New FHA Rules Doom Condo Values
By Peter G. Miller

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.

Pricing Impact
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."

Marketplace Demand
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.