LET S MIX IT UP: What you need to know to understand and evaluate mixed use projects.

LET S MIX IT UP: What you need to know to understand and evaluate mixed use projects. By Nancy T. Scull and Cathy L. Croshaw Luce Forward Hamilton & Scripps LLP League of California Cities Conference September 24 through 27, 2008 2008 Nancy T. Scull, Esq., Cathy L. Croshaw, Esq. 301045361.2 1

LET S MIX IT UP: What you need to know to understand and evaluate mixed use projects. Mapping Alternatives As more and more projects move toward higher density and more efficient land use, mixed use projects are becoming both more common and more complicated. Developers are now often combining a wider variety of commercial uses with residential uses, yet attempting to preserve the rights of each owner. Over time, new mapping alternatives are being developed which allow greater legal separation between the commercial and residential portions of mixed use projects. In some cases, it may be desirable to separate the residential, retail, office and hospitality portions of a project and in other situations, these components of a project may be interwoven. Instill other scenarios, it may make sense to separate the parking from other aspects of the project. Some of the alternatives available to developers and public agencies to accomplish these objectives are the creation of different airspace condominiums for different components of a project or the creation of vertical parcels. Challenge 1: How To Subdivide a Mixed Use Building to Separate Out Ownership Interests? In California, the California Subdivision Map Act limits the options for subdividing a mixed use project within a single building. A developer is limited to either creating vertical parcels or subdividing the entire building through a condominium structure, which may include the creation of separate commercial and residential modules. Public agencies may be more familiar with the traditional method of subdividing the building through condominiums. However, in many instances the option of whether to subdivide through a condominium structure or vertical parcels is driven by the lender or by the developer s need for flexibility to separately convey individual interests and/or to give control to either the commercial or residential owners within the project. Creation of vertical parcels may allow the developer to tailor the management and governance structure of the project in a manner which better suits the specific requirements of the project. Alternative 1: Subdividing Through Vertical Parcels. Many of the complex mixed use buildings that have been developed within the past 15 years in California have been subdivided through vertical air space parcels. A vertical air space parcel is a three dimensional legal lot. The air space parcels can be complex or simple. For example, in a building with a hotel and residential condominiums, a developer might subdivide the building into two vertical parcels. In other buildings, vertical parcels can be created for various floors, to create parcels that may be ultimately owned by a public agency, or to segregate each divergent ownership interest. The following is a sample of a complex vertical parcel map creating multiple legal parcels in a single city block: 301045361.2 2

301045361.2 3 Sample Vertical Airspace Parcel Map

Why does a developer use a vertical parcel map? In many complex projects where the value of the various components of the building (i.e., a hotel component or major retail or office) are substantial, it may be easier for the developer to obtain financing and/or market the commercial ownership interests as separate legal lots. If vertical parcels are not used, the only other alternative is a condominium and an institutional lender lending hundreds of millions of dollars on a component of a building or a purchaser of the commercial interest may feel that the value of the investment is enhanced by having a vertical airspace parcel rather than a condominium. Vertical airspace parcels also can serve to create a greater level of separation between the residential owners and the commercial owners and, in certain limited circumstances, may eliminate the necessity for the creation of an association. Often, building codes do not contemplate the use of vertical parcels. Accordingly, public agencies should anticipate that this form of subdivision may not fit within the existing building codes. For example, setback requirements relating to where lot lines are drawn may not be appropriate in the context of vertical airspace maps. In these situations, the agencies may need to create a separate set of rules or policies applicable to vertical parcels. Alterative 2: Creation of Condominiums If vertical airspace parcels are not created for a mixed use building, then a developer must subdivide through the creation of condominiums. A condominium consists of two separate interests: a separate interest which is typically the airspace in the unit and an undivided interest which can be an undivided interest in the balance of the building, a module or even a cloud. There are several options for the creation of a condominium structure. First is a classic condominium where each owner owns its airspace and all of the owners share an undivided interest either in the building structure or in a cloud above. Under California Government Code Section 66427, a developer can use modules on a condominium plan which separate the various interests in the building. Modules are used to separate the residential components of the building from the commercial components of the building, the residential owners own their residential unit and an undivided interest in their residential module and the commercial owners own their commercial unit(s) and an undivided interest in the commercial module. Alternatively, under either a classic condominium structure or a modular condominium structure, the building (except for the units) can be conveyed to an association and the undivided interest can be a cloud in the sky or even multiple clouds (i.e., a commercial common area cloud and a residential common area cloud). Subdividing through condominiums does have some advantages. Typically, building codes were designed with this structure in mind. The use of condominiums therefore prevents conflicts with existing building codes and results in a more expedited review for the governmental agencies. The map for a condominium structure would typically be a one lot map authorizing the creation of a maximum number of condominiums. The public agency would not be reviewing the same level of detail for mapping as it would for the creation of vertical airspace parcels. On the other hand, condominiums by definition mean that an owner owns a separate interest which is a unit and an undivided interest which is common area. This common area requirement may bring commercial and residential owners in closer contact either legally or figuratively than might otherwise be desired by a commercial owner. 301045361.2 4

Department of Real Estate Processing The Basics Most mixed use projects will be within the jurisdiction of the Department of Real Estate ( DRE ). The DRE has jurisdiction over the sale of five or more subdivision interests, including all residential condominium projects. The DRE does not regulate condominiums which are exclusively commercial, but is involved in any mixed use project containing a residential component. The DRE is a consumer protection agency which regulates the sales of common interest and other projects to residential buyers. Preparation of the initial submittal to the DRE is a substantial undertaking which includes a variety of legal documents, such as the purchase agreement form, CC&Rs, Bylaws, Articles, sample deeds, the condominium plan, in addition to an approved tentative map, a lengthy questionnaire, current title report, evidence of availability of utilities and services to the subdivision, and other documents. If the file is incomplete, it will not be reviewed and DRE will return it to the subdivision processor for completion. When a file is submitted to the DRE, it undergoes two types of review; budget review and legal department review. The entire process normally takes three months to a year or more, and runs concurrently with the city approval process. When a developer is about to obtain a tentative map, it will need to start along a separate track to begin processing the project with the DRE. In order to obtain final approval from the DRE to close escrow, the final map must be recorded. However, the developer may obtain conditional approval to allow the developer to begin sales by the time they have commenced construction or, in some cases, sooner. The conditional approval is given on the basis of the tentative map. The developer s timing in obtaining conditional DRE approval is driven by their target date to begin signing contracts. The target date may be 3 years in advance of completion of construction, just prior to commencement of construction, close to completion of construction, or any time in between, depending upon the developer and often, the lender. The following chart illustrates the different types of public reports issued by the DRE and how they relate to the timing of the entitlement process. Preliminary Public Report (Pink Report) Optional > Developer must have submitted an application for a tentative map or otherwise demonstrated that it has a strong likelihood that it will proceed with the Project. > Generally, approval may be obtained within 2 weeks after application. > Valid for one year. Can be renewed. Conditional Public Report (Yellow Report) Optional > Developer must demonstrate that it owns or controls the property. > Developer must have filed its application for a final map, but does not need to have an approved final map. > Approval may be obtained within 2 months after application > Valid for six months, with one six-month extension or 30 months, with one six-month extension (for 25 or more attached condos). > Developer may advertise the project. > Accept reservations. > Developer may enter into binding purchase agreements. 301045361.2 5

Final Public Report (White Report) Required > Developer must have legal right to convey the property to consumer > Final map must have recorded > DRE must have approved the final documents > CC&Rs and condominium plan must have recorded > Approval may be obtained within 4-6 months after application > Valid for five years, with one extension of up to five additional years. > Developer may enter into binding purchase agreements. > Close sales. Although the DRE process and the entitlement process run along separate tracks, they are not entirely independent. What are the basic timing constraints that a developer faces in the DRE process and how does that impact what is going on with the city? First, the DRE relies upon the issuance of the tentative map as evidence that the project is likely to proceed. In the conditions of approval, the city will often have input as to certain provisions which it will require in the governing documents. So, until the tentative map is issued and any requirements set forth in the conditions of approval can be incorporated into the governing documents, the developer will not be in a position to proceed with its submittal to the DRE. The issuance of the final map is required in order to obtain the final public report from the DRE. From the recordation of the final map, it will normally take approximately one to two weeks to obtain the final report from the DRE, which is required in order to close any escrows. Some cities require that the governing documents or at least the CC&Rs be submitted to the City for approval. The best time for this submittal to the city is usually going to be about the same time as the initial submittal to the DRE. The developer will need to have the city s comments and any final changes by the city before it reaches the final document stage. Ideally, the developer will have these comments before it is required to respond to the DRE s comments on its initial submittal, which will in most cases be two to three months after the initial submittal to the DRE for a conditional or final public report. If the developer is addressing the city s comments after it has revised its documents based upon the DRE comments and resubmitted the documents to the DRE, it will also be required to submit any further revisions which result from the city review to the DRE. Thus, if the city s comments can be addressed concurrently with those of the DRE, a second revision may be avoided. Fortunately, the city will usually have a different focus on the provisions contained in the documents so that the requirements of the city and the DRE do not often conflict. The city will ordinarily be looking at issues which affect planning, land values and long term property maintenance. The focus of the DRE is on buyer protection. The timing of the city s comments regarding the governing documents may also be critical to a project for another reason. Once the developer has obtained a conditional public report from the DRE, it will normally go to sale on the basis of the governing documents in existence at the time the conditional public report is issued. The contracts that are entered into under a conditional public report are binding unless there is a material change in any aspect of the offering when the final public report is issued. DRE regulations and policies only define what constitutes a material change in a very few specific instances. Otherwise, whether or not a material change has occurred may be the subject of debate between the developer and the buyer, particularly in a down market. To the extent that the city requires a change in the CC&Rs or other governing document after the conditional public report is issued, and that change is arguably material to a buyer, the consequence 301045361.2 6

may be the loss of some or all of the contracts which have been entered into under the conditional public report. CC&R Requirements in Conditions of Approval On a related note, there are some conditions of approval that work well to accomplish the City s objectives when required in the CC&Rs and others that can cause confusion for buyers. The single most significant characteristic to keep in mind when imposing a requirement that specific provisions be contained in the CC&Rs is that this is a document intended to last for decades. Therefore if the City s concern is for proper maintenance, it will be preferable to require maintenance in accordance with industry standards, rather than to specify the action that must be taken to maintain. Maintenance standards, technology or practices may change. A typical condition is that the documents require drought tolerant landscaping. To add definition to this concept, the documents can incorporate by reference a City landscaping plan, so that the plan itself may be subject to change over the years, but the requirement that it be followed is set in place. Another effective condition is for the City to include itself as a third party beneficiary to the CC&Rs and include a provision that requires approval by the City prior to any amendment of those conditions specifically required by the City to be included in the CC&Rs. In the particular context of mixed use development, the City may desire to prohibit certain types of uses at a project or to require that portions of a project be used in a certain manner. Zoning may address this generally, but on a project by project basis, the City may feel that additional specificity is beneficial. Again, the restrictions need to stand the test of time, so if specific uses are listed, consider whether to add a catchall phrase, such as or any other business which generates outside noise in excess of x decibels which will apply regardless of the specific nature of the uses. Parking restrictions are usually a concern as well. The developer will not only be working within any parking ratios established by the City, but will need to maintain the flexibility to sell to different types of businesses with different parking needs. As cities take more measures to encourage the use of public transportation, parking ratios may change. For that reason, the City will usually be serving its own and the developer s interests by steering away from requiring the current quotas or ratios to be listed in the CC&Rs. As with other issues, either 1) a reference to outside documentation of parking requirements or restrictions which will be adapting to changing circumstances over the years or 2) language which has the flexibility to adapt to change is advised. Finally, it is always helpful for cities to phrase conditions of approval which set forth requirements for governing documents in a narrative or general fashion so that the requirements can be adapted to the structure and definitions of the particular governing documents. References to common area for example could conflict with a defined term for Common Area and create confusion among buyers or the Association. References to a condominium may seem straightforward in the context of residential condominiums but may not be clear when applied to commercial condominiums which were set up as grids, rather than units of specified dimensions. Especially for mixed use projects, a simple reference to the Association may create ambiguity in the context of a complex structure of governance which may have a master and sub-associations or separate residential and commercial associations. Because of the constant changes in the law, and in approaches to the creation of condominiums and other mixed use projects, it is almost always preferable for a City to specify in a narrative what it wants to accomplish by required language in CC&Rs, so that the language can be 301045361.2 7

adapted to suit the particular documents than it is to dictate language verbatim. For the same reason, it may be preferable to include as a condition of approval that the CC&Rs be subject to approval by the City Attorney so that these drafting concerns can be addressed by the City Attorney rather than through strict language contained in the conditions of approval. Conclusion Concepts regarding the mapping, governance structure and content of the governing documents for mixed use projects are in a state of constant evolution. Developers routinely receive feedback from property managers, buyers, attorneys, budget preparers, city planners, engineers, architects and others regarding the elements of a project that work well together and the elements that clash. The final product of governing documents, maps, condominium plans and the physical project represent the culmination of a team effort that starts with the planning efforts of the developers in coordination with the City. In order that each mixed use project maximize the benefits to the owners and the City in which it is located, the development process requires flexibility, coordination and timing. 301045361.2 8