Co-op to Condo Conversion:
Understanding the Growing Trend
Last summer, a financially beleaguered 47-unit cooperative 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 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."
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."
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 homeowners' 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 Erroll Brett, a partner with the Manhattan law firm of Schwarzfeld, 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 would 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."
Barbara Dershowitz is a Contributing Editor for The Cooperator.