| By: Barbara Dershowitz
Last summer, a financially beleaguered 47-unit co-operative at 30 West
90th Street in Manhattan made news when it converted to condominium
status. That was not the first time a co-op converted to condo. A Teaneck,
New Jersey co-op underwent the process two decades ago, and others -
although not many - have done likewise over the years. But, it was the
first time ever for such a metamorphosis in New York State.
The concept of co-op to condo conversion has garnered a lot of
attention since the reconstitution of 30 West 90th Street, not only
because it was an historic event but more significantly because of what
happened immediately afterward. Before the conversion, "We had a
substantial amount of leverage on a property that had depreciated
significantly during the real estate market downturn," says John
Kaplan, who was board president during the conversion.
"Apartments were virtually unsalable, a lot of people were forced
to move out and sublet because they couldn't sell their apartments, and we
were looking for a way to increase the liquidity of the apartments and to
establish a less transient universe." Apparently, conversion to condo
was the answer.
Within three months of the conversion, which Kaplan estimates took
about two years and cost the co-op around $100,000, 15 units were sold
where none had been sold for six years prior, average sales prices
increased to market rate where they had previously been considerably
below, and the monthly carrying costs decreased an average of 20 percent
from what they had been when the building was a co-op.
Says Kenneth R. Jacobs, partner in the Manhattan law firm of Smith,
Buss & Jacobs, LLP, and the attorney who represented the shareholders
in the conversion process, converting co-ops to condos may be "the
next evolution of a maturing market."
Blazing a Trail
Jacobs, who is the only attorney ever to have participated in such a
conversion in New York State, has formed a pioneering alliance with two
other firms to help other co-ops make the switch. One is Residential
Ownership Alternatives, LLP, (ROA), a Virginia-based firm that specializes
in taking properties through co-op to condo conversion by attending to all
the legal, financial and secondary marketing aspects of the process. Since
its first conversion in 1994, ROA has effected seven conversions in the
Washington, DC, area, the second largest co-op market in the country after
New York. The results have been noteworthy: Sales volume and property
values increased markedly, monthly housing payments decreased almost
universally, and financing options that had not previously been available
were opened to unit owners. Several more ROA conversions are in the works,
and the company, currently in discussion with three Westchester and four
New Jersey co-ops, is now making a deliberate push into the metropolitan
area. "The activity in New York is just beginning," says ROA
managing director David Muelken.
The other player is The Corcoran Group, a Manhattan-based real estate
sales and marketing organization which earlier this year established a
Co-op to Condo Division that will perform an analysis of a co-op, and
present to ffb board members and shareholders comparisons of current sales
prices and projected sales prices if the property converts to condo.
Citing a recent Corcoran Group study that indicated that condo sales
prices are between 30 and 53 percent higher than co-ops throughout the
city, Co-op to Condo Division Director Gary Brynes says, "We
anticipate that there will be some percentage of people in the co-op who,
because the value of their apartments will jump up upon conversion to
condo, will want to take advantage and cash out. We will make our services
available as a marketing and sales company to help them sell their
apartments."
Why Convert?
With Jacobs and his firm serving as legal liaison, ROA doing the
technical leg-work, and The Corcoran Group offering sales and marketing
services, the three organizations have positioned their alliance as the
authority on co-op to condo conversion in and around metropolitan New
York. That they have identified a trend is evidenced by the fact that in
June, when the triumvirate inaugurated its jointly-sponsored "Should
Your Co-op Be A Condo?" seminar, 25 co-ops attended. When the seminar
was repeated in November, that number jumped to 50.
Based on a 1997 Yale Robbins study that counted about 1,388 co-ops and
about 337 condos in New York City, it would appear that co-ops are the
communal residential structure of choice in the city. Why, then, would a
co-op consider undertaking the complicated process of conversion to condo?
"Many co-op communities are caught in a situation where the market
value of co-op shares has plummeted, owners are unable to sell, buyers are
unable to secure reasonable financing, and the public perception of co-ops
is generally unfavorable," explains Muelken. "There are
literally hundreds of co-ops in this situation throughout the five
boroughs, Westchester, Long Island and suburban New Jersey. We have worked
with several co-ops that have realized that switching to condo is their
best bet for regaining market value and restoring liquidity."
"But," says Brynes, who has gotten inquiries from co-ops in
such prime locations as Park and Fifth Avenues, "we shouldn't have a
preconceived notion of who will and who won't be interested in
conversion."
Multiple Benefits
What typically makes condos more marketable than co-ops is the fact
that condos don't have the rigorous purchase application and interview
processes that co-ops do. In condos, which have the right of first refusal
when a unit owner wants to sell, boards have no other power to approve or
disapprove any prospective purchaser. In addition, like private
homeowners, condo unit owners can rent their units to anyone for any
duration, whereas co-ops that allow subletting at all almost uniformly
have restrictive sublet policies. Although some co-op shareholders like
the prestige of a restrictive admissions policy, others prefer less
exclusionary practices.
Those who favor condominium ownership point out that lenders are more
willing to lend high amounts for condo units than for co-op apartments,
and that rates charged by lenders for residential mortgage loans are
almost always lower than rates for underlying co-op building mortgages.
In addition, lenders are less concerned with the number of
owner-occupants in condo associations when making loans to unit owners.
Also, while co-ops have to deal with the 80/20 rule, which requires
that in order for shareholders to get home- owners' tax deductions, no
more than 20 percent of the co-op's income may come from sources other
than shareholders, condos do not operate under such restrictive tax
guidelines.
Jacobs also points out that condo common charges cover only the
operating expense for the building; each unit owner bears his own mortgage
and real estate tax obligations. Therefore, if a condo sponsor defaults,
only those units owned by the sponsor will be foreclosed.
Problems With Conversion
Attorney Eroll Brett, a partner with the Manhattan law firm of Schw ffb
arzfeld, Ganfer & Shore, is an outspoken opponent of the co-op to
condo conversion concept. Brett believes that it's "just a way for
attorneys to line their pockets," and that the conversion process is
a "needless act." Nevertheless, he does recognize that many
co-ops suffer from their admissions policies. In response, he suggests
that co-ops amend their by-laws to do away with such restrictive policies.
He also suggests that co-ops seeking to reduce their monthly maintenance
charges pay off their underlying mortgages.
Carmen Lee Shue, president of Lee Shue Realty and a board member in the
192-unit Manhattan condo where she resides, agrees with Brett in
principle, saying, "The time has come for co-op boards to revisit
their by-laws and do away with their archaic rules. They can still remain
a co-op and enjoy the protection they now have in collecting maintenance
that a condo does not have."
The protection to which Lee Shue refers is the fact that in co-ops, the
lien of the cooperative corporation comes before the lien of a lender so
it's easier for co-ops to enforce payment obligations, a decided advantage
over condos in which the lien of the lender supersedes the interests of
the condominium association. Co-op champions also point to the fact that
co-ops can borrow for capital improvements secured by a mortgage on the
building whereas condos cannot.
It's also true that some co-ops are better candidates for conversion
than others. Co-ops that have very large underlying mortgages or a
substantial pre-payment penalty on their underlying mortgages may not be
in the financial position to convert. In addition, buildings in which
there is no single individual or group of individuals willing to invest
the necessary time and energy to the conversion process will also have
problems. "Where there is not such leadership," says
Jacobs," the whole thing can be a mess." The best candidates for
co-op to condo conversion are smaller buildings in which all or nearly all
of the shareholders want to make the switch.
The Conversion Process
Once a co-op has expressed interest in conversion, due diligence must
be conducted, including an analysis of the legal and financial structure
of the co-op and a review of its article of incorporation, by-laws, rules
and regulations, reserve account, budget, and other pertinent data. A
limited scope appraisal of one or more model types is conducted to arrive
at projected condo values and projected monthly payments, and all data is
presented to the board.
Once shareholders have had an opportunity to get answers to their
questions, a resolution is presented for shareholder vote to authorize the
board to pursue dissolution of the corporation as part of a plan to
convert to condominium. Usually, a two-thirds majority is needed to
approve the resolution, but all the experts agree that without
overwhelming, if not unanimous, support of the concept, the conversion
process can be doomed. Once a favorable vote is recorded, appraisal,
credit reports, and required environmental and engineering studies are
conducted. Upon their completion, mortgage applications, title searches,
and all legal work are executed, and the end result is the recordation of
condominium. The property is then converted to condominium status.
Financially, the conversion requires the co-op to pay off its
underlying mortgage. In addition, all shareholders must refinance their
units to cover both the pay-off of any personal co-op loans as well as
their portion of the underlying mortgage. Next, co-op stock is exchanged
for condo unit deeds and the required title reports and title insurance
must be taken care of. A full and complete offering plan must be submitted
to the New York State Department of Law, Real Estate Financing Bureau for
approval and served to all shareholders.
"The requirements for the offering plan are voluminous," says
Ezra Goodman, a partner with the Manhattan law firm of Szold &
Brandwen, PC. "All the directors of the co-op would have to sign the
plan and wou ffb ld be held personally liable for omitting any material
fact, making any untrue statement of a material fact either knowingly or
negligently, or for any statement which is fraudulent or deceptive."
The cost of conversion is also a consideration. "It depends on
what you're including," says Jacobs. "If you're talking about
professional fees for lawyers and engineers, it could be around $50,000.
But if you add title insurance, mortgage costs, and other associated
costs, the cost increases. I would say you could probably do it for
between $3,000 and $5,000 per unit. It really depends on the value of the
units and whether the owners are getting financing or not."
A Challenging Undertaking
Depending on certain variables, conversion could trigger substantial
tax ramifications for both the co-op and its shareholders. "The basic
challenge is that the IRS treats the change as a taxable event," says
Jacobs. "They see it as a corporation dissolving, which it is, but
really it's dissolving and reconstituting itself with the same owners as
before. So this should be an exception, and a bill has been introduced in
Congress to create this exception, probably because this has been
happening a lot in Washington, DC. Initially, you have to do some
significant tax planning to make sure that taxable gains are minimized for
the corporation and shareholders. There are some points of due diligence
you have to do at the beginning.
"The second issue," says Jacobs, "is the mortgage
situation. If the underlying co-op mortgage has a significant pre-payment
penalty, you have to factor that into the costs of restructuring."
What's more, if the building is contemplating capital improvements, the
cost of the improvements also has to be factored into the financial
restructuring, and if the building has reached its limit of borrowing,
shareholders would have to be assessed for this purpose. "A unit
owner has to borrow enough money to pay off their own share loan and to
pay off their proportionate share of the building's underlying
mortgage," says Jacobs. "Also, part of the initial due diligence
is to do an appraisal to see whether people will be able to refinance
their units and then be able to borrow enough money to pay the cost of
conversion and also any anticipated capital improvements."
But Kaplan and Jacobs agree that the biggest challenge is shareholder
education and inertia. "It was a long process and took a long time to
educate and motivate the shareholders," recalls Kaplan, "and it
was difficult to delegate a lot of responsibility during the process
because not many people understood it."
"You also have to solve problems," adds Jacobs. "No
matter what the building, you're going to have shareholders who have real
financial issues and you have to sit with them and figure out how to
handle it. It takes time, energy and cooperation."
Then there's the matter of finding a lending institution willing and
able to work with the building. "Unless a bank has been through the
process," says Muelken, "they probably don't understand it. We
tend to work with just a couple of banks and walk them through the
process. If you don't qualify for a co-op to condo conversion as an
individual, we minimize the voluntary displacement by making sure there
are safety nets. We've had bridge loans in place for individuals, we've
had corporate guarantees (meaning that the condominium will guarantee the
loan for the individual), we've had individuals who didn't want to convert
paid off in cash or the title to the unit encumbered and they are still
owners of that unit. One of the overriding principles we take into this is
that is has to be a win-win situation. It has to be good for the whole
community. "
Preparing for the Future
"We're in a great real estate market right now," says Brynes.
"The values aren't shooting up like a year ago, but the market is
still strong and things are good. It's hard to say to someone to change
and go through a certain amount of aggravation when things are good. But
if they're good now, they could be a lot better because you'll see the
greatest appreciation in an up market. And if things get bad, which is
when we anticipate most people will look at this, then the ones that have
done it already will be in a better position because it will just flat out
be easier to sell condos than co-ops."
Although a lengthy and expensive process, conversion from co-op to
condo obviously can be done. "It's easier than people think if you
plan for it properly," says Jacobs, "and it can be
beneficial."
Ms. Dershowitz is a Contributing Editor for The Cooperator.
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