Avison Young__Section 15 Condominium Deconversions

Avison Young Residential Capital Markets Two sides of the same coin: A look at how investors and home owners should navigate the emerging world of Section 15 condominium deconversions.

James M. Hanson Principal Capital Markets james.hanson@avisonyoung.com | 312.273.4506

Avison Young Residential Capital Markets

Section 15 Condominium Deconversion Overview What is a Section 15 Condominium Deconversion? What are the benefits and pitfalls facing investors and condo unit owners?

Introduction The booming rental market in greater Chicago—which has grown by approximately 72,000 apartment units since the eve of the Great Recession— is now entering a maturing period, where demand remains strong but new construction opportunities are limited by development costs, the scarcity of land sites, community opposition and competition from other buildings.

An emerging trend in Chicago’s housing market—known as a Section 15 Deconversion—is starting to fill the gap, giving developers and investors a creative means for adding apartment supply in a tight rental market. This process of converting older condominium buildings into rental units is also creating opportunities for investors looking to gain entry into some of Chicago’s coveted neighborhoods.

The benefits for condo unit owners are tangible, typically translating to a 25 to 40 percent premium in per unit pricing compared to a typical sale. Because many of these older buildings are facing significant capital issues, the owner may also avoid the financial burden of a special assessment.

The Illinois Condominium Property Act, passed in 1963, allows for this unique investment opportunity, in certain circumstances, but also leaves some issues open for debate. The newness of this approach and the ambiguity in the law has left some condominium boards and investors searching for definition and direction. While there can be significant opportunities, there also are risks and obstacles to overcome.

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Investors Attracted by Shifting Economics Amidst a shifting homeownership landscape, where ownership is declining and renting is increasing, multi-family investors can leverage a deconversion in order to gain entry into some of Chicago’s most desirable rental neighborhoods. Many older high-rise condominiums present an ideal opportunity to overcome the zoning challenges and community opposition that would prevent a new high-rise of similar scale from being built.

Currently, apartment units in Chicago are generally more valuable than individual condominium units of a comparable age and quality. Professional apartment investors can create value by acquiring a condominium building and deconverting the units into apartments in order to take advantage of this anomaly.

Over the past 24 months, there have been more than 20 deconversions announced in Chicago, occurring in several popular city neighborhoods such as Old Town, Lincoln Park, the Gold Coast and various suburbs.

Select Section 15 Sales in the Greater Chicago Area 227 E. Walton Pl.

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Century Tower

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3244 N. Clifton Ave.

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Darlington Court Apts.

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445 W. Wellington Ave.

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Kennelly Square

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4954 N. Ridgeway Ave.

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Spring Hill Apts.

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625 Wrightwood Ave.

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Sunnyside Lane Apts.

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732 Bittersweet Pl.

13 The Flats at Gladstone

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Burton Grove Apts

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The Kent

LAKE’ MICHIGAN

Lake Zurich Highland Park

Algonquin

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294 90

94 90

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7

13 St. Charles

Glendale Heights

Elk Grove Village

290 90

O’Hare International Airport

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294 90

355 90 290 90

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How do the economics work -- when are deconversions feasible for the investor and the home owner?

Due Diligence

What are the potential pitfalls that residents and investors need to consider—and how can they be avoided?

How does a Section 15 deconversion work and what are the restrictions?

home owners are

Evanston

Elgin

Hanover Park

Economics

tangible, typically

Arlington Heights

90

What type of condominium associations are most likely to benefit from deconversion? Which ones should an investor avoid? Which neighborhoods are more suited for deconversions?

The benefits for

Lake Forest

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Market Centric

Legal

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When examining condominium deconversions, it is important to consider these factors:

4 12 6 2 3 14 10 1 8

CHICAGO

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translating to a 25 to 40 percent premium in per unit pricing.

Source: CoStar and Avison Young AVISON YOUNG | RESIDENTIAL CAPITAL MARKETS

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Economics, Rental Shifts Fueling the Deconversion Trend Many market observers wonder why Section 15 transactions have become so popular so quickly. There are a variety of reasons and all are based on fundamental real estate economics. Since the Great Recession, Americans have shown a strong inclination to rent rather than own their homes. The home ownership rate peaked at 69% in 2004. It now hovers around 64%, with the remaining 36% of the population representing approximately 115 million renters in the Unites States. This shift has generated tremendous demand for rental housing and new supply has not been able to keep up. When demand exceeds supply, prices will increase. Thus, the price of rental housing has escalated rapidly in most areas of the country. The sharp increase in rents has resulted in a sharp increase in apartment values as well, and apartments are generally more valuable now than at any time in history.

At the same time, condominium values in Chicago have struggled to recover from the recession according to data prepared by the National Association of REALTORS. The trade association notes that Chicago’s recovery has been the 35th weakest among the 66 major metropolitan areas in terms of year-over-year growth in median sales tracked in the index.

The weakness in values is particularly pronounced for smaller studio and one bedroom units, which have traditionally been owned by more transient owners. Whether a first-time homeowner seeking to grow equity in anticipation of a future upgrade to a larger home or a transitory worker with a short-term ownership horizon, smaller units tended to trade more frequently. In the current housing market, these temporary residents have a strong desire for rental housing, which depresses values in the condominium sector.

Chicago’s recovery has been the 35th weakest among the 66 major metropolitan areas in terms of year-over-year growth.

National Association of REALTORS.

Home Owners Gain Value, Ease of Sale The economics that make the deconversion attractive to investors also make the transaction attractive to condominium unit owners. In order to encourage condominium owners to sell through a deconversion process, the investor shares some of the deconversion value premium with the sellers. Investors in a deconversion often pay more for an individual condominium unit than it is worth on the market as a single condominium unit. While results vary with each completed transaction, the premium value realized by sellers in a deconversion can range from 25% to over 40% of the market value of the unit.

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FOR SALE

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RECENT AVISON YOUNG SECTION 15 DISPOSITIONS & LISTINGS

Kennelly Square 1749 N. Wells Street Chicago, IL

Gallery 1250 1250 N. LaSalle Street Chicago, IL

268 UNITS

196 UNITS

Prime Candidates for Section 15 Sales There are a number of characteristics that make a condominium building a good candidate for a Section 15 deconversion.

Location: As with many real estate investment strategies, location is a key factor. The most attractive deconversion candidates are located in Chicago’s most desirable areas, such as the Gold Coast, Old Town and Lincoln Park.

Density: Another benefit is that many of these buildings are much larger than current zoning would allow, so an investor can accumulate much greater scale through a single deconversion transaction than could be achieved through new construction. Many of these older buildings were constructed when the downtown area was not as densely populated. With fewer neighbors and less congestion, the city was much more willing to grant approvals for large residential buildings. These buildings are now much larger than any of their newer neighbors. The ability for an investor to secure this density without the time, risk and uncertainty of securing zoning approvals for a new building makes the deconversion strategy extremely attractive.

Deferred Maintenance: Another attractive characteristic for a deconversion is significant deferred maintenance. While this may seem counter intuitive, it is actually quite rational from the perspective of both the unit owner and the investor. For condo owners, significant deferred maintenance can mean a large pending special assessment. The special

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assessment can represent a significant percentage of unit value, especially for smaller units which have suffered the greatest value impairment since the recession. Even if the special assessment is a manageable amount, living through the noise, dust and disruption of a major repair project can seriously diminish an owners’ quality of life for the duration of the repair project.

For a professional investor who has the expertise to complete complicated construction projects, the deferred maintenance is generally less of a concern. This is particularly true when the deferred maintenance projects are completed in the context of a larger building renovation targeted at upgrading unit interiors and amenity spaces to meet modern apartment market standards.

Vintage: Many investors are targeting the hundreds of buildings that were originally constructed as apartments in the 1960s and 1970s and were then converted into condominiums in the 1970s and 1980s. Because these buildings were built 40 to 60 years ago, many of the major building systems are reaching the end of their anticipated useful lives. The pending special assessments add to the owners’ rationale for considering a deconversion.

These buildings also tend to be in very attractive locations.

As Chicago has grown and expanded outwards in recent decades, buildings which might have been on the fringe of a neighborhood when they were built are now in the heart of the neighborhood, offering residents attractive access to neighborhood amenities.

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Pitfalls‌and How to Avoid Them There are also potential pitfalls to a Section 15 deconversion that residents and investors should consider. The law is clear in some areas, but murky in others.

Open Process: Ensuring that the deconversion sale process is conducted in a fair and transparent manner is key to ensuring its success. Residents who do not trust in the process are much less likely to vote in favor of the sale.

Equitable Allocation of Proceeds: It is also critical that the proceeds from the Section 15 sale are allocated to individual homeowners in a fair and equitable manner. Real estate professionals and attorneys with experience successfully completing deconversion transactions can assist the homeowners association in completing a fair and transparent process.

They can also assist all homeowners in structuring a sale transaction to achieve a variety of other objectives, such as the potential Homeowner Questions & Concerns highlighted below.

All of these questions and many more can be addressed through the Section 15 deconversion process if they are identified early in the process and planned for.

Engage a Real Estate Professional: Section 15 transactions have grown from an afterthought in a little-read provision of a 55-year-old law to one of the most active areas of real estate investment in only a few short years. Like any new investment strategy, the field is maturing. It began with local real estate entrepreneurs knocking on the doors of friends and neighbors to see if they had an interest in selling. In those early deals, the homeowners were typically not represented by real estate professionals and responded to the unsolicited offer without much negotiation. Due to the lack of competition from other investors, the investor tended to capture the majority of the deconversion value premium for themselves.

The market has now matured to the point where homeowners associations are retaining the services of real estate professionals to prepare detailed offering materials and shopping the buildings to a broad field of potential buyers. By exposing the opportunity to more potential investors, prices and terms are often improved through competition.

In the current phase of the cycle, advisors to homeowners associations are using the entire marketing process to create value for homeowners through the sale. Terms such as price bonuses for speed of execution or level of homeowner participation are common. Favorable leaseback terms for sellers who desire to remain in their unit after the closing are also common. These and other terms result in homeowners capturing a much greater share of the deconversion value premium for themselves through the Section 15 sale process.

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Homeowner Questions & Concerns 1

ow do we structure a H sale to maximize funds going to the unit owners?

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hat if I am underwater W on my mortgage?

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hat if I have rented W my unit to a third-party tenant?

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hat if I want to sell, but I W do not want to move out of my unit?

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hat if I recently W completed a major interior renovation of my unit?

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Investment Outlook As condominium deconversions become more common, larger, institutional investors will begin to identify opportunities and move into the market. To date, most Section 15 investors have been local entrepreneurs who were willing to undertake the risk of a relatively untested Section 15 process. Because the ultimate outcome of the process was unproven, these investors demanded a relatively high return to compensate for the perceived risk.

Now that larger buildings have been successfully deconverted and the process is well-understood, larger investors are seeking to enter the market. By reducing the premium returns demanded for the perceived risk of the transaction, institutional investors will allocate even more of the deconversion value premium to homeowners.

A Section 15 deconversion can provide substantial benefits to

investors and homeowners alike.

The key to a successful transaction for all parties is for knowledgeable real estate professionals to assist the homeowners in conducting a process that secures as much of the deconversion premium as possible for the association, equitably allocates the value to all homeowners, and addresses as many non-economic desires of property owners as possible through the contract terms.

ADDENDUM

Understanding Section 15 Deconversions Section 15 refers to a portion of the Illinois Condominium Property Act (“the Act”) that went into effect in 1963; however, this provision was not regularly utilized until recently. Section 15 lays out the legal process by which a building that is owned as a condominium can be converted into a more traditional fee-simple form of ownership, where a single party owns all of the residential units. A popular term for this process is “deconversion”, which is a reference to past real estate cycles in which apartment buildings owned by a single party were “converted” into condominium ownership and residential units were sold off to individual owners. Section 15 of the Act provides specific rules for the process, but also lacks details, creating an uncertain environment for some associations and investors.

Specific requirements of a deconversion under Section 15 include: 1. The building must have at least 4 units; 2. A t least 75% of the membership interests in the homeowners association must approve the sale; 3. I f the 75% approval threshold is met, all unit owners must participate in the sale of their units; 4. A change in the economic terms of the offer that occurs after the vote has been completed may require that the association have a new vote to approve the new terms; 5. Section 15 provisions can require protection for individual unit owners where the proposed purchase price is less than the amount of any bona fide debt of said owner.

As noted, there are aspects of a deconversion for which Section 15 does not provide any specific regulation. These are areas where real estate attorneys and other real estate professionals can guide a homeowners association through the successful completion of a transaction: 1. What is the specific process for holding a Section 15 vote?

2. What is the duration of the vote and what are the important notice provisions?

3. H ow much information must be shared with owners in order for owners to make an informed decision?

4. H ow is the purchase offer to be structured?

5. H ow are the proceeds from the sale to be distributed to the individual condominium owners?

A recent uptick in deconversion projects in Chicago has led to the development of best practices addressing many of these gray areas.

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Kennelly Square

1749 N. Wells Street, Chicago, IL

About the Author James Hanson joined Avison Young’s Chicago office in 2014 as a Senior Capital Markets and Structured Finance Executive. He brings 28 years of Capital Markets experience to Avison Young, including over $5 billion of closed investment sale, financing, sale-leaseback, development capitalization and strategic advisory assignments.

James M. Hanson Principal Capital Markets james.hanson@avisonyoung.com 312.273.4506 One South Wacker, Suite 3000 Chicago, Illinois

Jim began his career at Jones Lang LaSalle, where he completed his tenure as a Managing Director in the Capital Markets Group. Based in the firm’s Chicago headquarters, he oversaw all Capital Markets Group activities in the Central Region of the US. These activities included asset dispositions and financings, structured corporate finance transactions and other financial advisory assignments on behalf of clients that included domestic and foreign corporations, developers, REITs, real estate fund operators and institutions.

After leaving JLL, Jim was a principal at Chicago-based real estate developer Mesa Development. At Mesa, Jim was responsible for all capital structuring activities related to almost $1 billion of urban, mixed-use, residential development completed during his tenure. Jim identified and structured approximately $700 million of senior construction financing, $125 million of mezzanine financing and $80 million of institutional co-investment equity capital.

Jim’s extensive real estate experience, including deep relationships with capital sources representing the full spectrum of the capital stack, allows him to provide valuable insights into the execution of transactions for clients of Avison Young.

Certain legal information in this document was provided by Jeff Richman of Bancroft, Richman & Goldberg, LLC | 312.252.4380

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E. & O.E.: The information contained herein was obtained from sources which we deem reliable and, while thought to be correct, is not guaranteed by Avison Young - Chicago, LLC.