Unlocking potential

For many years, developers of residential condominiums have constructed ground level commercial units which could be sold or retained by the builder as a strategic way to generate additional revenue from the project, in order to fulfill the community need for combined residential/commercial space. While this approach can be beneficial to developers, the ongoing operation of these units could give rise to a number of challenges for purchasers or tenants of the commercial space. In this article, we explore many of these challenges, which have led to a growing trend of developers ‘carving out’ portions of residential condominiums for commercial use.

Some of the common challenges of dealing with commercial units as part of an overall condominium development include:

1. Condominium declaration restrictions: The commercial unit would be governed by the provisions contained in the condominium declaration which was primarily designed for the operation of a residential building. These provisions could be unduly restrictive on the commercial owner; potentially resulting in future disputes with the board of directors of the condominium corporation over items such as the use of various condominium facilities.

2. Common expense allocations: In some situations, developers kept the allocation of the common expenses to these commercial units arbitrarily low so they would be more attractive to potential purchasers and tenants. Due to the difficulty of amending a condominium declaration, these allocations could often not be changed even if it was determined by the condominium’s board of directors, with several years of irrefutable evidence, that the allocations were inadequate to compensate the corporation for costs of the services attributable to the commercial units.

3. Construction liens: During the period prior to the registration of the condominium declaration, a construction lien registered by a contractor or sub-contractor doing work in a commercial unit will have to be registered against the whole property. This could result in the delay of the registration of the condominium and create other problems. To address this possibility, many developers insert provisions into the purchase agreement to protect themselves. These provisions can delay the completion of the fixturing of the commercial space to the detriment of a purchaser or tenant, particularly where commercial lenders are involved.

Due to these challenges, a trend has emerged where developers "carve out" portions of residential condominiums for commercial use, conveying them as freehold properties separate from the condominium corporation. Anyone looking at the residential condominium would assume this freehold space forms part of the condominium building, but the space will be comprised of a separate legal description by way of parts on a registered reference plan. While this approach seems to resolve some issues, it introduces a new set of complexities and increased transactional costs for purchasers.

When considering the purchase of freehold space “carved out” from a residential condominium, several critical issues must be addressed:

1. Shared facilities agreement    

The purchaser will almost always have to enter into shared facilities agreement with the adjoining condominium corporation on closing. Ideally, purchasers should have an opportunity to review the draft agreement and negotiate the terms regarding items such as allocation of expenses and use of common facilities. Provisions regarding the use of shared facilities such as loading docks, parking facilities, shared garbage rooms, utility rooms, and access hallways have to be carefully reviewed because they will significantly impact the future operation of the purchaser’s proposed facility. For instance, a restaurant may require 24-hour access to the loading dock for deliveries, which could conflict with residential owners' needs for moving in and out of their units. The review and negotiation of a shared facilities agreement can lead to significant additional time and legal fees for the purchaser’s counsel, and the time required for this process is often unpredictable.

Unfortunately, in many situations, a purchaser of a new build carve out may not have the opportunity to have any input into this document as the agreement may not have been prepared at the time the purchase agreement was executed. Even if a draft of the shared facilities agreement is presented, the allocation of expenses will often be made prior to any construction and will only represent an estimate of these allocation amounts; estimates which may not be accurate once the building has been completed. Further, a developer may attempt to bind the purchaser to whatever shared facilities agreement they produce. They might take the position that the agreement has been drafted and the purchaser is stuck with it, or that they as developer control the process and as such, there’s no opportunity for the purchaser to negotiate. It is important to have a lawyer who is aware of these possibilities and knows how to address them early, during the purchase agreement negotiations.

2. Easements and rights of way

The close proximity of the commercial space to the adjoining condominium will require mutual easements and rights of way over both properties for access and the ongoing operation of the condominium and the commercial space. Finalizing these easements can be complex due to the differing requirements of both parties. The complexity of the legal description will require extra time for counsel to ensure accuracy and completeness.

Typically, the vendor’s solicitor will provide a draft legal description of the property, including anticipated easements and rights of way, but this description may not be final and could require changes before registration. Purchaser’s counsel may face limitations in finalizing the draft legal description, easements, and rights of way, especially if the building is not yet constructed or is only partially completed. Additionally, many draft descriptions include provisions allowing either party to request the creation of additional easements in the future, with the requesting party usually bearing the costs associated with this process.

This is a two-fold issue, wherein a purchaser may not have an opportunity to negotiate easements and rights away that directly affect the carve out property they are purchasing, or alternatively, if they are given the opportunity, it may be a very involved and lengthy process. Neither of these are considerations in a typical condominium.

3. Open building permits

At the time of closing of the freehold space there will usually be several open building permits that have been issued for the construction of the condominium building. Builders will not be in a position to close out these permits prior to closing. The purchaser’s solicitor should ensure that a provision is inserted into the agreement of purchase and sale requiring the vendor to provide an undertaking on closing to close out these permits as soon as possible and to provide a “clear” building and zoning report from the local municipality for confirmation. In addition, on closing, the vendor must provide an undertaking to indemnify the purchaser and its lender against any costs, losses, etc. which the purchaser may incur if the open permits are not closed out against the freehold property.

Purchasers should be aware that the vendor will likely require a similar undertaking and indemnity from the purchaser with respect to the building permits issued to complete the purchaser’s work in its space.

4. Integration of building systems

In many cases, the building systems of the residential condominium (eg. water and sewer systems) will be integrated with those in the freehold space. This can present issues when the purchaser is completing the fixturing of its space and may have to tie in some of its systems into those of the condominium.

While this is primarily a construction issue, it should be considered by the purchaser’s contractors prior to signing the agreement of purchase and sale so that any necessary provisions to access the adjoining systems can be incorporated into the agreement to avoid any future disputes between the parties during the construction process.

5. Contract assumption

Purchasers may be required to assume certain contracts that are connected with and/or determined by the residential condominium. It is important for purchasers to be aware of possible restrictions, particularly in cases where the building is not yet constructed.

A developer is unlikely to have particulars on the finer details of specific contracts such as utility metering, garbage collection, or telecommunication. Purchasers should be aware of this restriction and should request disclosure of the contract providers during due diligence. If the developer has entered into a contract that does not align with a purchaser’s expected usage or operational needs, it could lead to unexpected costs and future disputes.

6. Variance

Developers may seek variances to accommodate specific needs or changes in the project. If a variance is granted, it could allow for modifications that may impact the commercial space. Even after signing a purchase agreement, developers typically retain certain rights over the property, especially during the construction phase. This means they may have the authority to make changes to the layout or design of the building, including commercial spaces, if they believe it is necessary for the overall project or to comply with regulations. Such modifications could affect a purchaser’s business operations and the value of its investment.

It is crucial to include specific clauses in your purchase agreement that protect a purchaser’s interests regarding these items. These clauses can outline the extent to which the developer can make changes to your space and require them to obtain your consent for significant alterations. Additionally, a purchaser may want to negotiate for compensation or alternative arrangements if changes negatively impact the purchaser’s business.

7. Vendor works

It is advisable to include provisions for regular inspections during the construction process. This will allow a purchaser to monitor the quality of work and address any issues as they arise. Additionally, this can help purchasers to ensure that all work performed by the vendor complies with local building codes and regulations, which can help mitigate risks associated with poor workmanship.

The purchase agreement should include clauses that protect a purchaser from inadequate work. These clauses can stipulate the standards of work expected, timelines for completion, and remedies available if the work does not meet those standards or deadlines. For example, provisions could be included allowing for inspections and the right to withhold a portion of the purchase price from the purchaser to the vendor until satisfactory completion of the work.

8. Financing

The majority of purchasers will be obtaining mortgage financing to complete the purchase of the freehold space. The complexity of such transactions can lead to unique challenges and increased legal fees for the borrower. For example, open building permits at closing must be addressed to the lender's satisfaction, often requiring additional undertakings and indemnities to protect the lender against future issues.

Should any of the shared facilities be operated by a third party (for example a parking company), the lender will likely want to review and approve a copy of the existing contact and in certain situations, request confirmation from the company of the terms and provisions of the contract and that it is in good standing as of the date of closing. Other building contracts that affect the operation of the freehold space and that impact the shared facilities may also have to be reviewed and approved by the lender as part of its due diligence activities completed prior to the advance of funds.

All of the foregoing items (and others) will be part of the lender’s due diligence investigations and may delay the final completion of the financing.

In summary, purchasing freehold space within a residential condominium involves navigating a unique set of challenges that must be addressed before, during, and after the transaction. As land prices rise and developers seek to maximize revenue from residential projects, this type of transaction is likely to become more common in many urban areas. A thorough understanding of these issues, along with strategic planning and legal guidance, is vital for purchasers to protect their interests and ensure the long-term viability of their investment in freehold space within a residential condominium.