Hard Times For Real Estate Developers and the Impact on Municipalities
by
Stewart H. Diamond and Julie A. Tappendorf
For almost 25 years, the occasional dips in the construction of new homes or multi-family units have been little more than seasonal aberrations. The price of homes has continued to rise and low-cost mortgages have encouraged the "American Dream" of home ownership. Developers have entered into annexation agreements for 20-year terms assuming that their projects would be successfully completed in 4 or 5 years at the outside. Annexation agreements have required Developers to pay increasing amounts of impact fees to a wide variety of governmental bodies. Even Illinois non-home rule communities began to take advantage of the fact that annexation agreements are not subject to the rather rigid provisions of State law and court interpretation that require impact fees to be "specifically and uniquely attributable" to the specific development. Some Developers have also agreed to construct sewer, water, drainage, and road improvements much larger than those needed by their development, relying on recapture agreements that require future Developers to pay their proportionate share of the costs of the oversized improvements. In this scenario, everything works so long as land values continue to increase and new Developers are there to be "recaptured" from. In an extended economic downturn, however, none of these old rules apply.
In an extreme situation, Developers walk away from their projects leaving half-completed homes, broken sewer systems, un-landscaped drainage basins, unfinished streets, and major intersections without traffic signals. In this situation, a Municipality acquires a whole new set of potential friends and potential adversaries. Sometimes, it is hard to tell the friends from the adversaries. Any list of the players will likely include the following interests: (1) New voting citizens who have moved into homes on lots that have not been landscaped on streets that have not been finally paved and who assume that their temporary certificates of occupancy issued by the Municipality means that it is the community's responsibility to complete all of these improvements. (2) Banks and other financial institutions that have foreclosed on Developers' loans and are unclear about how much additional money they will need to spend as the mortgagees in possession of the abandoned subdivision. (3) The Trustee in Bankruptcy and the Bankruptcy Judge, who sit above the entire process. If the Bankruptcy goes far enough, a new Developer, hopefully with more financial assets, may end up acquiring the land. (4) Finally, there is the financial institution or surety company that has issued an Irrevocable Letter of Credit or a Surety Bond to guarantee the completion and payment of public, and in some cases, private improvements. At each step of the process, the Municipality needs to decide the extent to which it is obligated to place itself among this new cast of characters and whether it will function as a shallow or deep pocket or as an active or passive litigator.
I. Step One: Recognition of a Problem
While this seems to be an obvious first step, oftentimes the Municipality is not among the first players to know there is a problem. Most of us have been made aware of the recent downturn in the market for residential development because this issue is getting widespread news coverage for its impact on Developers and home buyers and sellers. Not much has been reported, however, on the impact that this issue has on Municipalities except for the negative effect a downturn has on property tax revenues. Of course, the earlier the Municipality can be made aware of a problem with a specific development in the Municipality, the better able the Municipality is to analyze its legal obligations and identify its rights and the role it wants to take in the process.
What should the Municipality look for as signs that a particular development is in trouble and may not be completed as approved? One of the earliest signs of trouble is that the Developer has missed deadlines for submission of required plans to the Municipality or to other governing bodies or failed to revise plans in a timely fashion. This could be a sign that the Developer is having financial difficulties and has either failed to pay its consultants or has not directed its consultants to do the work on the plans.
Another sign of trouble is an extended delay in completing all of the site improvements for a development. There is no immediate monetary "reward" to the Developer for constructing and installing site improvements. As a result, the Developer may focus only on those site improvements that are absolutely necessary for the development (such as utilities and roads) and delay putting in those site improvements that the Developer thinks are not "necessary" to the residential development (such as landscaping, signage, lighting, and park improvements) in the hopes that the Municipality may issue one or more building permits to allow the construction of homes, the sale of which will bring in needed cash. If a Municipality is getting pressure from a Developer to issue building permits in advance of completion of all of the site improvements, this could be the first sign of a cash flow issue with the Developer.
If a Developer is selling off portions of a larger development to other developers, that may be a sign that the Developer is in financial trouble or has lost (or failed to get) financing from its lender. A Municipality should pay careful attention to a Developer's requests for approval of a transfer of all or a portion of the Developer's obligations to complete a development, and if a Municipality does approve a transfer of a Developer's obligations for part or all of a particular development, it should ensure that completion of, and security for, the site improvements, both public and private, are adequately addressed in the transfer.
II. Step Two: Analysis of Municipality's Legal Obligations
At the first sign of trouble in a specific development or with a particular Developer, a Municipality should take steps to analyze its own legal obligations, if any, with respect to the development. That should involve a careful review of all of the approval documents (planned unit development or subdivision approval ordinance or annexation agreement) to determine who is responsible for completion of the on-site and off-site improvements for a particular development? In today's "pay your own way" world of real estate development, it is almost always the Developer, and not the Municipality, that is obligated to construct all required improvements for a development. As a result, a well-drafted annexation agreement or Planned Unit Development ordinance will clearly place all of the obligations to construct and complete the development, including all public and private improvements, squarely on the Developer. A good agreement or approval ordinance will also include a plan for phasing for completion of the development, require the Developer to post adequate security with the Municipality, and describe the penalties for failure to comply with the requirements of the ordinance or agreement.
If the agreement or approval ordinance is silent on some or all of these issues, the Municipality's subdivision ordinance may be helpful in sorting out the issue of responsibility. A good subdivision ordinance will clearly state that it is the Developer's responsibility to construct, at its sole cost, all of the improvements that are required for the development, both on-site and off-site. The subdivision ordinance might also include requirements for security and penalties for non-compliance.
III. Step Three: Identification of Municipality's Rights and Role
Even if these documents place all responsibility on the Developer to construct and complete a particular development, they may provide very little comfort to a Municipality when the Developer fails or refuses to complete required improvements, particularly those improvements that will have impacts outside the Developer's property. A much bigger problem occurs if, for example, a Developer has not completed an important part of the Municipality's utility system. Other problems occur where a utility facility, like a lift station, has been constructed but the Developer gave up the ghost before transferring title to the land on which the lift station to the Municipality sits. The same difficulty also occurs, from time-to-time, with regards to municipal parks or other sites agreed, often in an annexation agreement, to be transferred to another governmental body. There, the Bankruptcy Court may order the property to be transferred. That is especially the case if the subsequent purchaser of the land understands that, in order to gain the benefits of the pro-Developer parts of the annexation agreement, the parts of that document not so favorable to the Developer must be adhered to as well. If the land has already been platted with the words "hereby dedicated," it should constitute an irrevocable transfer of the land to the governmental body subject only to its final acceptance. Of course, all of these standard Illinois rules may have a somewhat perilous existence when questioned in a federal bankruptcy proceeding where the judge possesses extraordinary powers.
If a Municipality is inclined to do so, it can use surplus funds to bring the public improvements up to an appropriate standard and perhaps even to make grants or loans to homeowners who find themselves the victim of the Developers' bankruptcy. Such a Municipality might become the subject of a heroic song, but rarely will a community use its funds in this way, especially when there may be other hemorrhaging problems within the corporate boundaries. The Municipality should determine what its legal obligations actually amount to and what role it will take, if any, to address these problems. A Municipality that has not accepted public improvements does not own them, although acceptance can be implied by the Municipality, not otherwise stating its position, which assumes maintenance responsibilities.
If a Municipality wishes to maintain but not accept the improvements it needs to make its intent clear. Obviously, the Municipality's first effort should be to call an Irrevocable Letter of Credit or convince the subdivision surety company to finish the work and pay the contractor. Irrevocable Letters of Credit are generally secure unless the financial institution itself is experiencing difficulties. In some cases, the Municipality has agreed to a prior reduction in the amount of the Irrevocable Letter of Credit so that there may be insufficient money left to complete the work.
In the case of a Surety Bond, another problem may arise. For example, the surety company, which had no difficulty in taking the premium, may become slow in undertaking its contractual responsibility. The only way that surety companies historically stepped forward with vigor is where they believe that less money will need to be spent if the work is done quickly. Obviously, the first step is to read the language of the Surety Bond, although most standard bonds are non-reducible and continue in force until the governmental body has accepted the improvement. In that case, the Municipality, if it wishes to plow snow from the streets for safety purposes, must make it clear that it is not accepting the improvement just by performing routine maintenance. If citizens very actively demand the public body to cause improvements to be completed, the Municipality may wish to consider the creation of a Special Service Area to provide the funds necessary to complete subdivision improvements where a Developer has abandoned the project. Special Assessments can also be used for this purpose.
If a subdivision or an entire planned unit development has a great amount of uncompleted facilities, the Municipality needs to determine whether it is wise to force the completion of all improvements even if it could do so. That is because a subsequent Developer of the land may wish to propose a significantly different site plan and the flexibility of that Developer will be greatly diminished if the Municipality imposes its full legal authority to cause the uncompleted parts of the previously approved and undeveloped subdivision to be entirely constructed. Communities may instead opt for temporary utility improvements such as an adequate, but eventually moveable, storm water detention area. Such an area needs to be established at a level to adequately drain the portions of the development already constructed, but leaving open, perhaps for another day 3 or 5 years in the future, a different design of the final construction.
The Municipality needs to have some role or presence in the Bankruptcy Court because there may be obligations of the Developer in a planned unit development, ordinance, an annexation agreement, or in the general ordinances of the Municipality that the Bankruptcy Court will allow collectible assets to fund. Although the Municipality may be an unsecured creditor regarding certain obligations, the court may recognize the need to use some available funds to secure the higher value of the land not yet developed or to satisfy ordinance violation claims.
The Municipality needs to talk to all of the parties at interest before making a final decision on a specific project. The availability of assets, in particular situations, may dictate an entirely different course of action. A Municipality must always remember that it was not a party to the contract between the home buyer and the Developer. It did not guarantee that the kitchen cabinets would completely fit. Nor does a Municipality typically agree to construct or complete the site improvements if the Developer fails to do so. The problem of the Municipality's intervention in these private disputes is present even in development taking place during good times. It is a process with much more pathos during bad times.
In addition, sometimes the Municipality has the undesirable task of telling homeowners who were granted temporary certificates of occupancy that it has now become their responsibility, with the Developer having defaulted, to complete the improperly-pitched and poured driveway and to install parkway trees. All of these obligations were initially that of the Developer/Builder. Most ordinances, however, pass on the obligation for completion of final subdivision improvements to the homeowner/voter. It is certainly human nature, but homeowners who demand perfection from their Developers often seek to provide less than perfection when they become the party obligated to complete the work.
For those developments that envisioned placing maintenance responsibilities for the subdivision improvements in the hands of a homeowners association, the Municipality may need to inform the homeowners association that it may have to step into the shoes of the Developer earlier than expected. This assumes that the association has already been established - oftentimes that is not the case until a substantial amount of the development is completed and a specific number of homes have been sold. Even if that threshold has not yet been reached, it may be desirable to have the association created earlier than expected, if possible, to ensure that the costs of completing the various improvements left undone by the Developer are more fairly distributed throughout the development. This also has the added advantage of providing a more efficient administration of these matters and a centralized point of contact for the Municipality.
In summary, an extended decline, or in some cases a complete halt, in the sale of houses creates massive problems for Municipalities that enthusiastically approved modern planned unit developments and other residential developments. The situation is made even worse if foreclosures of houses result in abandoned or poorly-maintained private properties. There, the Municipality will need to review, with great care, its property maintenance codes and the manner in which those codes can be enforced against both desperate families and absentee mortgagees. If the Municipality has not enacted a property maintenance code, this may be the time to consider doing so. As to the problems associated with the Developer itself, the Municipality may need to dampen the expectations of homeowners for immediate subdivision completion while making sure that the health and safety of the community is not seriously degraded. This is a time where the elected and appointed officials of Municipalities and their Municipal attorneys may need to dust off the ancient files of the past and combine them with the ingenuity of the present in proceeding at a pace which does not add a bankrupt Municipality to the bankruptcies of the residents and Developers.
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