Reining in the Rentals

It came as a shock, but someone should have seen it coming. Would-be-buyers were unable to obtain financing for their purchases.

The reason? Subletting was out of control.

Of the 500 units in the Yonkers cooperative, fewer than 50 percent were occupied by shareholders. That meant the property was on its way to becoming a de facto rental.

The cooperative had known subleasing was on the rise and, in fact, was making money from it: about eight years ago, the board had instituted a subletting fee. Although that earned the co-op income, it was also a mixed blessing. According to Kenneth Finger, an attorney with Finger & Finger who represents the building "[In 1995] prospective purchasers couldn't get mortgages. Banks looked at the co-op and saw a property going in the wrong direction, as far as owner occupancy was concerned."

The Yonkers co-op is not alone. In Manhattan, a 22-unit Upper West Side cooperative with a liberal subleasing policy found that there were only seven owners left living in the building. There had not been a sale in ten years. In another instance, a 35-unit Chelsea co-op, had 24 of its units owned by the sponsor or investors.

"We had become, essentially, a rental building," explains the Chelsea property's managing agent, Anthony Wolff, a principal in Wolff Management.
How did it happen? Following the market crash of 1987, many boards, sympathetic to the plight of owners who couldn't sell their units in the soft market, relaxed sublet policies. Now, however, they are finding themselves in a catch-22: absentee-owners can't sell because there are too many sublets — yet getting rid of the sublets so that people can sell means forcing the owners to make sales.

"This is an important issue for co-ops everywhere," argues Wolff. Consider this a wake-up call to boards who need to review their sublet rules.

First, be sure that you have an acceptable percentage of subleases. Most lenders refuse to grant or refinance individual and/or building-wide co-op mortgages — which is what is needed to make most sales — when more than 20 or 25 percent of a co-op building's apartments are rented out. Besides that, the high number of rentals is seen by many prospective purchasers as a sign of instability, making the building more hotel than home.

Your initial step should be to set up a group that can examine your options. That's what the Yonkers co-op did.

"The board undertook a major study and appointed a committee that looked at the whole issue," recalls Finger. "It came up with a recommendation that the board prohibit any further subletting until the number of sublets was brought down under 40 percent."

The co-op grandfathered in everyone previously subletting, including the sponsor's tenants, and through a process of attrition, many sublessors and renters moved out. When a sublease expired, the owner was not allowed to sublet again and had to go on a waiting list. In two years, the co-op has reduced the sublets so significantly that one bank agreed to pre-approve the building for loans.

"A number of people have sold rather than sublet," Finger observes. "There is less incentive to become an investment cooperative."

"In fact," says James Goldstick, a vice president at Mark Greenberg Real Estate, "in these situations, it is often not a question of being able to sell. It's a question of wanting to sell at a certain price. If someone bought a one-bedroom in 1988 at top dollar, with a $120,000 mortgage, it may be worth $75,000 today. In the meantime, they got married, had kids, and moved to a house. They had no choice but to sublet. If the board says, 'You've got to sell,' and they say, 'I can't,' the truth is they really don't want to sell because they can't make money. The bottom line is you've got to run it like a corporation. You can't concern yourself with just a few people."

Boards can take into account the concerns of the owners, however, and ease them into a policy. "If the board wants to adopt a more restrictive policy, it doesn't need shareholder approval," explains Robert Tierman, an attorney with Litwin & Tierman. "But it is better to make it progressively more strict, or at least give people notice it's going to become more strict so that people who don't easily meet the standards may decide it's time to sell. You shouldn't all of a sudden apply tougher scrutiny of sublet applications. It's not good policy, and could be subject to challenge, if you do it wrong."

At the Upper West Side co-op, for instance, the board reviewed policies at other properties and then composed its own. Every year the board would put a cap on how many sublets there could be, with a goal of reducing subleasing to five percent within three years. The board also put hardship exceptions in the policy so that no one would be forced to sell at a substantial loss. Realizing they had to, many owners began marketing their units.

Boards can also look at other types of restrictions. "How many consecutive sublet applications will you allow?" says Tierman. "You can say, a person cannot sublet for more than two or three consecutive years. After that, they have to move in or sell."

A series of escalating sublet fees is another approach." Many buildings find such fees useful," says Goldstick. "For the first year, you charge $1,000, the second year, $2,000, the fourth year, $5,000. The longer you sublet, the more prohibitive it becomes."

It is equally important to lay out the policy clearly, since any such change will often garner opposition. "You have to stress the fact that subletting in a co-op is a privilege, not a right," says Goldstick. "Many don't understand that."

The Chelsea co-op presented its policy in a very straightforward, printed format. "We put together a package that included all the rules on subletting, on transfers, on behavioral rules," Wolff notes. "This included basically a system of subletting which boils down to three years out of five. The package was an innovation and at that time it was rather controversial whether we could do it."

After imposing its policy, the board actually faced a legal challenge from one disgruntled shareholder. "She didn't want to obey," Wolff says. "So she put in an unapproved sublet and then sued us for trying to terminate it. Her suit claimed that the board did not have power to limit subletting, under section 15 of the proprietary lease. Section 15 is pretty standard and says that the board shall have power to make any restriction it thinks best in regard to subletting. But she charged bad faith. Her total charge was kind of crazy because she claimed the board had a vendetta against her, although she never offered any evidence for that."

Although the board tried to compromise — offering her an extra year of subleasing beyond the two years permitted by the new policy — she refused to back down, battling the co-op for 19 months in court. The suit was finally settled in the corporation's favor.

"She was alone in the suit," reports Wolff. "There were other people who objected to the rule since sublet rents are very high and sale prices are depressed. But we explained the situation to them, and people have been going along."

In the end, offering explanations and sympathy are the two crucial elements in making any such policy palatable. "We are sympathetic to the plight of the non-resident owners, but we have to act in the best interests of the building as a whole," wrote the Upper West Side president to the owners in a letter explaining the new sublet policy. "We are not taking these steps lightly. [This is a...] balancing act between the requirements of the cooperative and the needs of the shareholder. Tough economic times call for tough personal choices, but above all else, we will be sensitive. We feel it is imperative to try to do everything to ease any pain."