Articles

By Edward A. Peterson

Edward A. Peterson is a shareholder in the Dallas, Texas, office of Winstead Sechrest & Minick P.C.

During the second half of the 20th century, large cities in the United States began to experience what became known as urban sprawl. Most cities grew horizontally rather than vertically with some notable exceptions such as Chicago, New York, and Miami. The proliferation of the automobile brought increased mobility to society, and the close proximity to living space of goods and services was not perceived to be necessary. But as urban sprawl reached out 40 and 50 miles and traffic congestion became the rule rather than the exception, people began to put a premium on living and working in closer proximity. This seemingly natural progression has resulted in what is now known as the “New Urbanism,” which can loosely be described as multi-use real estate developments including “new towns,” “vertical multi-use condominiums,” “cluster homes,” and other ownership structures, all of which are often included in “smart growth initiatives” of progressive cities and towns.

This article will focus on the structuring fundamentals and critical considerations involved with vertical developments that include not only residential uses and amenities, but also retail, office, entertainment, and hotel uses in the same real estate project. The structures available under the law of most, but not all, states will be explored, and the challenges in the overall development process will be examined. There is no cookie-cutter approach to planning a multi-use common ownership project; however, there are guidelines to help the developer’s counsel in guiding the legal process. Condominium legislation is the statutory basis for all vertical subdivision of property at this time.

Structuring Fundamentals

Ownership

The owner of a property can use it for more than one purpose if the applicable zoning and land use regulations permit multiple uses. A planned unit development (PUD) is an example of a land use regulation permitting and often encouraging multiple uses of a tract of land. There is very little reason to have a common form of ownership in relation to a horizontal development if it is planned correctly. Separate ownership can be arranged for various platted parcels and the property can be separately owned and financed with a common management or easement structure for some portions of the development that are jointly used. In a vertical structure, however, common ownership is generally necessary, although not required, and the issues become evident. If the development is multi-storied and separate uses are planned, then specialized talents may be needed to lease or operate the planned components of the building. In such instances, the common ownership structure must be given consideration.

Zoning and Land Use Considerations

Full use of a building is imperative in urban settings. Often to make the site a profitable development, the project must have multiple stories and various uses. If the separate uses will be operated and owned by different owners, then the project is a candidate for condominiumization because replatting is generally not required, floor area ratios can be increased, and more flexible development plans can be accomplished.

Facilitate Financing

Lenders are more interested in financing a property that is used for a separate purpose because the stream of income and value is easier to underwrite. If the developer wants to develop a project that contains a hotel, residential space, and retail rental space, for example, it will not be easy to find permanent lenders to finance the entire project, but lenders in the marketplace will finance each of the above uses. Financing of commercial condominium units is still an infant industry; however, the author has found that a clear, precise presentation of the structure and a graphic display of the project with a short, simple explanation of the legal basis for the structure are extremely effective in gaining an expeditious understanding of the legal and business
concepts.

Maximization of Value—Flexible Exit Strategy

Often the parts are worth more than the whole, and developers can achieve a higher sales price for individual uses. If the developer owns an office building in a soft office market, the division of the building into multiple uses that may or may not include office space can substantially increase the value of the property. The condominium structure can be used, if there is a residential component, to provide another way to sell the rental property by condominiumizing the apartment units and selling them to individuals in the future when the market is favorable. Buildings are currently being structured that contain retail space on the ground floor with several levels of rental units above the retail. Most of these rental units have a reserved right to create a sub-condominium unit if the owner desires to market the residential units as residential condominiums in the future.

Conversion of Uses

Many owners of property in areas where the original use has run its course can use the multi-use concept to make a property useful and therefore more profitable. Examples are warehouses that can be converted to retail and lofts, apartments that are converted to retail and residential condominiums, hotels that are converted to retail and residential condominiums, and hotels that are converted to retail and office space.

Critical Considerations

The balance of this article will consider the critical issues that face a real estate lawyer who is structuring a multi-use condominium containing five separate units including a hotel unit, a retail unit, a residential unit, a parking unit, and a future development area unit. The basic structure is set forth in the box on the previous page.

Understanding the Project

The developer’s attorney must carefully establish unit boundaries and fully comprehend and explain to the developer how the multiple unit boundaries will affect the responsibility for maintenance, repair, or replacement of the property, whether the property is a unit or a part of the common elements. This process will help the attorney to understand the project and to advise the developer of the many use rights necessary to address the needs of each unit owner. Within the condominium structure, separate categories of common elements, such as general common elements, residential limited common elements, hotel limited common elements, retail limited common elements, and special limited common elements should be created. These separate categories will help avoid the typical disputes between co-owners over financial responsibility for maintenance, repairs, and replacements of portions of the property, particularly disputes that arise when sharing responsibility for common elements. It is possible to structure a multi-use condominium with most of the common elements placed in a separate unit of which the associated costs are shared on a predetermined basis.

Structuring the Project—Who Is in Control?

If there is a residential component to a multi-use project, and depending on the relative size of the commercial and residential components, a critical issue will be to balance control carefully among the units’ owners. Control involves several aspects, including negotiations relating to the condominium and other project documentation, the administration and financial management of the overall condominium project, maintenance and repair of the common areas, actual control of the governance of the master association, and structure of the dispute resolution provisions. For obvious reasons, the commercial owners will have a strong desire not to be involved with the multiple owners of the residential condominiums. The eventual owners of the individual residential condominiums will have little or no desire to be involved in any of the commercial aspects of the condominium. The owner of the hotel unit will be subject to a complex set of requirements imposed on the hotel under the hotel operating agreement.

If a developer decides to reserve the right to build a second residential condominium in the air space over the parking garage, the developer must have the proper rights and easements to allow future construction and to integrate the future residential tower into the project or perhaps keep the second condominium completely separate. Assuming that the developer has arranged ownership of the various units, there will be complex negotiations among the various parties before the commencement of construction. The lawyer must guide the parties so that the uses can co-exist in the same structure and have a minimum of overlap in administration and a workable process to deal with dispute resolution. Through the negotiations it will become apparent which unit will have the leverage necessary to control the administration of the property. A variety of control mechanisms can be used for actual control of the master association. Class voting may be allowed if the class has a legitimate interest to protect. See, e.g., Unif. Condo. Act § 2–107(c) (1980). For example, if the hotel unit has a legitimate interest in maintaining the quality of the overall project, giving the hotel unit control through a class of membership should be allowed under the Act. It is important to segregate the residential units from the commercial to the greatest extent possible. This segregation can be accomplished in numerous structures; however, the formation of a master condominium (the “Master Condominium”), as shown in the box on the previous page, is the most efficient. The Uniform Condominium Act permits the subdivision of units, and the declarant is allowed to reserve a development right to subdivide units. Unif. Condo. Act §§ 2–113, 1–103(11). The residential unit will be subdivided into multiple residential units, and these units will have a residential association (the “Residential Association”) that will handle the administration of the individual residential units. The master condominium association will have a representative of the Residential Association on its board of directors, but the commercial unit owners will generally control the master association. Although not appropriate in the structure shown in the box on the previous page, there are projects in which the residential unit owners would control the master association or where one association would be appropriate.

Regulation of Uses

The uses for each unit within the condominium must be carefully analyzed so that each unit is properly defined, limited, and permitted. A natural tension exists between the residential and commercial uses in a building. The box on page 54 illustrates the tension between the hotel owner and operator and the residential condominium owners. Counsel must examine applicable zoning ordinances and covenants, conditions, and restrictions when preparing the condominium declaration so that there are no conflicts and so that the condominium declaration is properly integrated with the provisions in these land use regulations. All parties, particularly owners of units other than the residential units, and their mortgagees and tenants must determine that the condominium declaration permits uses that will be necessary to the conduct of their respective businesses. Commercial unit owners and their mortgagees must ensure that the condominium declaration cannot be amended without their respective consent. Owners of individual residential units will want to provide reasonable limitations on the commercial uses in the condominium so that there is no unreasonable interference with their lifestyles. Developers generally impose restrictions that are usual in the market and do not affect the marketability of the individual residential units.

Easements and Licenses

There will be many easements in relation to a multi-use project as outlined in the box on page 54. Counsel must carefully analyze and determine the easements to be granted and retained in the condominium declaration. Under many states’ laws, the easements must include a legal description of the area to the extent feasible. See, e.g., Tex. Prop. Code § 82.059(5). Some easements may be expressly provided by applicable state law, but it is good practice to carefully outline and set forth each necessary and required easement. A partial list of the possible easements that will be required includes access, support and encroachment, parking, loading, elevator, utilities, amenities, signage, stairs, garbage chutes, construction, easements relating to the future development area, roof, communications, and common element easements. A determination should be made about the permanence of each easement and whether it is assignable, exclusive, or non-exclusive. Each easement should specifically state who is responsible for maintenance of the easement. Some use rights might properly be licenses that can be easily terminated by the master association. If payments are associated with the use rights, consideration should be given to suspension of the rights if the payments are not made.

Allocation of Expenses

A predetermined expense allocation must be established between the owners or potential owners of the various units based on some formula or method. This allocation can be accomplished in numerous ways. The condominium declaration may authorize the allocation of common expenses and votes in a manner other than based on a unit owner’s common interest. The Uniform Condominium Act states:

The declaration shall allocate a fraction or percentage of undivided interests in the common elements and in the common expenses of the association, and a portion of the votes in the association, to each unit and state the formulas used to establish those allocations. These allocations may not discriminate in favor of units owned by the declarant.

Unif. Condo. Act § 2–107(a).

The method most often used is to require the developer (and the unit owners) to prepare a line item schedule specifically indicating how different expenses will be split on a percentage basis among the unit owners. Under a variety of alternatives, however, the declaration can

• allocate based purely on the percentage of common interest, if appropriate;

• provide that expenses relating to each particular portion of the property will be paid by those unit owners that use that portion of the property;

• assign the responsibility to the master association to allocate expenses reasonably and fairly;

• try to get utilities and other ser-vices sub-metered or assigned;

• require that the parties agree to split expenses based on third-party reports of actual usage after a reasonable period of usage;

• use the appraised value of each unit as the basis; and

• develop a formula that includes subsidization of one or more uses based on benefit received or penalty based on burden inflicted.

Common Elements; Shared Facilities

The designation of the common elements for a multi-use condominium is very important. All spaces that are used by one or more, but not all, unit owners are limited common elements. Unif. Condo. Act § 1–103(19). All common elements that are not limited common elements are general common elements. See, e.g., Tex. Prop. Code § 82.003(14). Parking can be designated as a limited common element, together with balconies and patios. Any space that is used only by a unit or units in the Master Condominium, such as amenities used by the hotel unit and the residential unit, would generally be limited common elements. Parking and storage can be designated as separate units within the condominium and often are so designated. The designation of common elements will be different for each project and each developer.

In a project such as that diagrammed onin the box on page 54, the aspects of the project that must be examined to designate common elements include the swimming pool and the pool area, health and fitness club, spa, parks and other public spaces, private club, meeting or club rooms, lobbies, elevators, and staircases. Each of these spaces can be part of the common area or can be included within one of the units, depending on the negotiations between the unit owners and their operators. In addition, the project could be structured so that all of what normally would be common elements are placed in a separate unit, provided there are at least some common elements, such as the real property and the structure of the building. Having a separate “shared facilities unit” provides the benefits of a mechanism for one or more of the constituencies in the Master Condominium to control the quality of the overall condominium project. The common elements also can be divided among the units by designating limited common elements as “hotel limited common elements,” “retail limited common elements,” “residential limited common elements,” and so on.

Parking

The parking plan for a multi-use condominium project inevitably becomes one of the most difficult decisions for the developer. The plan must, of course, meet code for the number of available spaces and must be practical and efficient in relation to the design of the building or buildings. Counsel should remember to advise the developer that the parking spaces can be individual units of the condominium that can be sold separately and that all the parking for the hotel unit and the residential unit could be placed in a separate unit that could in the future be sold separately. These decisions could benefit the profitability of the entire project. Parking for the residential component ideally should be separate from the parking for the other units. Parking for the retail unit should be located as close to the retail establishments as possible, and, for the hotel unit, parking must be reasonably convenient but can be offsite. Access to each of the parking areas must be carefully planned.

Amenities

Depending on how the amenities are structured, special easements or use rights may be needed so that the owners of the individual residential units will have the right to use each of the amenities intended for use by such unit owners. The right to use these facilities can be structured as revocable licenses that can more easily be terminated if the users fail to pay the required fees. The hotel owner will want to have the exclusive right to use some of the amenities for limited time periods, and these types of rights can be provided in the rules and regulations.

Future Development Rights

Often the developer has additional land adjacent to the primary development or conceives a way to add additional density to the site under development. In the structure contemplated by the condominium that is diagrammed in the box on page 54, the developer contemplates building an additional residential tower in the airspace above the parking deck attached to the main hotel/residential tower (“Future Development Area”) and intends to build the parking structure so that the necessary structural components to support an additional 25 stories are in place. This future use can be accommodated if the declaration is properly structured. The developer of the condominium can reserve “development rights” as defined in the Act. The Act defines “development rights” as a “right or combination of rights reserved by a declarant in the declaration to (i) add real property to a condominium; (ii) create units, common elements, or limited common elements within a condominium; [or] (iii) subdivide units or convert units into common elements . . . .” Unif. Condo. Act § 1–103(11). Because the Future Development Area is real property, the developer can add it to the condominium as part of the residential unit or as an additional unit to the Master Condominium, which can be further subdivided. These rights must be specifically set forth and special declarant rights reserved to exercise the development rights in the condominium declaration filed in connection with the master declaration. Unif. Condo. Act § 1–103(23). Easements relating to the construction of improvements in the Future Development Area should be reserved in the master declaration, and the configuration of the added area should be analyzed to assess the need for access, parking, and use rights, if the Future Development Area is added.

Dispute Resolution

The more complex the structure of the condominium, the more problematic the dispute resolution process becomes. Having all disputes in a multi-use structure end up in the courthouse is not the most efficient way to deal with this issue. The alternatives are forced mediation, binding arbitration, or a combination of these processes. The author believes that a combination of forced mediation and mandatory “final offer” or “baseball” arbitration is a fundamentally sound approach to encourage the parties to compromise their disputes.

Given the vastly disparate uses between the [residential and the commercial units in a multi-use condominium], a balance must be established on the question of the governance and affairs of distinctly separate owners and uses, maintaining, on the one hand, flexibility for one owner’s use while, on the other hand, respecting the rights of and ramifications upon neighboring owners. Thus, drawing upon a dirt lawyer’s knee-jerk drafting technique of conditioning defaults based on “materiality” or (as here), “adverse effect,” a balance of the potentially competing interests is reached which should accommodate the day-to-day operations of each of [the competing interests] in . . . [a] multi-use building. Providing a dispute resolution mechanism—such as one which would be triggered by a reasonable notice by an objecting party challenging a [board determination]—affords all users in a multi-use property an equitable avenue to communicate concerns over a Board’s action which may affect an owner’s use and operation.

Arbitration is sometimes suggested as a mechanism for the board to resolve its differences. However, deferring to issues of corporate law, some practitioners have questioned whether a board can be emasculated and delegate its right of decision to another body. If this is a concern under local law, creative lawyers might consider whether it would be possible to craft a system of guidance which would, in fact, rely upon what is essentially an arbitrarial device.

See Alan Goldberg & Matthew J. Leeds, A Guide to Special Concerns in a Multi-Use Condominium: A Review by Annotated Example, American College of Real Estate Lawyers, Spring Meeting, Mar. 2003, available at www.acrel.org/Documents/Seminars/Goldberg.rtf (last visited May 20, 2005) .

Special Provisions for Casualty and Condemnation

The Act requires certain provisions on casualty and condemnation. Unif. Condo. Act § 3–113 (dealing with insurance and administration of proceeds of insurance) (the provisions cannot be varied if there is a residential component to the condominium), § 1–107 (dealing with condemnation) (these provisions may not be varied by agreement). Notwithstanding that the condominium is multi-use, these provisions cannot be varied if there is a residential unit, and counsel must be careful to assure that the condominium declaration reflects the provisions of the Act. Some practitioners have suggested that these provisions could be circumvented by having unit owners give powerof attorney to the association; however, this procedure is specifically prohibited by Unif. Condo. Act § 1–104. The Act allows the use of an insurance trustee if the condominium association deems such a procedure appropriate. Unif. Condo. Act § 3–113(e). It is suggested that in a multi-use context the declaration should provide that insurance proceeds above a fixed amount be administered by the master association as insurance trustee.

Plats and Plans

The plats and plans that define the condominium are the portion of the condominium declaration that allows the creation of separate parcels that can be conveyed. It is therefore extremely important that great attention be paid to the specificity and detail of these documents. Tex. Prop. Code § 82.061 provides the detailed requirements of the plats and plans required to be filed. Structuring a multi-use condominium by using a Master Condominium with a sub-unit structure for the individual residential units magnifies the complexity of the plats and plans. An experienced condominium surveyor will be helpful, if not crucial. Each of the master units must be identified, all easements must be legally described, all property subject to development rights must be described, horizontal and vertical dimensions of the units must be set forth, and many other requirements under the Act must be followed.

Sub-unit Condominium

The residential component of a multi-use project is often structured as a subdivision of the residential unit of a Master Condominium. As previously stated, this is one of the most efficient ways to separate the residential owners and the administration of their community from the commercial units. This structure is authorized by provisions of the Act previously discussed. In practice, this subdivision is achieved by the filing of a residential sub-unit condominium declaration in the condominium records of the county where the property is located that subdivides the airspace of the residential unit of the Master Condominium and the appurtenant common elements into the required number of individual residential units in the sub-residential condominium. The sub-unit residential condominium will have its own residential condominium association that will administer the business affairs of the sub-unit individual residential units. The sub-unit condominium will have representation on the board of directors of the master association.

Conclusion

Multi-use condominiums are more than just residences. The multi-use project can include any combination of uses of real property. The project can include all the environments of urban existence (live, work, play, living essentials, and entertainment). These types of projects require the lawyer to be more than a scrivener. The lawyer must understand what the developer is creating and assist with a structure that will facilitate the workability of the live, work, and play environments.

If the use-model or governance-model structured by the developer and its lawyers fails, the “New Urbanism” project also may fail. Users must have the necessary legal structure to navigate the often choppy waters that make up a high-density, multi-use environment. The lawyer must have a thorough understanding of the Act, land use regulations, covenants, conditions, and restrictions covering the property, and of the site plan and preliminary plans relating to the project so that a proper structure can be developed.

The above discussion by necessity is a broad summary of the many considerations in the multi-use condominium structure process and does not purport to cover all that will be required to complete the final development plan and its documentation. This summary should give the practitioner a good starting point to working through the many complexities of the process.

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