Getting In: Sublets

If you don’t have a sublet policy – or you have one that you haven’t
reviewed in years – guess what? It may be time to revisit it.

When Avi Horwitz was elected president of his cooperative board at the Toulaine at 130 West 67th Street nearly 15 years ago, one pressing problem came into stark relief: the number of sublets. During his first month on the board, Horwitz learned that almost half of the 234 units were being rented. While the building was raking in money in subleasing fees, it could not refinance its mortgage because banks were wary of the high number of rentals.

It was a stunning blow to Horwitz and his fellow directors, who needed money to finance expensive capital repairs the subletting fees would have covered. With the building’s sublets nearing the 40 percent mark, the board members were told that refinancing would be a very delicate dance with the lender. The managing agent “indicated that we had to be kind of evasive with the bank [over the number of sublets],” recalls Horwitz.

Today, the board members at the Toulaine are facing a different picture. The co-op is more than 95 percent owner-occupied. “We wanted to get back to more owner-occupancy,” explains Horwitz. They did that by imposing a new policy in which first-year homeowners cannot sublet. After those initial 12 months, they can only sublease for two three-year periods, with a break where they cannot sublease between the two periods. After that, no more subletting is allowed. The twin goals, says Horwitz, are “to discourage very short-term subleases and to discourage people from investing. We want to have people who are committed to the building.”

If you don’t have a sublet policy – or you have one that you haven’t reviewed in years – guess what? It may be time to revisit it. Subletting is a perennial problem and if you don’t address it, you could be facing serious financial, security, and/or quality-of-life dilemmas.

Co-ops: The Next Generation

For any number of reasons, some boards are dead set against subletting. One factor is the “transients” issue. Many contend that a renter doesn’t care as much as an owner because he or she doesn’t have as much invested (both financially and emotionally) in the property.

In addition, some professionals say that the current increasingly higher resale prices of apartments everywhere in the city have led to heightened concern about quality-of-life issues and how they affect the market value of their units. “There’s a new generation of people who are buying into co-ops, both to live in but also because they’re deemed to be good places to park your money, with the rapid appreciation,” says attorney Robert Tierman, a partner at Litwin & Tierman. “So people are obsessed with who’s living in the building, and what kind of reputation the building has, and does the building have problem tenants, and does it have litigation resulting from that?”

Beyond quality-of-life questions, some boards oppose subletting because it complicates the resolution of issues. “If there is a controversy, you have a three-party situation because you’ve got the co-op, you’ve got the shareholder, and you’ve got the subtenant, so that makes it more complex,” says Tierman. “It’s not as easy for the co-op to go deal directly with a subtenant who’s causing a nuisance. You are supposed to deal with the shareholder.” But trying to compel the shareholder to take action against the subtenant can be difficult. Many times, the shareholder doesn’t want to interfere with the flow of rent from that subtenant. In addition, it may be that the shareholder is abroad.

Excessive subletting can also cause financial hardship for the co-op and its residents. While trying to gauge the future of the real estate market and interest rates is akin to reading tea leaves, no board should create a sublet policy without understanding a little bit about what the current real estate market looks like, and whether changing its policy will affect future ability to refinance the mortgage or, even, prevent new buyers from getting a loan to purchase a unit.

Over the past half-decade or so, as interest rates have dropped, co-ops looking to refinance mortgages have found lenders offering unprecedented flexibility, even for buildings with a large number of sublets. Right now, says Edward Howe, senior vice president of the National Cooperative Bank, “the difference in the rate that a co-op would get for a building that is 100 percent occupied versus one that is 30 percent [occupied] is probably only a tenth of a percent, or 10 basis points. It’s really negligible. Six years ago, a building that had a lot of sublets found it was very difficult to qualify for refinancing. But today, that’s not the case, because money is running freely.” However, adds Howe, if the credit markets tighten up a little bit, a building with a high rate of owner-occupancy “will get a better refinancing rate than a building with a high rate of sublets.”

Design for Living

Knowing the drawbacks of subletting is essential before you design or revise your sublet policy. But before you create a new one, check your proprietary lease and bylaws to make sure that you actually have the power to restrict subletting. Some may not. “There are a pair of infamous decisions which curtailed boards’ rights of subletting, because the bylaws were restrictive,” warns attorney Bruce Cholst, a partner at Rosen & Livingston. “At least one court has said that if there’s no such thing in the lease, then you may be stuck with a decision either to accept or to reject a sublet without any flexibility.”

When creating a subletting policy, there are a number of issues that need to be considered. Among them:

Consider the building population. Look at the size and culture of the building, says Mitchel Hammer, general manager of Manhattan’s 400-unit Rivercross cooperative. While Hammer has worked at large and small cooperatives that allow subletting, the one thing that the board always needs to keep in mind is the “feel” of the building. Is it a co-op where shareholders prefer anonymity, or is it a building where people like knowing their neighbors? Because, in the latter, if the board introduces a sublet policy, there may be some unpleasant surprises at the annual meeting. Particularly in smaller buildings where “strangers raise eyebrows,” warns Hammer.

Set a term. When it comes to length of the sublease you may want to be very restrictive. Most boards almost always set one-year terms. “They might let you renew with the same subtenant for an additional year, but the co-op will want the right to deny it, just in case there are some problems going on with that subtenant,” says Tierman. “They’re not going to grant a two-year lease.”

“If it’s too short a term you’re encouraging transiencies, and if it’s too long a term then you get into the issue of whether you want to be restricting or encouraging sublets,” adds Cholst. “A lot of boards, for example, will say, ‘All sublets have to be at least one year, because that prevents transiencies.’ So a lot of boards will say, ‘You cannot sublet more than two years or three years out of every five.’”

Observes Tierman: “Such restrictions are a good thing, because people might be more inclined to sell now, rather than try to hold onto it in situations where they’re never going to come back to the building.”
Limit the total number of units sublet in the building. Another consideration is that you do not want too many sublets in the building at any one time because banks have been – and may again be – reluctant to offer loans to properties with a high percentage of sublets. “You might want to consider saying that no more than 10 or 20 percent of the apartments can be sublet at any one time,” notes Donald H. Levy, an account executive and vice president at Brown Harris Stevens, a management firm. “And, if you happen to be a Johnny-come-lately to the process, you may be out of luck.”

At a 41-unit building on East 93rd Street, off Lexington Avenue, for example, the board members decided to implement a sublet policy several years ago that permits shareholders to sublet for only two years, except in cases of hardship. When the policy was introduced, 10 percent of the units were being sublet. To bring the number under control, the board grandfathered in everyone who was already subletting, giving the shareholders a three-year window to get rid of their tenants.

Another consideration is whether or not you want to discourage investor ownership. A lot of buildings are saying you must have lived in the building for a certain number of number of years, or been a shareholder for a certain number of number of years, before you are eligible to sublet.

Charge reasonable fees. A co-op is entitled to charge a reasonable sublet fee. “The amount is a board policy call,” Cholst says. “For most buildings, the benchmark is 10 percent of maintenance. A lot of buildings have based it upon a percentage of maintenance, on the theory that you could get more money that way. But recent case law has said that the fee should be based upon shares or the reasonable costs of the transaction, if the bylaws of the co-op say so. If you have that kind of language in your bylaws or in your lease, and you’re trying to assess a sublet fee of, say, 10 percent of maintenance, or X dollars per share, then your sublet policy is vulnerable to legal challenge.”

Consider conditions under which subletting will be permitted. Many buildings seem to be open to the hardship standard. In other words, if there is a short-term hardship where the owner is going to be away for a year for some reason, the board will allow subleasing after performing due diligence. At the East 93rd Street co-op, for instance, fairness is the watchword, explains Jay Ackroyd, the building’s treasurer. “We’ve worked hard to create a family atmosphere, but sometimes people are just in unavoidable circumstances [and have to sublet].”

Reviews Are In

One major portion of the policy should concern reviewing the application. How extensive should that be? Experts say that the board should interview the applicant as it would a purchaser, with credit check, tax returns review, and so on. Most buildings that permit subletting have a full financial and personal review.

But, says Tierman, “you could argue that you don’t quite need the same level of scrutiny from a financial point of view because you’ve got the shareholder on the hook financially. So, if the subtenant doesn’t pay the shareholder, the shareholder is still obligated to pay the co-op. So, you could say that it’s somewhat less crucial to evaluate the financial wherewithal of the subtenant. In terms of the character of the person or the potential effect on quality of life, it’s every bit as important, and it might be even more important. Because, with the shareholder, you know that he has a stake in the building, and, even if he’s a little wacky, he’s going to be there for the long term, and have more interest in getting along with his neighbors. If you allow a wacky subtenant in there, that person has no long-term ties that are going to regulate his behavior. You have to apply more scrutiny with regard to the character issues.”

At the Stonegate cooperative in Peekskill, NY., where close to 60 of the 218 units are sublet, there is a special admissions committee, composed of three board members and two shareholders, who review all new buyers and sublet applications. All buyers and prospective tenants have to submit an extensive financial portfolio, followed by an interview with the admissions committee, which then passes on its recommendations to the co-op board.

But even before a shareholder can submit an application package on behalf of a prospective tenant to the admissions committee, the shareholder has to have his apartment inspected by the managing agent, and then pay a $150 processing fee at the time he has submitted his prospective tenant’s financial application, a 75-page collection of papers that includes indemnification forms and waivers for the co-op in case of a falling out between the shareholder and his tenant. At the same time, if the tenant has been approved, the shareholder has to submit a check in the amount of two maintenance charges. Each sublet is done on a year-to-year basis, and is “infinitely renewable,” explains Dennis O’Sullivan, the property manager for Stonegate.

“Our big focus is the credit reports,” adds Margaret Smith, a director at the co-op. The board won’t even talk to a prospective sublessee unless the financial package looks good. As for the interview after that, it’s “really more like a getting acquainted meeting.”

Once the policy is established, how do you enforce it? “Your penalties and your rights really are against the shareholder, not the subtenant,” says Levy, the manager. “And you retain all your rights against the shareholder. If there’s a nuisance, if the subtenant is in default, the shareholder still pays his or her maintenance. But if there is any kind of a problem with damages, or with noise, or with quality of life, the board retains all of its rights vis-à-vis the shareholder. The problem often is that, once the sublet’s been permitted, the shareholder is no longer readily available. There may be legal problems in terms of service, and a lot of other things that you don’t have if you have the owner in New York State and in residence. That’s another reason that buildings are frequently reluctant to have subtenants.”

Does It Work for You?

Ultimately, the only people who can decide whether and how a sublet policy will be enforced is the board. Some management companies believe in a strong hands-on approach, where the board takes steps to institute a clearly worded policy, and then enforces it consistently.
Then again, other management companies take a different approach, and believe that, unless there is a problem, anyone who wants to sublet should be allowed to, and that the board should just stay out of the whole thing, unless – and until – there is a problem. “I have an unorthodox view on this,” admits Alvin Wasserman, director of Fairfield Property Services, which manages more than 7,000 co-op and condo units in Queens, Nassau, and Suffolk. “My belief is that there is practically no reason to turn someone away, particularly with a sublet, because the financial responsibility still lies with the shareholder. So, even if they [the sublessees] don’t pay their bills, the shareholder is still obligated to pay the co-op.”

Concludes Irwin Cohen, president of A. Michael Tyler Realty: “We firmly believe a sublet policy is an important thing to have. Even in small buildings where they say, ‘We are like family.’ The procedure is there, because if you need it, you have it. Our little friendly community changes, and someone buys the apartment and isn’t as nice as the people who used to be there, so you need rules. I believe in rules. If the board doesn’t want to enact or impose them, that’s up to them. We work for the board; they’re the boss. But, in the end, you need to have policies and procedures in place, and have the board stick to them. Otherwise, you will have people violating the proprietary lease.”