Subletting Concerns

I read in The New York Times last month that co-ops had lost the ability to prevent certain shareholders from subletting their apartments. Is this true, and, if so, is there anything co-ops can do about it?

This question is just the excuse I’ve wanted to answer another question: are there any negative consequences for co-ops of the recent boom in apartment prices and the related increase of new co-op apartments for sale through conversions, new construction, and gut renovations?

Concerning the questioner’s query: in late June of this year, New York State’s highest court overturned over ten years of regularly reaffirmed appellate court precedents directly affecting many co-ops. The court of appeals ruled that co-ops cannot challenge shareholders’ claims to the rights of holders of “unsold shares’’ based on shareholders’ failures to acquire or maintain the rights in compliance with the regulations of the New York state attorney general. I will not provide a full analysis of this decision. For that, I refer to you to “Hotline: Co-ops Lose,” in the September 2005 Habitat. I’ll just touch on some of the basics in light of the two queries under consideration.

The decision, Kralik v. 239 E. 79th St. Owners Corp. , does not affect the ability of the co-ops to regulate subletting by shareholders who have used their apartments, at any time, as residences for themselves or their families. For those situations, co-ops still can require board review and approval of potential subtenants and impose fees and other conditions. (I note at this point that the same applies to apartment sales by these shareholders, as opposed to holders of “unsold shares.”)

So, on the one hand, Kralik does not negatively affect co-op regulation of the vast majority of long-established co-ops with relatively few investor-owned apartments. Kralik does, however, constitute a major wrench in the ability of co-ops to regulate subletting by those shareholders who have never resided in their apartments. To understand how bad this decision is, I will digress for a brief, vastly oversimplified primer on the structure and evolution of co-ops.

Co-ops are corporations. Apartment owners are really owners of common stock in these corporations and are tenants under leases from these corporations. Sponsors are the original sellers of this stock to two categories of purchasers: those who purchase and plan immediately to reside in their apartments, and those who purchase and plan to hold their apartments as investments.

This latter group includes purchasers who plan to move into their apartments at some point (most commonly upon the departure of rent-regulated tenants) and purchasers who plan to hold their apartments indefinitely as investments (generating income from renting them at market rates). The New York attorney general regulates initial sales of these apartments to all purchasers and the resale of these apartments by investors. These are considered in many ways similar to sales of stock of publicly traded business entities.

Starting in the late 1970s, conversions of buildings to co-op ownership burgeoned. Owners became sponsors in large part to free their buildings from the shackles that rent regulations placed on property values and rental incomes. Renters with means gladly purchased vacant apartments to escape high rents of scarce “free market” rental apartments and to catch the wave of rapidly increasing apartment prices.

As with any boom, the conversions got more and more speculative. Sponsors converted buildings even though large and protracted shortfalls (between rental income and maintenance obligations) were inevitable for the unsold apartments usually occupied by rent-regulated tenants. Banks and other lenders (some then recently deregulated) provided ready funds that allowed these sponsors to cash in immediately on frequently non-recourse loans, leaving the costs and risks of carrying the shortfalls to the co-ops and lenders if and when these sponsors could or would no longer carry them.

Ultimately, many such “houses of cards” collapsed and, in the process, a new breed of co-op apartment owner evolved: purchasers from sponsors in default or foreclosing lenders who acquired apartments for investment and commonly asserted the rights to sublet and sell their newly acquired apartments with the same privileges as sponsors.

Now let’s return to the present, and the two questions at hand. Kralik significantly affects the rights of co-ops to regulate this class of non-sponsor investors, many of whom acquired their apartments during the sponsor defaults and lender insolvencies of the late ’80s and early ’90s, and contentedly thereafter have rented their apartments without co-op regulation and at market rates as rent-regulated tenants inevitably surrender these apartments through death or the need to move out.

This was a non-issue to co-ops while rent-regulated tenants, whose occupancy remained unchanged from year to year, occupied the apartments. So long as these investors paid maintenance to their co-ops (and thereby covered any shortfall between rents and maintenance), the co-ops could do little to increase the percentage of owner occupancy of their buildings, which was, and remains to a lesser extent, a critical factor in securing co-op-wide and individual apartment loans.

As the 1990s evolved, however, more and more of these investor-owned apartments became deregulated. But instead of cashing in on the sale of now-vacant apartments, investors chose to rent them at market rates and increase their investments to unprecedented heights. Co-ops slowly began to question whether these investors could and should be allowed to rent their apartments with little or no co-op oversight and with exemption from co-op sublet fees applicable to all other shareholders.

This led to a series of appellate court decisions that held that investors could do so only if there had been strict compliance with the regulations of the attorney general, both in the initial grants from the sponsors to the investors, and in the actions of the investors after the grants, of the rights of holders of “unsold shares.”

In other words, for over ten years, co-ops periodically were able to successfully challenge the right of these investors to freely sublet their apartments and, as a result, many of them were compelled to sell their apartments. Since co-ops now had higher percentages of owner-occupied apartments, lenders were more willing to offer loans to the co-ops and purchasers of their apartments.

Kralik has the potential to severely limit all that. As stated above, co-ops can no longer challenge the “unsold share” status of investors based simply on the attorney general’s regulations. But all is not lost. First and foremost, co-op regulation of subletting by others is entirely unaffected by Kralik.

Moreover, the decision is not a complete barrier. The court plainly stated that the determination of an investor’s rights should depend on the co-op’s governing documents, and not the attorney general’s regulations. So, if the offering plan or proprietary lease, or some other governing document, provides requirements for acquiring and maintaining the “unsold share” status, then a co-op can challenge the status in the event of non-compliance. And I believe that this should be true even if the co-op’s governing documents are similar or even identical to the attorney general’s regulations. In addition, an investor still must establish that it received a grant of “unsold share” rights from a sponsor, which surely had the right, and in many cases the incentive, to sell apartments without granting the rights. Finally, under United States Supreme Court precedents, I believe that strong arguments can be made that Kralik should not be applied retroactively. So it may be that co-ops that have terminated the leases of investors prior to Kralik, still may proceed under far more favorable pre-Kralik law.

The second question is more complicated and has far wider implications. Kralik reminds us of the days when sponsor defaults followed an extended appreciation of co-op apartment prices almost as rapidly as in the current white hot market. The dangers are not necessarily as great as they were in the late 1980s, mainly because most lenders have not forgotten the pains and losses of those years.

But, as the peak has arrived or approaches, the deals for new construction, gut renovations, and conversions mandate heightened vigilance. Many of the same factors that drove irresponsible sponsors are still present. Buyers of apartments in those categories should be especially cautious about the financial underpinnings of their investments. Remember: much disaster can befall a co-op whose shareholders are uninvolved in its operations and controls.