Biting the Bullet

When confronting rising costs, boards must take the bitter pill of budget discipline – or face the (often dire) fiscal consequences.

Three co-ops, three stories. At one co-op, the sponsor defaulted nearly a decade after conversion, turning the unsold apartments over to its lenders. Then, the lenders themselves defaulted. At another, more established cooperative, capital improvements were deferred for years, until the façade and pool deck showed signs of serious deterioration. No matter how they each got there, these two properties were in crisis mode. But in a third co-op, the board had exercised rigorous fiscal discipline – raising maintenance regularly, building a reserve fund with those increases, and imposing special assessments – and avoided any major fiscal crises. In one regard, however, all three share a point in common: whether because of crisis or through design, they finally had boards that were ready to make the tough decisions. These are their stories.

336 WEST END AVENUE: CARPE DIEM

The big capital project started after the building was struck by lightning. During an intense electrical storm, 336 West End Avenue, a 92-unit co-op on West 76th Street, got hit by a bolt from the blue. That led to a visit by the city’s Department of Buildings to inspect the roof for structural damage. What the inspectors found was a decades-old rooftop swimming pool that did not have the proper materials or paperwork. The cooperative was told to correct it. And, since it was renovating the pool, the board took the opportunity to make a number of capital improvements at the same time.

Practical? Sure. Expensive? You bet. But the directors never flinched, taking the common sense approach that what you don’t pay for today, will cost you twice as much tomorrow. “They decided they’d do pavers,” says manager Bernie Iser, an account executive at Orsid Realty who has handled the property since 1995. “And as long as they were doing that, they said, ‘The roofing membrane is 18 years old, with two years to go on the warranty. Let’s do the whole thing: new membrane, new pavers, and new planting boxes that fall within code.’ And it was very carefully costed out.”

Co-op and condo professionals often talk about this kind of approach to fiscal planning, but it is, for practical reasons, not often put into practice. Budgets are tight, taxes are high, and many buildings operate on an “if-it’s-not-broken-don’t-fix-it” philosophy concerning financial and structural matters. Not 336 West End. For years, the board has exercised rigorous fiscal discipline – raising maintenance regularly, building a hefty reserve fund with those increases, imposing special assessments – with few complaints from the shareholders, who have re-elected essentially the same directors for a decade at least. And the owners have been rewarded with regular sales – about five or six sales a year on average – and an improved quality of life.
How do they do it?

An Unusual Building

Three Hundred Thirty-Six West End Avenue was unusual from the day it opened. Built in 1932, during the Great Depression, it was not a typical Upper West Side building of high-ceilinged apartments and long, rambling halls. Rather, the first 16 stories featured a standard configuration of two studios, two one-bedrooms, and two two-bedrooms on each floor. After the 16th floor, the building was set back in wedding cake fashion, and all the apartments above were different. Some of them have been radically altered because of combinations over the years.

In 1972, the building converted to a cooperative, and almost from the beginning, the board exercised a rigorous watch over the budget. “They’re a conservative group,” says Iser, the manager. “The building is basically conservative, and they operate it very carefully. They’re not cheap.”

One factor that helps in the process is the stability and professionalism of the board. Most of the members have been serving since the mid-1990s, and they currently include a retired lawyer (the president), a retired accountant (the treasurer), a semi-retired advertising executive, a marketing executive, a financial trader, an industrial hygienist, and a lawyer who works with co-ops (his firm represents Co-op City).

“If you imagine a co-op that is being well-managed by its board members, who are a congenial group, then you have a good description of the building,” notes Iser. “They have always been a board that was very representative of their body of owners in philosophy and temperament, and they take time to think about things. Very rarely have they ever had to encounter a surprise for any building emergency.”

And even if there is an emergency, the board approaches it just as methodically. On Iser’s first day managing the building, for instance, pipes broke simultaneously all over the property. The agent was there “all day, every day” for part of the week. “The situation was taken care of,” he notes. “But nobody went crazy; everybody was calm.”

The board is forward-thinking as well. When the building across the street added air-conditioning to the lobby, Iser recalls that the 336 West End directors said, “Well, maybe we should, too.” Iser says that “they explored it. They had done a water-cooled system across the street. But we decided no, that’s not practical because, if the city declares a water emergency, you have to turn off your air conditioner. So, we did some real exploring. We finally found a unit that could be put in [that didn’t have this problem].”

The Budget

The budget process is as straightforward and as professional as the board. When the end of the year approaches, the co-op’s accountant, who has worked with the building for at least 30 years, prepares a proposed budget. The treasurer and assistant treasurer “go through it line by line and figure out where we need to increase, where we need to cut, and then run it by the full board,” explains Dan Demichelis, former board president, current treasurer, and a resident since 1980. The board then tinkers with it, making the hard fiscal choices unflinchingly (or, at least, with few noticeable flinches).

“The [accountant] lets us worry about the capital improvement side of the house; they tell us how much fuel we use, and we take a guess at what the fuel cost per gallon is going to be, and we budget it at that rate,” he continues. “Last year, our cash budget was spot on. There was a variance of about 0.05 percent. Now, I think we over-budgeted on fuel and we under-budgeted on repairs and maintenance. We’ve been working up to this year because we knew we were going to have to have a capital improvement project somewhere in the range of $250,000 to $350,000. And we’re going to come pretty close to that estimate. We have a pretty clear picture of what’s coming.”

Indeed: the directors take a practical view of budgeting, saving money by looking at the long-term. Notes Iser: “They have some Local Law 11 work coming up, and it was bid in two pieces. That work is mandatory, but they then said, ‘As long as we’re there, it would be nice to caulk and paint all the windows in the building’ – which is very good preventive maintenance work. So they took a look at the costs and decided to do it, because if they deferred that work it would have to be done probably by the next go-round. The startup costs – the scaffolding and the sidewalk shed – would be almost as much as the differential on this job. It was $80,000 extra to do this additional work, and if they waited and had to remobilize, it would have been $125,000 or $130,000.”

If you put off capital work, explains Demichelis, “eventually it catches up with you. You’re faced with a huge $1 million project and you’ve got to go up to the shareholders and say, ‘Guess what? We want $3,000 from each of you and we want it next month.’”

The building’s budgets bear out this philosophy. Since 2003, dealing with financial issues as they come up has meant that the maintenance has gone up every year. Costs are rising and the shareholders have to pay for that. Explains Demichelis: “What’s really going up are the taxes as a percentage of actuals. Taxes as a percentage of the operating budget in 2003 were 34 percent; in 2004, 35.4 percent; in 2005, 36.5 percent; and in 2006, it is 39.1 percent. We’ve gone from $433,000 in actual taxes in 2003 to next year’s budget of $643,000. The biggest jump has been from 2005 to 2006, $533,000 to $643,000. And that’s primarily because of the assessed value. They really cranked up our assessed value. They’ve increased it 50 percent over the last couple of years.

“Mortgage, payroll, and fuel, as a percentage of the total, have actually gone down from 45.6 percent [in 2003] to 43.2 percent, from 44.5 percent, to 42.6 percent [in 2006],” he adds. “But the totals have gone up as a percent of totals. If you add them together it’s 79.6 percent, 78.6 percent, 81 percent, and 81.7 percent. And, of course, fuel has gone from $66,000 in 2003 to – what we’re budgeting next year – $108,000. The insurance market has tightened up, so you’re stuck there, you really haven’t got a lot of discretionary spending. I mean, we don’t do parties!”

Rather than curse the darkness – or, more pointedly, the taxman – Demichelis offers the board’s operating philosophy: “The numbers are what they are. If there’s a way we can cut costs, we cut costs, but our budget is driven by four line items over which we have very little control. The biggest problem is taxes; the next problem is fuel and what’s going on with fuel prices; the third problem is labor – and we go along with the RAB [Realty Advisory Board] and the contract that’s negotiated by the RAB; and the fourth biggest expense is [mortgage] interest – and that’s fixed until 2014.”

Maintenance and Reserves

The co-op has paid for the building’s operations by a combination of maintenance increases, special assessments, and a 2004 mortgage refinancing. Last year, the board raised maintenance by 10 percent, and this year it was 11.5 percent. A yearly assessment is currently tied to the annual tax rebate from the city. “The rebate is 17.5 percent of the owner’s tax bill, and the rebate comes back to the building rather than the individual shareholder,” explains Demichelis. “So what we do is we decide how much we’re going to need to assess and generally we’ve taken 75 percent or 85 percent of the rebate [through an assessment of equal value] and given the rest back to the shareholders. This year, we’re probably going to take about 95 percent of it. That way, it’s money that they don’t see. It’s semi-painless. They don’t have to cough up the money out of their own pockets, but they don’t get the rebate. So, they don’t have to sit down and write a check.”

The board is very careful about keeping its reserve fund healthy – and strict about what it is used for. The annual goal is to use special assessments earmarked specifically for capital improvements to build a reserve fund that totals three months of maintenance – roughly $400,000 to $450,000. “That’s the goal,” explains Demichelis. “Sometimes we make it, sometimes we have to do repairs and we fall short.” But, he adds, “You can’t live off a reserve fund. To use a reserve fund for operating expenses is, in my view, a huge mistake. You need the reserves there for when you face an emergency or when you’ve got to finance capital improvements.

“From a tax standpoint,” he notes, “if you impose an assessment for capital improvements, and instead you use that assessment to pay for rising fuel costs and rising insurance costs, then that assessment is not an addition to the apartment’s tax basis. But if you use that assessment either for capital, or you put it on the reserve fund and the reserve fund eventually pays for the project, that is an addition to each shareholder’s tax basis.”

(Tax basis is essentially the cost of an apartment at sale. “When you buy your apartment, what you paid for your apartment is the starting point for your tax basis,” explains Mark Shernicoff, an accountant at Zucker & Shernicoff. “At closing, you had other costs that you incurred – lawyer fees, other fees – and those get added to the basis. When you make capital contributions through assessments for improvements, those get added to the basis. All of this reduces your capital gain – the difference between your proceeds less the cost of sale, less the basis. A fuel assessment doesn’t affect the basis, however; it’s like operations.”)

Sales Job

To reduce possible dissent, the board thinks it is crucial to keep the shareholders in the loop. “We try to write them a detailed memo every year,” explains Demichelis. “Rather than give them a memo that says, ‘Look, your maintenance is going up by 11 percent; it’ll be in your next bill; good-bye.’ We try to give them a memo that says, ‘Your maintenance is going up 11 percent; here is why,’ and we talk about the fact that taxes have gone up $100,000 in any given year, the fact that the labor contract has gone up another percentage. It’s about a page-and-a-half, it gives details and a detailed schedule, and it talks about the capital improvements necessary with Local Law 11. Some people read the schedule, they look at the number, they scream like crazy, and then they pay it. Other people actually read the memo.”

“A real key is communicating to your shareholders and acting as a cohesive board,” adds Iser. “In this building, they are pretty careful that board members do not answer as individuals. They’ll take individual people’s questions, but the response comes back from the board. [And the board knows that] whether you’re going to raise maintenance or lower it or leave it alone, [the board should] be prepared to answer the question, ‘Why?’ in detail and honestly. Because if you don’t give them an honest answer it’s going to come back to bite you.”

This year, there has been some grumbling from a few of the shareholders. Consequently, Demichelis has been preparing an even-more-detailed document for the shareholders that hopefully will answer any and all questions. “We’re calling it Co-op Governance and Finances. You get people who come in, they buy an apartment, and they don’t know what the hell they’re buying,” the treasurer notes. “This says, ‘This is what a co-op is; you elect a board of directors who hires the managing agent who supervises the super,’ and then we talk about what the board does and what the managing agent does, and we talk about the difference between a co-op and a condo. And we’re going to talk a little bit about why maintenance has been going up, and we’re going to lay out real numbers. Now, in the past, we’ve told shareholders that maybe the taxes have gone up $100,000, or labor has gone up $50,000, but now we’re going to show them some actual numbers. We’re going to actually show them the line items.

“It’s one or two or three shareholders who are making some noise,” he adds. “Everybody else realizes that there’s a reality here. But we decided, ‘Look, it’s time to just go out and tell people [in even more detail]: this is how we run the place and this is what the realities are.’”
If that doesn’t work, the directors will do what the board always does: point to the co-op’s fiscal record and let the voters decide their fate at the annual election. Demichelis is not overly concerned, though, because he thinks that common sense wins out every time. “You can’t put your head in the sand and hope it’s going to get better. The best we can hope for sometimes is that it doesn’t get any worse. You have got to face reality.”

GLEN OAKS:
BACK FROM THE BRINK

Glen Oaks Village, the well-tended 110-acre Queens co-op development near the Nassau County border, doesn’t look like it could ever have been in trouble. Constructed as rental garden apartments in 1947, it was converted to a cooperative in 1981. The complex consists of 134 buildings containing 2,904 units that range from one- to three-bedroom apartments, with shareholders owning almost 90 percent. The situation was very different about 16 years ago, however, when the sponsor’s financial situation collapsed, with 500 units at stake.
“Two banks took over,” explains the board president, Bob Friedrich. “Then they went under, too.” The apartments became the property of Resolution Trust, the government agency created to handle the insolvencies of about 750 failed savings and loans institutions, and the Federal Deposit Insurance Corporation.

With $200,000 in reserves, Glen Oaks assumed control of its destiny: the board decided that its best move was to waive the accumulated arrears on the orphaned apartments – about $1 million – and reclaim them. The immediate picture was grim; no lender would provide financing to a co-op in these circumstances. To make matters worse, the overall co-op market was in a slump. But, Friedrich says, “We realized that there was an inherent value in these apartments, which were mostly occupied [and covered under rent stabilization regulations]. As they became vacant, we could sell them.”

When outside investors offered $2 million for the block of units, board members resisted pressure to accept the deal from the co-op’s former directors and then-current shareholders who felt the property couldn’t survive without it. Instead, they created an internal homesteading program. Pricing the apartments at $15,000 to $30,000, they gave the rent-stabilized tenants the opportunity to purchase their housing through two plans. Under the first option, buyers would put no money down; if and when they sold, they would owe the co-op its list price. With the second plan, buyers would pay half upfront and owe no further money, apart from maintenance fees.

“We provided the mortgage,” says Friedrich, who may be more comfortable with numbers than the average New Yorker is – in his day job, he’s the controller and chief financial officer of The Well, a marketing and public relations firm in Manhattan. “When you’re selling property you own, you don’t have to put down money.”

In hindsight, the arrangement would seem tremendously appealing to buyers. But, at the time, it was a hard sell. The board put together a booklet and encouraged tenants to talk to their advisers. Ultimately, about two dozen people bought in. “They’re very happy,” observes Friedrich. “It was the best decision they ever made.” All of the homesteaders realized substantial gains. But the program also helped the co-op, transforming rental units into property in which residents had a stake.

Meanwhile, the board adjusted maintenance fees, implementing two increases in a single year in the early 1990s. Most owners accepted the increases with minimal complaint because the board established a policy of operating with complete transparency. “If you tell people everything, you have nothing to worry about,” Friedrich insists. “We [always] explain the reasons for every decision. We count not only votes but names of people and how they vote.”

It’s no small challenge to communicate effectively in a multi-building complex with a population of 10,000. During its turnaround, Glen Oaks began issuing a professional newsletter three times a year. [More recently, the co-op branched into virtual publishing by launching a website. All financial data, such as tax statements and annual reports, is posted to the site, www.glenoaksvillage.com, so shareholders can access information at their convenience.]

Lend-Worthy

With its affairs in order, Glen Oaks became lend-worthy. “Once we cleaned up our finances, we called in the bank and said, ‘This is what we’re doing,’” Friedrich says. The co-op got [an underlying] mortgage, which gave it breathing space and allowed prospective shareholders to get financing more easily for the purchase of individual apartments.

At what point did the board relax in the knowledge that its methods were successful? “When we took over the apartments and were able to fix up and sell them,” concludes Friedrich. “The entire process – from the time we had to take over the apartments to the time we started to have a market going – took about five years.”

Out of concern that outside managers would give the property insufficient attention, this large co-op prefers to manage itself. “We’re a $23 million corporation,” notes Friedrich. “Our people are working solely for Glen Oaks. We have our own staff and our own controller. Financially, we’re the healthiest garden-type co-op in New York City.”

The board keeps a tight lid on expenses. A full-time purchasing agent is charged with finding the best prices. Refinancing the mortgage in 2005 cut outlays; the co-op took out a $39 million loan for 20 years, saving $800,000 in annual payments. In 2003, maintenance was raised 4.76 percent, the first increase in nine years. Since then, there have been two more increases totaling 6.37 percent, including the 2.52 percent raise that became effective this past January.

The board averts larger, permanent increases by factoring STAR credits and New York City property tax rebates into its budget through mandatory shareholder givebacks. Glen Oaks supplements its income with residential sales. It still holds about 350 apartments, which, in effect, serve as an enormous IRA. As tenants move out, the co-op renovates the units and sells them at what have been steadily climbing prices. Collecting extra fees from the people who opt for them offsets other improvements, such as garage electrification.

“We used to farm out a lot of work that we now do in-house,” says Glen Oaks general manager Mildred Marshburn, who says that the maintenance department operates more efficiently since supervisors were persuaded to take non-unionized managerial positions at the complex. Today, employees perform such tasks as putting up shutters, replacing basement windows, filling in concrete, and resurfacing blacktops. A computerized work order system allows the co-op to track every repair, and monitor the crew that does it. For big projects, Marshburn pulls people off other duties to pool her resources.

New and long-term owners are encouraged to make further upgrades to their homes. The complex permits construction of decks and rear entrances. If an apartment is above an unutilized basement – one that doesn’t have a meter room or a sewer trap – the shareholder can annex that space, although he or she assumes responsibility for any asbestos abatement that may be required.

Lately, working with the city’s Board of Standards and Appeals, Glen Oaks won the right for individual owners to put up dormers, extending the height of buildings by five feet. Interested people are referred to an architect who handles the filing, and the dormers are constructed off-site. Says Friedrich: “If we can create modern-day amenities, such as more usable space, it’s a way to keep people here and drive up values.”

NEPTUNE TOWERS:
A CLOSE SHAVE

Lack of amenities was never a problem at Neptune Towers Cooperative in Long Beach, Long Island. A nine-floor, 152-unit beachfront property erected as a co-op in 1962, it has terraces, a swimming pool, and a parking garage. It also has a history of ducking conflict. “Year after year, the board tried to avoid making unpopular decisions,” reports Tom Graziano, who was elected to the board in 2004 and became treasurer the next year. Translation: the board regularly raided the reserves instead of raising maintenance, and the directors preferred cheap temporary fixes to costly long-term repairs.

As a result, the co-op developed huge fiscal and structural issues. Although the co-op was never at risk of bankruptcy, the failure to cover expenses led to a maintenance deficit, which some shareholders chose not to see. The wear and tear to a once-glamorous property was harder to ignore. “Salt water and sand started beating up the building,” says Graziano. The façade needed a major structural exterior restoration. The windows and the terrace railings were due for replacement. Worse yet, water from the pool was seeping into the ceiling of the garage, a symptom of the deteriorating pool deck. Even the elevators were showing signs of age.

Compensating for lost time, the board went into overdrive to determine what had to be done when, and how to subsidize it. The co-op’s construction committee (President Bonnie Lichtman, Vice President Vinny Pugliese, and Secretary Linda Mills), spent many hours meeting with engineers and contractors and would then advise the full board regarding the work needed.

“From late 2004 through 2005, we felt like we were meeting every week,” recalls Graziano, who immersed himself in co-op minutiae. He adds that members’ collective expertise in financial and construction topics – for example, he’s a tax manager at a pharmaceutical firm – helped them formulate a battle plan. Repairs were prioritized, with the pool coming at the top of the list. Other projects included overhaul of the elevator mechanism and cars, and renovation of the entrance.
To fund all this work, which had a combined price tag of $5 million, Neptune Towers had to tap its reserves and open multiple income streams. But first, the co-op addressed its maintenance deficit. Following the recommendation of its management firm and accountants, the co-op increased maintenance by 17 percent. Softening the shock, the board scheduled a 5 percent raise in April 2004, a 6 percent raise half a year later, and another 6 percent raise in January 2005.

“We struggled very hard,” says Graziano. “We have a lot of older people on fixed incomes.”
Next, the building, which owed $4 million in principal, refinanced its mortgage. “The biggest challenge was getting the board to agree on what to do,” recalls Patrick Niland, president of First Funding, who brokered the loan. “Neptune Towers has a mixture of people – senior citizens, long-term residents, and new residents who may be here only a few years before moving on. Each constituency has its own angle on financing; the extremes would have significantly different economic impact.”

“Some shareholders thought we should take out $8 million instead of assessing all of the shareholders,” Graziano adds. “We kept arguing with each other before deciding that $6.5 million was the maximum the building should borrow.” In April 2005, the co-op closed on a 10-year mortgage, with a 30-year amortization at 5.32 percent. Then, the board tacked on a pair of assessments with extended due dates. The first, for $2.4 million, started in May 2005 and must be paid by April 2010. The second, for $250,000, started in October 2005 and must be paid by May 2010. Shareholders can shell out the money in installments or, if they’re selling their apartments, pre-pay.

The Big Factor

Of course, vendors have to get a check long before the assessments are complete. Not to worry. Niland advised Neptune Towers to open a $2 million line of credit with a variable rate. The co-op can draw on the credit line to pay vendors, and then use the assessments to repay the credit.
Unfortunately, coming on top of the higher maintenance fees, “the assessments were very hard for people to bear,” Graziano admits. “They had gotten comfortable with the idea that big increases wouldn’t happen.” Some enraged shareholders yelled at their treasurer in the hallways, urging him to pave over the swimming pool and turn it into a parking lot. (Speaking of which, the shareholders who use the garage’s 77 rentable spaces had to ante up, too; parking fees went up 23 percent in September 2005.)

Officers held open meetings and published newsletters to clarify their positions. “Communication is a big factor,” says John Wolf, president of Alexander Wolf & Co., which has managed Neptune Towers since 2000. “Once we come up with the right numbers, we have to sell it to the shareholders.”

Tensions have abated as work has progressed. The pool opened later than usual last summer to accommodate a total revamp; at the same time, new lights were installed. Exterior repairs and elevator work is under way, and should be completed this year. “In our last release, I wrote that these were achievements, not penalties for living here,” says Graziano. “I said that anyone who doubts that this stuff was necessary should come and talk to me.”

Amid all this activity, Neptune Towers’ reserves have stabilized, thanks to the board’s policy of augmenting them with a portion of maintenance. In 2005, 2 percent of maintenance fees were allocated to reserves; this year, that figure dropped to 1 percent. In addition, flip taxes go toward reserves or capital expenses, not operating expenses. By any standard, the co-op is on sound fiscal footing.

“Everybody had to take their medicine,” remarks Graziano, who knows his building isn’t the only one engaged in major restoration efforts – he’s noticed scaffolding on numerous neighboring properties. He hopes that in the next decade, the co-op won’t need as many repairs. But whether or not work is required, he thinks fees should be raised routinely, to keep pace with the cost of living. “If you don’t look at increases each year, then you have to ding people with a big increase further down the line,” he says. Apparently, Neptune Towers has gotten the message. In March, the co-op ratcheted up maintenance by 3 percent.

“Buildings have to look at two things,” concludes Wolf. “The operating budget has to be balanced on an annual basis. Then you have to look at your capital budget to see what you have to do and how you can do it.” Neptune Towers, he continues, now has “a good formula.”