FEATURE ARTICLE, APRIL 2006

COMMERCIAL CONDOMINIUMS ON THE RISE IN CHICAGO
The development of commercial condominium properties in Chicago has increased significantly in recent years.
Michael Tuchman and Mark Pearlstein

The last several years have seen a proliferation of commercial condominiums in the Chicago real estate market. While composed mainly of office building projects, the market is marked by a few retail condo properties that have filled in what is a relatively new trend in Chicago. One may attribute the trend to low interest rates for acquisition finance making owner-occupied space economically attractive as well as the continuing exuberance — rational or not — in the real estate markets.

While it is said that a company can best use its capital by growing its business rather than by investing in its facility, owners of many middle market companies can point to a strong record of accumulating wealth through company-owned real estate.

The following information touches on a few notable differences between the development of and investment in commercial condominiums and residential condominiums, discussing matters of interest to users, investors, developers and lenders.

Users

Purchasing a commercial condominium may appear to be a less momentous undertaking for the user than purchasing a freestanding building, but structuring considerations are similar and it is a rare circumstance in which the company that conducts the business should also own the real estate. Ownership by the operating company exposes the equity in the property to the claims of business creditors, something that is generally unnecessary.

The most prudent owner-user of a commercial condominium will own its unit through a separate limited liability company owned by the shareholders of the operating company. Ownership of real estate through a corporation is generally disadvantageous from an income tax perspective. In addition to the creditor protection benefits mentioned above, a limited liability holding company can facilitate good estate planning.

Users who are certain types of not-for-profit entities may realize significant reductions in occupancy costs by avoiding all or a portion of real estate taxes on commercial condominiums that they own and use. These exemptions generally cannot be captured by landlords and therefore cannot be passed through to exempt users.

Investors

The tax considerations for those purchasing commercial condominiums for investment rather than for their own use are not significantly different from those for freestanding properties, but a number of business issues are compelling. For example, investment returns will be impacted by the cost of repairs and maintenance that are assessed by the condominium association; returns are thus subject to the vagaries of collective management rather than individual prerogative. While less of a concern in the commercial context, associations do have the legal right to impose leasing restrictions, and they can prohibit leasing altogether. Finally, associations may restrict permitted uses beyond the restrictions contained in local zoning ordinances. An investor in a commercial condominium must understand that his or her market prerogatives may not be as broad as those of an owner of a freestanding building.

Financing for Users and Investors

While a commercial mortgage lender should be able to underwrite a commercial condominium as well as a freestanding building or a residential condominium unit, the commercial condominium market has not grown large enough for the development of settled underwriting criteria. Some lenders may be inclined to establish slightly higher rates, shorter terms and/or shorter amortization periods. While the ability of a lender to realize upon the mortgaged commercial condominium should not viewed as much different from a residential condominium unit, the relatively small size of the commercial condominium market in Chicago coupled with transfer, use and leasing restrictions may make the typical lender somewhat more cautious when approaching this asset class.

Development Financing

Development finance, whether for new construction or conversion, is likewise generally available, but once again there are fewer lenders and lending programs, with the result that some lenders feel compelled to offer less advantageous loan terms. The need for separate underwriting criteria for a commercial condominium seems reasonable enough, but for some lenders it has not gone much beyond noting that the asset class is different and riskier. Some lenders put themselves at competitive disadvantage by not working with local real estate professionals and counsel to help them measure and price the risk. There is plenty for both borrower and lender to think about. An experienced developer of office buildings may not be attuned to thinking about the need to negotiate release prices with the lender, especially for a project that may sell out over several years, producing taxable income long before cash profits are realized. Where the developer intends to bifurcate the project into development (ordinary income) and investment/rental (capital gain) components, the lender will need an appreciation for the complexity that is required to achieve a tax-optimal structure.

Developers — Tax and Creditor Protection Planning

Developing a commercial condominium project is, in many respects, similar to developing a residential condominium project. From a tax standpoint, ordinary income on development profits is the general rule. In the typical development structure, the opportunity for realizing capital gain may be limited. But with some planning, the developer of a commercial condominium project can realize capital gain rather than ordinary income on those components of the project that may be leased before they are sold. Indeed units may be offered on a lease-to-own basis, providing still further opportunity for what could be a more than 50 percent reduction in the effective rate of tax on profits.

Where the developer holds a substantial portion of the project for rental use, interesting structuring options are available. Separate entities can be used to own the for-sale units independent of the investment/rental units. Not only can this result in meaningful income tax savings, it will help insulate equity in the leased components of a developer’s project from the claims of unit purchasers and the condominium association.

Also consider the increasingly prevalent mixed-use building with ground-floor retail units and either commercial office or residential space above. The ground-floor retail offers the opportunity for long-term investment gains if held for rental. It would generally be wise for any separate retail component to be owned separately, not to be dedicated to the condominium and to subsist as a separate legal estate under reciprocal easement agreements. Here again, there is opportunity for smart tax and creditor protection planning.

In a residential setting, the developer’s ability to retain amenities and charge users is limited. But the enterprising commercial condominium developer may be able to create additional sources of cash flow by retaining amenities — such as a cafeteria, a health club, parking structures and telecommunications facilities — through vertical subdivisions of the property. While such retained interests would be unusual in a residential setting, they may not adversely impact marketing in a commercial setting.

Municipal and State Law Issues

Municipalities in the Chicago area with condominium conversion ordinances do not have explicit provisions for commercial condominiums or restrict their application to residential properties. Questions of disclosure, rights of refusal, notices to existing tenants (in the case of conversions) and similar issues are left to the discretion of the developer. The Illinois Condominium Property Act was written with residential projects in mind, but does exempt commercial condominiums from detailed insurance requirements. Good counsel is needed to balance compliance with pragmatism through careful drafting.

In some municipalities officials may struggle with how to interpret land use rules for a commercial condominium. Commercial condominium space that may work adequately for a company headquarters office or an accounting firm may not work for a physicians group under the local zoning ordinance. Does the developer have an affirmative obligation to vet the prospective use? Perhaps not. But does this potential problem suggest that the developer’s disclosure to prospective purchasers should be heavier on the detail? Probably.

The intersection between commercial property, condominium development and the litany of tax laws and condominium law rules is indeed an interesting place, but a place in which the Chicago market increasingly sees room for profit. As with any real estate matter, a modicum of planning will go a long way towards mitigating some of the business risks of this unique segment of the Chicago real estate market.

Michael Tuchman and Mark Pearlstein are partners in the Chicago law firm of Levenfeld Pearlstein LLC. Tuchman concentrates his practice in transactional structuring and taxation for real estate investors and developers. Pearlstein focuses on condominium law, representing both developers and associations.

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