Saturday, October 25, 2008

When Condominiums Become Obsolete

What Determines the Lifespan of a Common Interest Development?

"Obsolescence” is the process by which something loses its value and relevancy usually due to being supplanted by a better product or changes in its environment. Several times we have written about our concerns for the impact of that process on common interest developments,[1].

First, let's realize that the obsolescence of most common interest developments, as with other man-made structures, is inevitable. It can't be stopped; it’s simply a matter of time. If you doubt that, ask yourself how many residential buildings that you know have lasted, say 100 hundred years or more. Look around and you’ll see only a few buildings that have survived the century mark--public monuments, and buildings that have historic worth or intrinsic value due to their unique location or architectural style. Most others have been replaced with newer structures.

A building reaches the end of its service life when it is no longer economically viable in its present condition. Examples are: an apartment house so run down that the rents it can obtain from tenants will no longer sustain the maintenance necessary to make keep it safe and habitable; a commercial structure in a neighborhood that has too much crime to be able to conduct business normally; and, single-family homes in a deteriorating neighborhood that cannot sustain their value and are not a desirable place to live. Another example, and one we have discussed before, is a low-density, multi-family complex with enough land to accommodate higher densities, where the value of the land alone begins to approach the value of all of the interests of the existing development--values depressed, perhaps, because the complex is reaching the end of its economic service life.

Delaying the Inevitable

Location and style can preserve a home that has otherwise outlived its economic usefulness. Look at the many “Victorian” homes in the San Francisco Bay Area. Those buildings, all built in the late 1800s, survive today because they are located where they can sustain market value as a single-family home, or where their value as rental property justifies their continued use.

In cities where that was not the case, they have been removed and replaced with larger, multi-family, or commercial structures.  In the city of Alameda, for example, there are many beautiful old Victorian homes. But there were many more 40 years ago. Developers began buying these old homes, situated on large lots, in the 1960s and replacing them with apartments. Several hundred were lost in this process until the voters halted the destruction. But this was political, not economic, intervention. Left to market forces alone, most would have been replaced with multi-family structures by now.

Other structures survive because they have public importance, like our government complexes, or buildings that have been preserved because of their historical value. But again, these structures have been saved through government or political intervention. Economics alone would not justify their survival.

Most community associations can lay no claim to such importance, either historically, or because the neighborhoods in which they are built are not unique. Also, historical preservation usually favors single-family homes, or unique commercial or public buildings. Apartment buildings have no such government or public support, and neither will common interest developments.

So again, obsolescence is inevitable for most community associations. The only question is how long will it take?  The normal economic “service life” of a building depends on several independent factors—the materials used in construction, the quality of maintenance, neighborhood conditions, and its fitness for the use for which it was intended in the neighborhood, to name a few.

Obsolescence Usually Leads to Re-Development

There used to be single-family homes in the financial district of San Francisco--125 years ago--but the neighborhood changed dramatically to commercial uses and the one-family home became obsolete because that same plot of land could be used for an office building, a multi-family residential building, or could be combined with other plots to build a manufacturing plant, or as it turned out, high-rise office buildings—all with greater economic rewards to their owners. Without government intervention for political reasons, properties left to the open market will develop into what’s known to city planners as the “highest and best use” and that usually means replacing smaller buildings with larger ones or residential buildings with commercial structures.

We have seen redevelopment go in reverse—where a former industrial site is re-developed into a residential development, but that usually includes various mixed uses to go along with the homes—retail, offices, public structures, like schools—so that the economic value of the replacement exceeds that of the old structures. But mostly, smaller, lower density residential structures will be replaced with “higher and better” uses. 

The Variables that Influence Service Life

What influences the service life of a common interest development? Many of the same factors as with other buildings—quality of construction, the adequacy of maintenance, a changing neighborhood; or newer buildings built nearby. But in the short term, the condition of the buildings is the primary factor—the result of construction quality and maintenance--which is in turn is impacted by the owners’ willingness to invest the resources necessary to maintain it properly.

An independent variable—the status of the neighborhood—is probably beyond the control of the typical community association. But the primary dependent variable, funding for maintenance, is squarely within the power of the owners to influence, and the ability of the association to adequately maintain the project is heavily influenced by that.

If a complex is maintained properly it might influence the neighborhood around it. And if the need for housing in that neighborhood remains unchanged for many years, and if values stay high, the community association may co-exist and thrive for a long time. But our research has shown that this can be undermined by the gradual underfunding of adequate maintenance and repair resulting from the unwillingness of the owners to tax themselves to pay for it.[2]

The Funding Problem

The board can only do so much. If it brings the need to raise additional funds to the membership, and it is defeated, the directors can ask themselves if they adequately explained the problem or if they sufficiently researched the costs and the projected need for additional funding. But in the end, it is up to the members unless the board is willing to antagonize them by raising the assessments 20% over the prior year without a vote or imposing a 5% special assessment whenever it is needed. The board of directors can do this[3], but the adverse political consequences may, and often do, dissuade them.

Also, the economy can have a grave impact on funding. When the instances of foreclosure rise, so does the rate of assessment delinquencies, further exacerbating the funding problem.

Association politics and the economy are therefore critical issues that directly influence the fiscal health of an association and its probable life expectancy. If we use funding adequacy to assess the probable service life of a common interest development then, we can clearly see that many will fail for lack of adequate financial support in the coming years. Whether that will be 50, 75 or 100 years depends almost entirely on the will and economic wherewithal of the owners.

There are many associations approaching 40 years old and beyond today and that population has increased dramatically with the recent addition of hundreds of condominiums converted from older apartment buildings. Further, the assessment delinquency rate is higher now than at any time in many years. The California Civil Code requires that an association’s replacement reserve budget must include any component that has a service life of 30 years or less.[4] Can a forty year-old building last another 30 years? In some cases yes, but how many developments can be expected to last a total of 70 years? At what point does the entire development become a reserve component?

When a common interest development deteriorates to the point that basic safety and habitability are called into question, the local government authority must act to either force the owners to repair it, or failing that, to close it down. We have seen such instances in complexes that were only a few decades old so we know that it can happen, and easily within our lifetimes. Also, once that deterioration spiral starts, it can increase with exponential speed as the condition begins to reflect poorly on the market value of the individual interests such that units will become impossible to sell and the owner’s interest in providing additional economic support will wane accordingly.

All of this suggests that the political will of the members, and their individual financial condition, will have a far greater impact on the useful life of a common interest development than any other factor. If they are not convinced that funding the association for future costs is worthwhile, the board's ability to respond to the factors promoting obsolescence will be cut off. Perhaps this is just good economic theory in action. But if so, then many of our community associations will eventually be re-cycled into something with greater utility. Anyone who has an investment in a common interest development must be aware of this, because the profit earned through re-development is, at least in part, the value lost by prior owners.

 [1] Berding, “The Uncertain Future of Community Associations” 2005; Berding, “Predicting the Future of Community Associations,” 2008.

 [2] Berding, “The Board’s Dilemma,” 2008

[3] California Civil Code Section 1366

[4] California Civil Code Section 1365.5