Issues in Receiverships of Residential Real Estate Development Projects
May 1, 2008
The failure of a residential real estate project is frequently a combination of increasing interest rates, declining sale prices, slow sales, and cost overruns. This combination of factors often leads to an insolvent project, leaving the developer with little incentive to make additional capital contributions. Lenders may have lost confidence in the developer’s ability to complete the project, leading to the refusal to fund draw requests. The withholding of funding has a snowball effect, causing the recording of mechanics’ liens against the project, an unhappy municipality, dissatisfied owners of completed units, a frustrated homeowners’ association, and a myriad of other problems. Many distressed development projects end up in receivership pending the lender’s foreclosure on the project. If the parties anticipate the issues that are likely to arise in a development-related receivership proceeding, the parties can craft the order appointing the receiver to give the receiver the powers necessary to address these issues cost-effectively. This article highlights some of the key issues a receiver, the project lender, and the developer may anticipate in a receivership proceeding.
Project Completion If construction is halted in mid-stream, the receiver may need to complete unfinished units, or at a minimum winterize the project against the elements. The lender should be prepared to fund amounts necessary to secure the condition of its collateral. The receiver will typically engage a construction or inspection company to tour the project and identify any apparent defects in existing construction and necessary completion items. Such an inspection may reveal defects in construction, or inconsistencies between the on-site construction and the original project plans. The receiver will typically wish to engage a construction company or developer to serve as general contractor for the completion items, yet the general contractor will be wary of issuing any warranty in connection with the completion of the project – and may seek indemnification from the project lender on account of any construction defect claims. Development agreements between the receiver and supervising governmental entities may be necessary. Mechanics’ liens must be resolved. Project insurance should be secured.
Warranties and Emergency Repairs Frequently, the distressed developer will have issued its own warranty to unit purchasers, and will have served as the point of contact for any emergency repairs. The developer’s warranty will become essentially worthless upon the appointment of the receiver. Thus, the receiver should be prepared to address warranty demands from unit owners, and calls for emergency repairs affecting both sold and unsold units. The receiver’s most logical course of action is to purchase warranties for finished units from a third-party warranty company. The project lender may see little benefit in funding the purchase of warranties for units already sold as of the appointment of the receiver. Yet the receiver may determine that keeping existing owners happy will be key to the marketing of the remaining units and undeveloped lots and ultimately in the best interests of the receivership estate.
Unit Sales The lender may contemplate that the receiver will dispose of as many completed units as possible, as quickly as possible, pending completion of the foreclosure. The lender may also ask that the receiver attempt to find a purchaser for the remaining building pads. The parties should realize the practical limitations of retail marketing of completed units, or wholesale marketing of building sites, in a project in receivership. It is unlikely that the receiver will be able to maximize the value of those assets during the receivership proceeding. The most expeditious marketing may be to investor-owners who plan to rent the units, but lenders may be loathe to approve unit sales that may undercut the value of the remaining project, or render FHA financing unavailable. The developer may have retained certain units as models, or may have leased back units sold to investors to serve as models. The receiver has the power to reject model home leases that he concludes are not necessary for the future marketing of the project.
HOA Issues If the HOA is developer-controlled as of the appointment of the receiver, the receiver will have the power to appoint representatives to the HOA for the developer. The minimum board member provisions of the project declaration may require the receiver to engage consultants to act as the receiver’s representatives on the board. The receiver may need to bring current unpaid HOA dues for developer-owned units and to fund reserves required under the project declaration. The receiver will want to facilitate completion of buildings and common areas, and turn maintenance responsibility over to the HOA, as expeditiously as possible.
Multi-Project Developments Frequently, a developer will have more than one project under the supervision of common management and subject to typical economies of scale such as a central management office, corporate personnel, centralized banking, a common mail address, and a blanket insurance policy. The receiver must anticipate these issues early and take steps to protect the receivership estate, including gaining control over incoming mail involving the project in receivership and securing project bank accounts and receipts. Frequently, the developer has not secured separate tax identification numbers for each of its development entities. The receiver will find it impossible to open receivership bank accounts using the parent tax identification number, given the strictures of the PATRIOT Act. The order appointing the receiver should either require the developer to secure a separate tax identification number for the entity subject to the receivership proceeding, or authorize the receiver to do so. The receiver should promptly review project insurance policies, should be named as an additional insured on the policies, and should agree to a methodology for allocating premiums between the developer’s remaining projects and the receivership assets. The receiver may prefer to secure separate insurance for the receivership project, though separate insurance may be more expensive. The receiver may need to unwind commingled assets, such as personal property and equipment, which may not have been properly accounted for on a project-by-project basis.
Other issues The receiver should take steps immediately to secure possession of the site, changing locks as necessary, and preparing an inventory of personal property, construction equipment, model home and office furniture on-site. Most development projects have numerous utility accounts. Getting a handle on these accounts before shutoff notices are issued is critical. The receiver should be granted the authority to pay pre-receivership expenses, such as utilities, that are critical to the project operations. The receiver should also be granted the authority to settle and resolve mechanics’ liens that impair the project, and threaten the senior position of the project lender. Receivership financing may typically be secured by receiver’s certificates that are given a priming position against the project – though if the foreclosing lender is in a junior position, the senior lender may object to that priming. The receiver should be given the authority to review the project books and records to make sure that funds advanced by the lender were properly disbursed to the contractors in accordance with project budgets and not misapplied to unauthorized expenditures or misappropriated by the developer.
This article highlights only a few of the significant issues that the receiver and lender of a distressed real estate project may encounter. The cooperation of all parties involved will minimize the costs of the receivership, thereby increasing the return from the project to the lender.
This Article is published for general information, not to provide specific legal advice. The application of any matter discussed in this article to anyone's particular situation requires knowledge and analysis of the specific facts involved.
Copyright © 2008 Fairfield and Woods, P.C., ALL RIGHTS RESERVED.
Comments or inquiries may be directed to:
Caroline C. Fuller