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How developers should exit real estate projects

By Amrit Soar and Maureen Nyakinyua

The real estate sector has been the key to creation of wealth for some of the world’s tycoons. It  therefore comes as no surprise that Kenya too has been, more so in the last decade, experiencing massive investment in real estate developments due to the sector’s perceived high return. Kenya is also estimated to have an annual housing deficit of approximately 2 million residential houses, which arguably makes a case for the large-scale residential developments as a lucrative sector for investors looking for high returns. However, like any other good investment, careful planning of a developer’s exit in such developments is essential to navigate the significant legal and management issues that could potentially dilute a developer’s return, more so, in large scale and phased residential developments.

The core aim of most development projects (especially those that are ear-marked for sale), is to maximize returns on capital through a clean and quick exit. However, for most developers, the reality is that there is usually a mismatch between the project completion and sale of all the units in the development. As a result of this mismatch, developers are usually ‘forced’ to retain ownership of the common areas and control of management of the development until the last unit is sold. At this point, the homeowners are not involved in the decision making on how service charge is levied or utilised and the general management of the estate.

As a result, mismanagement of service charge and poor management of developments in the hands of developers has become a major source of friction between developers and homeowners, especially in large scale developments, and developers are slowly being held more responsible for violations of their obligations to homeowners.

This practice by developers of maintaining control of the management of a development is expected to change once the new Sectional Properties Act, 2020 (Act) gains full traction. Where  a development is not exempt from the Act,  a developer  is required to appoint a board of the Corporation within 90 days from the date 50% of the units are sold or within 180 days from the date the first unit is sold, whichever happens earlier. However, before the tide fully shifts in favour of homeowners taking responsibility of the property owners management company (MC), a developer should take it upon themselves to ensure that they are ready to handover when that day finally comes. How then can a developer prepare for such a handover when they are ready to exit a development and mitigate against liability?

Whilst the list of considerations that a developer should take into account are as diverse as the types of developments, there are a number of key considerations, both governance and operational structures that a developer should put in place while preparing to handover a development to the homeowners .

As a starting point, the developer should formally create the MC and become the "initial board" of the MC. At this point, the developer will be playing a dual role of first, operating the MC and second, developing and marketing of the project. This dual role creates a conflict of interest considering that the developer bears all the associated responsibility and potential liability of a director of the MC for acts done or omitted to be done while operating the MC. It is therefore advisable, from the onset, that a developer creates a clear separation of roles by ensuring that all contracts with third parties relating to management of the development are entered into by the MC, not the developer and preferably, all operations are done by a third party property management company, with the oversight of the developer.

It is also expected that once the last unit within the development is sold, the developer should handover the management of the MC to the homeowners.

Often the separate homeowners will own their individual units and manage the common areas (such as gardens, lifts, clubhouses, lifts etc) jointly through the MC. The first step, if a developer has not already done so, and with the help of its lawyer, should be onboarding all the homeowners as member of the MC either by transfer or allotment of shares. The next natural step once the homeowners become members of the MC is to form a unit-owners controlled board of directors, which would take over the management duties from the developer.

On the other hand, the new homeowner controlled board, should, before taking over its duties in the MC, independently or through its lawyer retain the services of an independent auditor to review the books and records of the MC while it was in the control of the developer. This would assure the new home-owners board that the developer acted properly while they were in control of the MC.

It is also expected that for proper operation of a development, each homeowner within a development is required to pay service charge, which is utilised to fund the running of the MC and maintenance of the common areas. As the party in charge of the MC before exiting a development, the developer plays the role of the MC. In that case, the developer performs the duties of the MC such as collection of service charge; accounting for service charge paid and utilised;  procuring annual service charge audit and maintenance of the common areas. To achieve proper accountability and avoid service charge related disputes, segregation of service charge funds from the developer’s other funds is a crucial step in preparation of the handover by a developer.

During handover, the developer is expected to account for service charge paid and transfer any unspent and advance service charge to the homeowners. The reconciliation can be complex especially for large developments and a developer should therefore ensure that the MC’s service charge and service charge deposit bank accounts are set up from the onset to ensure segregation of service charge and service charge deposit from the purchase price and other costs that are paid by the property owners to the developer. A developer-controlled board, as any other board, owes a fiduciary duty to homeowners and developer’s liability can arise from actions taken in the pre-closing or post-closing periods.

A skilled and professional managing agent can be very instrumental in ensuring that the developer achieves a smooth handover since they also act as agents of the developer and custodian of all records of all transactions and contracts entered  by the MC. These records form part of the documents that are handed over to the homeowners board of the MC.

A developer should, from the onset consider engaging a property managing agent who can subcontract the provision of services to one or more third party service providers on the developer’s behalf. The managing agent should be contractually engaged, and their  duties should mirror the obligations of the management company either as provided in law under the Sectional Properties Act or the lease between the developer and the homeowners to ensure that the developer is meeting all its ‘management company’ duties as promised to homeowners.

A professional managing agent should be able to support the developer in service charge collection and accounting; service charge budgeting and annual audit; record keeping; and common area maintenance and repairs. Managing agents owe a duty of care in contract to the developer to act with a degree of skill and care expected of a reasonably competent managing agent.

It is also advisable and where applicable,  a developer should have foresight by ensuring that covenants and obligations of the homeowners to contribute a defined amount to the sinking fund either annually or quarterly, are clearly stipulated in their agreements at the contractual phase of the development. The money in the sinking fund should be distinguishable from advance payment of service charge on account of actual anticipated annual expenditure and the contributions to the sinking fund should be ring-fenced and should be immediately paid into the sinking fund when payment is made. The sinking fund is a like an insurance policy for homeowners within a development with communal assets and it would support future capital expenditure within a development such as major structural repairs, redecoration, and replacement of expensive shared assets. The sinking fund helps homeowners preserve the value of their homes and their communally held assets even many years after the developer has exited the development.

In conclusion, over and above the measures highlighted,  developers should consider taking out an adequate directors and officers liability insurance cover to hedge against any director or officer liability that may be brought against them for acts done or omitted to be done during their tenor as directors and officers of the MC.  It is also important to note  that not all developers are failing to act in the best interest of the homeowners, and some do appreciate that they have a fiduciary obligation to the homeowners to act in good faith. To have a viable project, developers need to engage, educate, and respond to homeowners concerns regarding the handover process. This could potentially save the developer not only from legal disputes but also from reputational risk.

The article was featured in the Business Daily on 28 June 2022 and can be accessed here.