners agree not to rebuild. A lienholder is not entitled to receive any insurance proceeds unless there is a surplus.

Special Declarant Rights

The Act gives developers the flexibility necessary to complete development of the project — even after units are sold — by permitting the developer to reserve certain rights, such as the ability to add, subdivide or combine units; convert units to common elements and vice versa; and control the board of directors of the association. Lenders can protect their interest in the collateral by prohibiting the developer from exercising any of these rights without the lender’s consent.

If a lender forecloses its lien, it can succeed to the reserved special declarant rights, although the lender also will assume all of the developer’s liabilities and obligations under the Act. To avoid potential liability, a lender can elect to assume only a portion of the special declarant rights or can preserve these rights for transfer to a third party, in which case the lender will only be liable as a fiduciary for the unit owners — provided it does not exercise any special declarant rights.

Qualified Contracts/Pre-Sales Requirements

Lenders might consider establishing a pre-sales requirement that conditions the closing of construction financing upon the execution of a specified percentage of qualified contracts. What constitutes a qualified contract varies by project and by lender, but requirements can include a minimum sales price and non-refundable minimum earnest money deposit. The ability of the developer to meet the lender’s pre-sales requirement should be a gauge as to the future viability of the project. Its failure to produce the requisite number of contracts within the feasibility period could indicate that the project will not perform strongly in the market.

Representations, Warranties, Covenants and Legal Opinions

Each construction loan on a condominium should contain representations and warranties made by the developer regarding the formation and authority of the association and the enforceability of the contracts. Depending on the particular condominium, the lender should require representations regarding registration or exemption from the Interstate Land Sales Full Disclosure Act (ILSFDA) and compliance with the Fair Housing Act. A condominium lender should also consider requiring an opinion letter, which provides at a minimum that the condominium documents are in compliance with the Act and that the project is registered with or except from the ILSFDA.

A lender cannot fully appreciate all the unique legal and practical issues involved in underwriting loans for condominium development based on this article alone, but a basic understanding of several key issues — together with representation by skilled legal counsel — will enable Texas lenders to take advantage of the opportunity to finance high-profile condominium projects in Texas.

Lorin Williams Combs is an associate in the Dallas office of Winstead PC.


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