COST ALLOCATIONS IN MIXED USE, MIXED OWNERSHIP DEVELOPMENTS

American College of Real Estate Lawyers, October, 2014

Matthew J. Leeds
Ganfer & Shore, LLP, New York, NY

Edward A. Peterson
Winstead, PC, Dallas, TX

David M. Van Atta
Hanna & Van Atta, Palo Alto, CA

Introduction

It is a given that the world of commercial real estate is becoming ever more complex. One aspect of this trend has been the growth over the past 15 or 20 years of various forms of mixed use developments with multiple ownerships of various subdivided components. These can be established under the condominium form of ownership or under other common ownership subdivision arrangements.This article focuses on the topic of the determination and allocation of common expenses to be charged to the separate ownership interests in mixed use, mixed ownership regimes. Although the authors recognize that similar issues as to cost determinations and allocations may arise in horizontally subdivided developments, we address this topic concentrating upon vertically divided properties found mostly in urban and suburban settings.

It is important thatissues as to such cost determinations and allocations be understood not only by the parties who are creating these developments and the legal team that prepares the documentation for the developments, but also by various other parties, includinglenders, potential buyers or owners,equity providers,property managers, title insurers, property and liability insurance providers and other service providers and, of course,counsel for all of these parties. In some jurisdictions, the municipal authorities may get involved as the project is going through the approval process.In addition, at another level, regulators and their counsel must understand what is allowed and when, as a matter of policy or fairness, they should insert themselves in the process, and more importantly, when they may lawfully have input.

What are Common Expenses in the Mixed Use Context?

The share of the common expenses inmixed use, mixed ownership developments, whether set up as a condominiumproject or other subdivision format, is clearly not the same as the more familiar concept in commercial leasing where expenses are allocated in the form of Common Area Maintenance (CAM) charges, although this type of allocation can be analogous. The approaches to determining the actual amount of common expenses and the methodology of allocating common expenses to a particular separately owned unit or parcel are important commercial considerations,since they have important ramifications beyond a given year’s expenses and reach deeper into considerations of management and co-dependence.

The method and standards for determining and allocating the common expenses in these projects will be based upon several - sometimes competing- fundamental criteria, including applicable state statutes and the project’s governing legal documents. Also involved when making the allocation determination will be the perceived desires of the developer and the marketplace, and the perception of what potential future separate owners will want or will tolerate.

Mixed use separate ownership projects can be established as condominium regimes under a state’s condominium statutes, or they can be set up based upon a vertical subdivision of the property by a subdivision map or other parcelization that establishes separate ownership parcels or components. (See Van Atta. David. M., Mixed Use, Mixed Ownership Developments; Air Space Subdivision Techniques and issues; The ACREL Papers, Spring, 2003; pp3 et seq.) Common expenses for a particular separate parcel or unit will be determined primarily by the fundamental project organizational legal documents. For condominium projects, these are generally described as the declaration of condominium (which in some jurisdictions is referred to as a “Master Deed”) and the by-laws of the condominium association. For other types of subdivisions, such as vertical air space divisions or complex horizontal mixed-use projects, the operative document usually takes the form of a declaration of reciprocal easements, covenants and restrictions, sometimes with specific rights and burdens also memorialized in the deeds to the properties.

There may be limitations, however, on what those governing documents provide,based on the operation of the applicable statutes.If the condominium structure is used, many states have adopted a version of the Uniform Condominium Act (the “Uniform Act”) or the Uniform Common Interest Ownership Act ("UCIOA"); however, most of these individual states have varied many of these uniform acts' provisions, so there will be variations of the applicable local law even in states that have adopted these uniform acts. It should be noted that some of the states that have seen the greatest amount of activity with mixed use mixed ownership developments have not adopted either the Uniform Act or UCIOA. The applicable statutes in some of these states are unique and idiosyncratic. In California, as one example, that state’s laws pertain to both condominium projects and other forms of common interest developments under the Davis Stirling Common Interest Development Act (Civil Code sections 4000 et seq.).Therefore, most of the provisions that apply to the organization and operations of condominiums also apply to other common interest types of development as well. New York's Condominium Act is what is referred to a “first generation” condominium law, dating from 1964 (New York Real Property Law Article 9-B). Texas, on the other hand, has a version of the Uniform Act.

The principal focus of these materials will be to address issues regarding the determination and allocation of common expenses in the context of mixed use, mixed ownership verticaldevelopments. An entirely separate set of considerations relates to mixed use horizontal developments, often being driven by the residential single family housing aspects of the project or containing a plethora of different considerations for uses on separate tracts. A discussion of mainly horizontal developments is left for another presentation. Specifically,we will address methodologies and strategies for the determination of common expenses and the allocation of these expenses to the various ownership components. This discussion will necessarily entail reviewing various operational concerns that can have ramifications on how common expenses are identified, determined, allocated and assessed.

These operational issues include the following:

  • Insurance
  • Restoration
  • Condemnation
  • Distribution of excess proceeds (insurance or condemnation)
  • Challenges to expenses and allocation methods
  • Mechanisms for the creation of budgets
  • Expenses for capital improvement, including proper reserves
  • Repercussions of the amount of common interest that is used to determine allocations of common expenses
  • Enforcement mechanisms and dispute resolution. (Although not in the realm of normal operation, these considerations can also affect the overview of distribution of sales proceeds upon termination of a condominium and sale of the entire property.)

This article seeks to raise concerns relating to these issues and to suggest some sample strategies and drafting approaches that have been used to navigate the business responses and related legal concerns. We have attached some sample provisions to this presentation, but,as with any such exemplar, it should be understood that these examples areforms and not the product of a particular set of facts and possible detailed negotiation, and have the perspective of the relevant statutes and that of a developer. No approach is necessarily appropriate unless the facts surrounding the development are known and analyzed. Fortunately, many statutes allow for such flexibility. Partly because of that, and partly because in money matters the parties tend to make real estate compromises, there is not much case law to point to, and it is hoped that examples can spark thinking as to issues that might be available in other situations.

In addition, a final caveat relates to the background of the authors. Although the intention is to present an objective analysis of concerns that will arise in most drafting efforts or negotiations, the three authors represent personal experiencesthat have centered in three of the largest states with very different state laws. One author, Ed Peterson, works primarily in Texas, a state that has a version of the Uniform Act, but with special state provisions and a wide-open attitude. Matthew Leeds primarily deals in New York, a state with an old first-generation statute dating from 1964 that has not been amended very often. David Van Atta practices primarily in California, a state with an idiosyncraticstatute that has been expanded and amended frequently and was just restated effective in 2014, including a revision to place non-residential projects into a separate statutory scheme.

Fundamental Definitions

For background and terminology, where a condominium structure is involved, it is useful to recall that condominiums are creatures of statute that changed the early concept that ownership of real estate meant owning everything above and below the area of the land (Cuiusestsolum, ejusestusqueadcoelum et ad inferos, which the authors in consultation with Henry Campbell Blacktranslate roughly as “to whomsoever the soil belongs, he owns also to the sky and to the depths”). Rather, condominium acts allow one property to be sliced and diced into less inclusive parcels. An owner in a condominium owns a condominium unit, which is fundamentally a specifically described amount of air space, along with a shared interest in a portion of the project that is designated as “common area.” The most generic condominium unit is one that is described from the inside of one wall to the inside of the facing wall, and from the top of the floor to the underside of the ceiling above it. Condominium statutes do allow for variations in the description of a unit, but the fundamental notion remains that the unit is an increment of airspace that exists within the context of some common area or areas as, if you will, a floating form. Each condominium unit is a separate parcel of real estate, and thus is a separate tax lot with its own tax assessment, and is a separate parcel of real estate that can be mortgaged. The remainder of the property where the condominium units are located, including the land and the structure (the building with its walls and roof, common hallways, etc.), are referred to as common elements. Each owner in a condominium owns a condominium unit and an undivided percentage interest in the common elements. These two aspects of ownership are inseparable. Accordingly, the ownership of each unit owner in the common elements is analogous to an ownership of tenants-in-common. The unit owner’s percentage interest in the common elements is called its common interest. (Remember that because we are discussing commercial and mixed use situations, drafters and deal makers have been very creative about expanding the definition of what is included in a condominium unit, but the fundamental definition will apply, particularly as examples to present the terminology that will be used in this presentation.)

In other subdivisions contexts, such as vertical subdivision parcels, the same ideas are generally in play. That is, the idea is to create separate ownership parcels of air space and internal improvements within the context of an overall project.

The combination of unit owners or air space parcel owners is generally represented by the owners being members in an association (“Association”). In different jurisdictions, this Associationmay have different legal characteristics. Many are set up as incorporated entities; in some instances an unincorporated association is utilized or even mandated by law, andin many instances the preferred and often required method is a non-profit corporation. TheAssociation’s membership is generally the owners of the units or air space parcels. These members normally will elect or appoint a discrete group to run the operational detail of the Association, which is board of directors or a board of managers (the "Board"). This Board’s responsibility almost invariably will include operating the common elementsof the project. Importantly, this will include budgeting, allocating and assessing for the costs of operation of these common elements and other common expenses related to those common elements. Nevertheless, it is not unusual for a Board to hire a professional management to carry out the day-to-day job of managing the common elements of the Condominium on behalf of the Association and its Board, although the Board remains fundamentally responsible. It should be kept in mind that in many statutory schemes the Association does not own the common elements,and in such instances it is clear that the Association's responsibility is management of the common elements. In fact, in some of these jurisdictions when the Association is said to own something, the technically correct formulation would be to say that it is owned by the Board on behalf of the unit owners (and in such an instance, the Board is almost a representative or agent, or even possibly a nominee).As one example where this is not the case, in California Associations may hold title to common elements (one legal difference being that the Association is a more recognizable legal entity, rather than an agglomeration of unit owners).

Among other responsibilities, the Board will formulate a budget for the project’s common expenses for operation, administration, maintenance, repairs and replacements of the common elements. These include, as examples, cost and expense of maintenance and repair of common element improvements, infrastructure and facilities; the costs for professional management fees or salaries for employees who manage the Association and the common elements; expenses for landscaping in common elements; utilities and fuel for the operation of common elements, such as a lobby or common hallways; insurance for casualty insurance covering the structure of the building (the common elements); accounting fees for the preparation of annual financial statements; casualty, liability, directors and officers liability insurance etc., and so on. In addition, under some instances, services provided by the Association to the separate interests, such as utilities or security, might be included in this budget as common expenses to be allocated among the various ownerships.

Normally, there is no common expense for real estate taxes, as real estate taxes are assessed, by the taxing authority, to each of the units or parcels separately and are liens on the separate units or parcels. Similarly, there would not be a common expense for debt service onmortgagedebt covering the units or component parcels or the common elements.Any mortgage on a particular unit or air space parcel, together with its share of the common elements, will be the individual responsibility of the owner of that unit or air space. The repercussion of an owner’s failure to pay its real estate taxes or its own mortgage is that the taxing authority or the mortgage lender can foreclose on the owner’s unit or air space parcel, along with its appurtenant interest in and to the common elements, but not on Association property.

The expenses relating to the common elements are generally referred to as common expenses.These common expenses are divided among the owners of the component units or air space parcels. The methodology for allocating these common expenses is one of the core issues of this article.

The obligation of the owner of a separate interest to pay its share of common expenses is normally secured by a lien on the owner’s unit or parcel in favor of the Association, which is enforced by the Board. Some states have rigorous detail as to how these liens may be enforced. There may be concern in some jurisdictions as to whether lien rights on behalf of the Association or group of owners can be imposed in the context of a mixed use project that is not a condominium regime. In some jurisdictions, the creation of a lien outside of the condominium context would seem to be a matter of negotiation, with a lien and lien rights to be preserved in carefully drafted documentation recorded against the various parcels. Interestingly, in California this issue is resolved if the project constitutes a “common interest development” under one of two acts: for projects with residential components, the Davis Stirling Common Interest Development Act, found at Civil Code Sections 4000 et seq.; and for projects that do not have a residential components, the Commercial and Industrial Common Interest Development Act, found at Civil Code Section 6500, which was effective in 2014. Both of these acts provide lien rights to Associations to enforce Association assessments, whether the project is a condominium project or other type of common interest development regime. However without this express statutory authority, imposing a lien right in such a jurisdiction outside of the context of a condominium project set up could be an issue.

State statutes differ as to the priority between real estate taxes, a first mortgage of record and the Association’s liens to protect the Board's lien priorityfor commonexpenses. For example, the Uniform Condominium Act provides a six month priority of the common expenses over a first mortgage of record. However, the New York Condominium Act generally provides that a first mortgage of record is superior to a lien for all common expenses. New York Real Property Law Section 339-z. Even then, the New York statute does allow that in a condominium that has no residential component, the parties may agree to a priority of common expenses as against mortgages. (In California, the relevant statute provides: A lien created pursuant to Section 5675 shall be prior to all other liens recorded subsequent to the notice of delinquent assessment, except that the declaration may provide for the subordination thereof to any other liens and encumbrances. (California Civil Code Section 5680.))