For the past two years the FHA has been involved in an effort to lower its risks, a process which is entirely understandable given that the government program is nothing more than a type of mortgage insurance. But now the FHA has tightened its underwriting practices in a way that’s likely to impact marketplace values. The good news: More pressure to raise single-family home prices. The bad news: Condo prices are likely to take a beating.
The FHA has insured some 34 million mortgages since it first began in the 1930s. Instead of 20 percent down borrowers with FHA coverage can buy with far less up-front, but in exchange for less down they have to purchase insurance coverage. If there’s a foreclosure the FHA insurance kicks-in and protects the mortgage lender.
Among recent steps to reduce risk, the FHA has increased its down payment requirement from 3 percent to 3.5 percent for most loans, raised mortgage insurance premiums and banned the use of down payment assistance programs (DPAs). DPAs were programs which allowed a seller to pay money to a third-party non-profit organization and the nonprofit then gave down payment money to an FHA borrower, thus getting around the FHA down payment requirement. Unfortunately, the FHA reports that DPAs make up 14 percent of its outstanding loans — and 31 percent of all FHA foreclosures.
Now the FHA has come up with new rules for condominiums, rules which will significantly reduce available condo financing and thus condo values. With condos less desirable, there will be more demand for single-family homes, something which should help bolster values for properties with one to four units.
Condos Versus Fee Simple Houses
There are various forms of real estate ownership. Figures from the Census Bureau show there are 80 million detached single-family homes as well as almost 8.5 million condos.
In basic terms, each type of ownership represents a bundle of rights. The form of ownership with the most rights is fee simple, meaning that you own the property and all “improvements” (such as the house) and can finance any way you wish.
With a condominium you own your unit, can finance however you want and have the right to use common areas.
Each form of ownership poses different issues for mortgage insurers. Fee simple properties are the least risky for mortgage insurers because the borrower is good as long as he or she pays the mortgage, property taxes and insurance. To assure that this happens most loans with less than 20 percent down collect not only the monthly mortgage payment but also the money needed for insurance and taxes.
In addition to a mortgage, property taxes and insurance, a condo owner must pay a condo fee. This is not necessarily a big expense, and it may actually be a smaller cost than the fee simple owner pays for exterior maintenance and repair. The catch is that a condo fee is a lien against the property. Don’t pay the condo fee and your unit can be foreclosed. That means more risk for lenders.
If a number of unit owners are foreclosed and their condo fees are unpaid, the result is that then all remaining unit owners may face substantially higher condo fees. Units which were affordable in good times may suddenly become unaffordable because other owners cannot make their payments.
Condos also present other forms of risk. For instance, if a large percentage of the units are rented then the entire property may be regarded as “investment real estate.” That hardly sounds important, but what it means is that ALL units in the project, including owner-occupied units, will need investor mortgages when sold or refinanced. Since investors face higher rates and tougher qualification standards, units requiring investor financing are harder to sell.
Another form of condo risk is group responsibility. If the roof leaks and reserves are insufficient, then all units may face a “special assessment,” sometimes thousands of dollars. Like condo fees, special assessments are a lien against the property — don’t pay it and you can be foreclosed.
The FHA is keenly aware of these issues and traditionally has restricted mortgage insurance coverage for individual condo projects. Now new rules make the restrictions far tougher, meaning that financing for condo units is about to get much harder to obtain.
The New Rules
In rules just posted, the FHA says that starting October 1st condos must meet several new standards:
• All projects not deemed to be used primarily as residential real estate are out.
• Because of noise worries, FHA insurance will be unavailable when properties are within 1,000 feet of a highway, freeway, or heavily traveled road; 3,000 feet of a railroad; one mile of an airport; or five miles of a military airfield. The FHA says that lenders “must avoid or mitigate” such conditions before completing their loan review process, but how does one avoid or mitigate an air force base? How much mitigation is enough mitigation? The obvious result is that with an abundance of caution lenders will be unable to finance properties with potential noise hazards.
• There will be no more FHA loans if the “property has an unobstructed view, or is located within 2,000 feet, of any facility handling or storing explosive or fire-prone materials.”
• Also, FHA loans are out if the property is located within 3,000 feet of a dump, landfill, or super-fund site.
• Not more than 25 percent of the property’s total floor area can be used for commercial purposes.
• No more than 10 percent of the units may be owned by one investor. This will apply to developers/builders that subsequently rent vacant and unsold units. For two and three unit condominium projects, no single entity may own more than one unit within the project; all units, common elements, and facilities within the project must be 100 percent complete; and only one unit can be conveyed to non-owner occupants.
• No more than 15 percent of the total units can be in arrears (more than 30 days past due) of their condominium association fee payment.
• At least 50 percent of the total units must be sold prior to endorsement of any mortgage on a unit. Valid presales include an executed sales agreement and evidence that a lender is willing to make the loan.
• At least 50 percent of the units of a project must be owner-occupied or sold to owners who intend to occupy the units. For proposed, under construction or projects still in their initial marketing phase, FHA will allow a minimum owner occupancy amount equal to 50 percent of the number of presold units (the minimum presales requirement of 50 percent still applies).
• Projects in designated wetland and flood zones will not qualify for FHA insurance.
If you look at the new FHA rules above you will instantly notice several problems. First, a lot of existing condo projects are easily within 1,000 feet of a “heavily traveled road.” That’s why they were built in major metro areas and while the financing rules have changed the condo units cannot be moved.
Second, huge numbers of properties — especially in California, Florida and Las Vegas — will never pass muster under the new ownership standards or the arrears guidelines. This is a significant problem given that FHA-insured loans now represent about one-quarter of all mortgage financing.
Third, condo loans under the FHA rules will be dependent on the use of land NOT controlled by condo owners. For instance, if someone builds a gas station two blocks away is that an example of a “facility” which handles or stores explosive or fire-prone materials? Why is it so terrible to have a property near a golf course that was built on top of a reclaimed landfill?
Fourth, the cost of private-sector condo financing without FHA insurance will increase because borrowers will have fewer options.
“From the perspective of a mortgage insurer the new FHA rules make a lot of sense,” says James J. Saccacio, chief executive officer of RealtyTrac.com, the leading online marketplace for foreclosure properties. “However, in many cases these new standards will apply retroactively. Projects built long-ago and units bought when the rules were different will be impacted. Many of the states which now have the worst foreclosure problems will be hurt because less condo financing will be available. In general, the FHA needs to re-think its standards, especially those which are beyond the control of unit owners.”
Assuming that the new FHA guidelines remain in place, condo financing is about to get more expensive in those cases where units are re-defined as “investment property.” Higher financing costs are a sure way to reduce demand and force down condo prices. At the same time, higher financing is at least better than no FHA-backed financing, the situation which will prevail at many condo projects.
With less condo demand, and given a steady population, interest in fee-simple owner-occupied properties with one to four units should increase, meaning there will be additional pressure to raise prices for such properties.
Whether you’re an investor or an owner-occupant, the market for condo units has just become both more complex and less desirable as a result of the new FHA policies. While it’s possible the rules could change before the October 1st start date, no one can count on such a reversal. Alternatively, fee-simple houses and properties with no more than four units have just become a lot more desirable. ____________________
Peter G. Miller is syndicated in more than 100 newspapers and operates the consumer real estate site, OurBroker.com.