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The 10% Solution

An important factor in buying or selling an apartment is whether the building itself has been approved by one of the three government entities (or quasi-government entities) involved in the home lending industry.

Approval allows a purchaser’s loan to be either sold by the lender to Fannie or Freddie (buyers of home mortgages) or be insured by the Federal Housing Administration (the “FHA,” a loan insurer).  Approval is important even for the “all cash” buyer because their eventual buyer might need a loan and sellers need to know if their building is approved when figuring out how to market the apartment.

Over the years, Fannie Mae, Freddie Mac and the FHA have been implementing more restrictive guidelines to obtain approval.  A recent change requires a lender to review a condominium’s budget to determine that it is adequate and, among other things, provides for an amount equal to 10% of the annual operating budget to be set aside in a reserve fund for capital expenditures and deferred maintenance[1].

This new requirement is applicable to all condominiums, but in the case of a new condominium (gut and non-gut rehab), a reserve study is mandatory requirement for approval.

A reserve study is an in-depth evaluation of a the useful life, remaining useful life, current repair and replacement costs for each reserve component, a review of future funding and an analysis of existing reserve funds.  The reserve study will detail anticipated replacements or repairs to common-area elements and recommend an annual reserve funding to cover future capital expenditures.

If the condominium’s budget does not meet this 10% requirement the condominium might still be approved if a reserve study confirms that the financial condition of the development is stable (FHA Mortgagee Letter 2009-46b , Section V(11)).  If Fannie, Freddie or the FHA is satisfied with the financial condition of the building and that the reserves are adequate despite having less than 10% of the condo’s budget in a reserve account, the requirement can be waived.

In today’s market, many sponsors and developers obtain pre-approval by Fannie, Freddie or the FHA thereby opening their projects to purchasers who will be using Fannie, Freddie or FHA loan products.

Given the current economic climate, it seems prudent for sellers to strive to have their buildings meet the new reserve requirement and for buyers to focus in on this issue.  One can determine if the FHA has approved a condo at HUD.gov although the site is a bit cumbersome to navigate through.

By Jerome J. Strelov and Nahum M. Palefski

[1]              The new guidelines discussed in this post apply mainly to condominium developments.  The guidelines are not mandatory for co-ops, but could be applied on a case by case basis by the various approving entities.

Category: Financial Statements, Financials, Get the Co-op in order, The Buyers World, The Sellers World Comment »


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