CHAPTER 5.03. Types of Collateral

• Jurisdiction: United States

5.03. Types of Collateral

[1] General

A mortgage will create a lien only on the real property collateral identified in the mortgage.⁵⁸ Certainly the scope of that identified collateral may change over time, such as fixtures becoming part of the real property or by accretions to riparian real property.⁵⁹ Likewise, growing crops are included in title to real property.⁶⁰

[2] Condominiums

At times, the collateral for a commercial loan is condominium property. This collateral can take the form of existing condominium units, land being developed for a condominium community, or portions of an incomplete condominium project. In Delaware, condominiums are created and governed pursuant to the Unit Property Act,⁶¹ the Delaware Uniform Common Interest Ownership Act (DUCIOA),⁶² or both. DUCIOA applies, with a few exceptions, to all common interest communities (which includes condominiums), including those common interest communities in existence when DUCIOA was enacted.⁶³ Most of DUCIOA does not apply to commercial condominiums; if a commercial condominium unit or project is collateral, most aspects of the condominium will be governed by the Unit Property Act unless the declaration establishing the condominium has opted to be wholly or partially subject to DUCIOA.

[a] Units

A condominium unit constitutes an interest in real property and is therefore mortgageable.⁶⁴ A condominium project consists of two types of property—units and common elements.⁶⁵ Any common elements are appurtenant to units and not independently owned or transferable by unit owners.⁶⁶ There can also be portions of the project referred to as limited common elements, which are those common elements appurtenant to one or more but not all of the units; however, the Unit Property Act does not refer to limited common elements, and they are governed by contract (i.e., the condominium declaration) except to the extent the statutory provisions of the Unit Property Act governing all common elements apply.⁶⁷ DUCIOA has now given statutory authority for the existence of limited common elements.⁶⁸

Generally speaking then, any portion of a condominium community is either a unit or a common element (or its subset, a limited common element). There is nothing else. For example, a stormwater easement benefiting the condominium community is a common element in which each unit has its respective percentage interest. Likewise, until a unit exists, which means that the relevant improvements have been completed (and in some jurisdictions in Delaware, a certificate of occupancy issued), those improvements do not constitute an independently transferable or mortgageable real property interest.⁶⁹

[b] Land

In a construction loan for the development of a condominium community, the collateral generally starts off as the land on which the community is to be developed. At this juncture, the questions to be considered are no different than those for a construction loan for the development of a fee simple community. Just as with a fee simple community as collateral, the lender will be lending to the borrower for it to improve the land with infrastructure, buildings, and other improvements. These improvements are intended to increase the value of the collateral commensurate with the loan funds that are advanced for that purpose. As the borrower completes construction of condominium residences, for example, the expectation of the parties is that the borrower will sell those residences to homebuyers, thereby generating revenue to pay down the loan through the release fees paid to the lender for each residence sold. This is functionally the same as the process in a fee simple community where the borrower sells land lots with completed residences and the sale proceeds are used to pay down the construction loan. The only difference is that what is sold, and thereby released from the mortgage, in a condominium community is not the separately subdivided lot of land and the improvements on it, but rather a unit and that unit's percentage interest in common elements, which are owned proportionally by all unit owners—both the developer and third-party home owners. What that unit and common elements consist of is established not by the common law, as in a fee simple community, but by statute and contract.⁷⁰ Because so many of the rights and interests in a condominium community are created by contract, through the declaration that creates the community, it is critical that the mortgage be subordinate to that declaration either by recording the declaration prior to recording the mortgage or by the lender subordinating its mortgage to the earlier declaration by a separate subordination contract. Absent this subordination, a foreclosure of the construction mortgage would extinguish the declaration with respect to all of the collateral other than units previously released from the mortgage,⁷¹ which could be catastrophic for the community and leave the now unencumbered, foreclosed land possibly undevelopable under land use regulations (e.g., setbacks relative to existing improvements) or title defects (e.g., whether the residual land has rights to use streets and utilities infrastructure developed in the condominium portion) and therefore possibly unmarketable.

[c] Incomplete Project

As discussed above, a condominium consists exclusively of units and common elements. Accordingly, the issues that arise when financing an incomplete project (that is, where not all of the potential units have been completed and sold) relate to the nature of the borrower's interests. For example, if a condominium community was originally planned for 100 residential units but only 50 were completed and sold to homebuyers before a foreclosure of the construction mortgage, what is the foreclosed property purchased at that foreclosure? It is not 50 lots of land, because the land has not been subdivided into separate lots of land. Nor is it 50 units, as those additional 50 units were never built and therefore do not exist as a matter of law.⁷² While the answer to this question will be largely dictated by the governing documents that created the condominium and the applicable statutory basis for that condominium (either the Unit Property Act or DUCIOA), the answer will usually be some variation of the following. The purchaser at the foreclosure acquires title to the land and improvements that exist, subject to the interests of the existing unit owners in their units and the common elements—both those existing at the time of the foreclosure and those existing thereafter that a unit owner would have an interest in under the governing documents and the statutes. But what does this really mean? Certainly, the purchaser is the owner of the real property foreclosed on, but what rights does the new owner have to use that property?

There are two sets of issues. First, one must consider how the governing documents for the condominium continue to apply to this real property. If the real property is subject to the declaration creating the condominium, and as all real property in a condominium is either a unit or common elements, this remaining real property must be one or the other. If undeveloped, it cannot be a unit;⁷³ therefore it is a common element, owned by the existing unit owners as appurtenant to their units to the extent of their respective percentage interests in the common elements. Accordingly, the new owner, who does not own a unit, may not have an interest at all and may not be able to do anything with that real property.

On the other hand, some declarations do not subject the entire project to the condominium but add separate portions of the project to the condominium from time to time, leaving other portions of the project free of the condominium. Moreover, some declarations take the approach of subjecting the entire project to the declaration but excepting out those portions that are intended to become units or possibly common elements in the future.⁷⁴ Either of these approaches to a so-called expandable con-dominium⁷⁵ results in the possibility that the foreclosed collateral could include real property interests that are part of the condominium and real property interests that are free of the condominium. In that case, and depending on the governing documents, the new owner may be free to develop the land independently of the condominium previously established, though such development would remain subject to applicable land use regulations and approvals and potential liabilities to the established condominium community.

For example, in Bethany Marine Townhouse Phase II Condominium Inc. v. BMIG, LLC,⁷⁶ the Delaware Supreme Court held, in ruling on a summary judgment motion, that the developer retained the right to construct improvements, free of the condominium declaration, on lands designated for future units. The developer in this case had purchased all of the original developer's rights to the condominium project and to lands not yet submitted to the condominium. Unfortunately, the court did not have to address the many other issues associated with those unannexed lands, so there are more questions than answers. For example, how would a court address claims of existing unit owners based on an expectation of the inclusion in their condominium of these additional units (which would mean a potentially lower percentage obligation for each unit owner for common assessments).⁷⁷ And while the court dismisses the concern that the residual lands are not legally subdivided parcels, the court's finding that the condominium plan shows the location of these properties does not provide certainty for future development of these lands. Without title subdivision for these residual lands, any units will likely violate setback and other zoning requirements and might therefore be unusable. Accordingly, the developer will presumably establish a new condominium for the residual property. However, these residual lands only exist by virtue of...