Found Money

How one board raised $4 million – and still stayed on the right side of the “80/20” rule.

In recent months, Lenox House has been a hub of activity. The 115-unit East 70s co-op is nearing completion of an expanded and renovated lobby. Before that, the seven-member board oversaw the building of a new 1,300-square-foot gym with flat-panel TVs and high-end gym equipment. Other recent additions include a children’s playroom that doubles as a meeting center, and storage lockers. And all were constructed without an assessment or maintenance increase. In fact, the building has not had more than one three-percent maintenance increase in the last five years.

“During this period, we also refinanced our mortgage and reduced our loan balance from $3.6 million to what is now a little over $1 million,” reports Alan Kramer, the former board president at the cooperative. “We have a fully liquidating loan and we are expecting to pay off our mortgage completely in a little more than six years. In addition, we recently agreed to reduce our flip tax. It will be half of what it originally was.”

What did this board do to create such a windfall? “What they did was, from my perspective, a grand-slam home run,” says the co-op’s accountant, Norman Prisand, a partner in Zeidman, Lackowitz, Prisand & Co. “They were able to drastically reduce the existing debt on the property, and it will be debt-free by April of 2013. They were also able to substantially improve the property, and at the end of the day, they expect to still have a substantial reserve fund, approximating a million dollars.”

And what they accomplished, others in a similar situation can do – as long as one is not adverse to long hours of planning, hard work, and dealing with both the Internal Revenue Service and the city’s Byzantine bureaucracy.

The Problem

It all started as a question of too much space and too little money. Four years ago, when this story begins, the building, at 301 East 78th Street on the corner of Second Avenue, held a 40-year commercial lease that had just expired. This lease represented about 7,500 square feet out of a total of 10,000. At the time, the market rent for the 7,500 square feet was at least $650,000 per year.

But the co-op board members – especially Kramer (“He was the spearhead of most of this,” says Prisand) – were frustrated because they could not charge that figure. The most they could get was $225,000. The reason was simple: Section 216 of the Internal Revenue Code. As most co-op owners know, Section 216 states that only 20 percent of a cooperative’s income can come from “non-members,” such as stores. Dubbed “bad” income, it is an infuriating cap on what a co-op can make on its commercial space. But if a property doesn’t adhere to this so-called “80/20” rule, the consequences can be dire: the corporation will lose its Section 216 status and its shareholders will lose their tax deductions for that year.

“We could not achieve the market rent,” explains Kramer. Adds Prisand: “They were faced with the 80/20 dilemma, and they had to find a way to take care of it.”

The Options

The board examined ideas presented to them by their professionals, attorney Richard Siegler, a partner at Stroock & Stroock & Lavan, and accountant Norman Prisand. Among the choices: converting to a condominium or becoming a hybrid “cond-op.” In the latter case, the co-op would have been transformed into a two-unit condominium, one consisting of the residential component, and the other the commercial portion. “The co-op continues to own the residential portion of the building and sells the commercial portion to a third party. The cond-op avoids the risk of ‘bad’ income, because the co-op no longer owns the commercial space and no longer receives commercial income,” explains Siegler.

But neither route appealed to the board. “The other options were more complex and less lucrative,” Kramer says. “The feeling was that they would be disruptive to the unit-owners. Each individual apartment owner would have had to effectively close out their co-op loan – they had an individual mortgage outstanding – and replace it with a condo loan. There would have been some other complexities in terms of recognition of cost from years ago versus market value.”

There would also be immediate tax consequences, as people would be recognizing their values prematurely. “Some might have had a market value that was in excess of the level in which they would own tax liability,” Kramer notes. “They weren’t selling their co-op – but it was as if they were and buying a condo in its place. So, again, that was something that if you look at it conceptually, it might work, but practically, it was too disruptive.”

The Plan

The option the board finally chose was one suggested by Siegler: convert its commercial space to “residential” space, assign it shares, and then sell it for use by a commercial entity. Explains Prisand: “I was a part of the meetings along the way, and the board, after looking at the different options, felt that this package would be the best for this building. We did projections of what the numbers would look like. And then we discussed the risks and the rewards, and the board decided the path that they chose was what best fit the property. There are not that many situations where it works out this well.”

The process was not easy, however, and involved a number of steps. The first was to determine how much space the board members wanted to convert. They decided to keep a certain amount commercial as long as it would still let them come out ahead under 80/20. The remaining space would be turned into “residential” used as commercial. “So, we said, ‘All right, we have approximately 5,000 square feet that we do not want to be counted on the “bad” income side. So that’s the piece that we should turn into residential shares and convert and effectively take out of the equation,’” explains Kramer.

The next step was to obtain a Private Letter Ruling from the Internal Revenue Service that allowed the commercial space to be considered residential. “They went for a ruling from Internal Revenue to make sure that everything was okay,” recalls Prisand.

Getting the ruling was not easy. Among other things, the board had to hire an architect to prepare drawings showing how the commercial space could be used for residential purposes. “There are considerations in terms of how you design the space,” explains Kramer, who has a graduate degree in finance and was a driving force behind the plan’s implementation. “The objective of that exercise is to demonstrate that the space could be used as residential. It doesn’t mean that it had to be used, just that it could be used in a way legitimately – that someone could live in it as a residence.

“Beyond even the architectural plans,” he adds, “I think we priced out what the cost of making those changes would be, because there was a formula that said it had to be financially viable. In fact, we had to get a broker to give us an estimate on what the residential real estate value would be if we were going to take this commercial space and really make apartments out of it. You didn’t have to build it, but they wanted to see that it’s viable.” The plans that were developed (but not actually implemented) included skylights and terraces on Second Avenue, designed to conform to residential building codes regarding light and windows.

The board also had to come up with the number of shares that each of these new stores represented. It looked at how many square feet were on an average floor of the building, and then computed how many shares were allocated to the total apartments on that floor. “So, we used that as a guideline, because we had to show that there was some kind of science to where you came up with these numbers. It’s similar to what you would do if you were to build a new offering,” Kramer says.

There was some drama along the way. The board became nervous when it had to get clearance from the Department of Buildings, and it was told it had to find out “whether or not we were zoned to increase our residential density,” notes Kramer. “Our building was built in 1963 just as zoning rules were changing. Depending on whether or not the new rules applied or the old rules applied, we might not have been in a position to increase our total square footage for residential purposes. We ultimately got the ruling that we needed but it was not easy.”

The Investor

These new “apartments” were then sold to an investor (found by a broker), who paid over $4 million – all tax-free since it was considered new capital. “We allowed the investor to sublet these apartments to commercial tenants with a detailed set of restrictions, ensuring that we would not be unhappy with the tenants that we would not have direct control over,” notes Kramer, who adds: “Another option that we considered was to have an actual store, someone who’s in business who wants to buy the space that they’re going to put their store in, rather than rent. In fact, we were talking to a number of end-buyers. But we went with an investor.”

The investor put in stationery, shoe, and kitchen and bath stores and agreed to pay the co-op a monthly maintenance fee. The market rent that is earned by the investor from commercial tenants has no bearing on the 80/20 calculations. In fact, the new monthly maintenance from the investor is considered “good income” (since it is member income) and thus the co-op can earn more on its other commercial rents.

Explains Kramer: “We are earning approximately $60,000 per year in new maintenance, which allows us to earn an additional $15,000 per year in ‘bad’ income and still stay under the 20 percent maximum.” The calculation was straightforward. “If you knew you had rent coming in of $450,000,” Kramer notes, “in order to stay within 80/20 guidelines your good income has to be equal to at least four times that number in order to have your ratio. That implies that you must have at least $1.8 million in good revenue. If you have less than that, you are out of whack because 80/20 is a 4 to 1 ratio. If you add $1.8 million to $450,000, you get a total income of $2,250,000, of which $450,000 represents 20 percent. You have to watch it very, very carefully. Each additional dollar of good income allows you to earn 25 cents of bad income. The fact that the stores we sold provided us with an additional maintenance of $60,000 implied we could earn $15,000 more from rental income from the other stores. In the end, you look at the totals.”

The board managed to keep some say-so over what type of businesses went into the space as well, again with guidance from Siegler, by creating a “restricted usage clause.” That item did not allow the stores to be employed by pornography dealers, businesses that have medical waste, or food stores, among other things. “We wanted to make sure that the valuation that the investor was willing to pay us was a function of his understanding that they could not put in certain tenants,” says Kramer.

The Future

The board also communicated with the shareholders about the plan. “We felt that they should hear this directly from Richard and directly from Norman and understand that it was an opportunity for them to ask questions,” says Kramer. “So we had specific information meetings to supplement our normal annual cycle during this whole period. In terms of things to do, that was critical because people felt they were part of the process, and they felt informed. We had extensive newsletters going out communicating where we stood.”

The meetings helped prevent rumors and misinformation from spreading. “It took us some time to lease that space,” Kramer says. “But once we did, it didn’t matter that the other space was sitting vacant because we couldn’t have earned any more anyway. And it wasn’t being marketed. But it was funny because the typical, uninformed shareholders would probably walk by and see that it’s empty and think that was a terrible thing, like we were losing all this money. So, one of the things we really had to be proactive on was saying, ‘We’re not losing any money, we’re making so much more than we did.’ This small store that we created, which was 2,500 square feet, earned almost double what we had been earning when the space was 7,500 square feet.”

In the end, the “good” income for the entire building, including maintenance from all the shareholders as well as other ancillary items, came to $1.9 million; of that, the portion paid by the stores that were sold as “apartments” is $60,000. (The ancillary revenue deemed good income included such items as cable service for the building, which the co-op pays for and bills back to the shareholders, and fees for the gym and storage lockers.) According to Kramer, the legal, accounting, architectural, and brokerage fees were in excess of $250,000.

To get something like this accomplished, says Prisand, you need to have an activist board, or at least one or two members who are quite involved. “The board was very on top of these matters,” he notes. “There were many meetings. There was a lot of time spent with Richard Siegler, who, of course, is very knowledgeable about these things. And Alan Kramer was always pushing.”

Kramer – who says he “must have been working for a period of at least a full year, for about 25 hours a week. It was becoming a full-time part-time job” – warns that you should know all the hurdles that you will face ahead of time. And get the right broker.

“We had to fire our first broker. It wasn’t that the space was so difficult to market; I think that they just weren’t tapped into the right group of people. I know because I was pretty good at networking. I found out a bit of information, and what we saw was a fair number of people who tried to lowball us. How would we know? What would our basis be for knowing that it was worth $3 million versus $4 million? You know, $3 million’s a lot of money, too.”

Be warned: this technique is not for every building. There are certain prerequisites. “You have to be a building that the New York City Department of Buildings would allow to add to your residential density. There are zoning rules that come into play for that,” says Kramer. “A lot of buildings are built pretty close to the max. Even though, technically, no one is moving in, what you are doing when you’re designating commercial spaces as new residential units is really not that different from saying, ‘I’m going to add a floor. I’m going to build new penthouse apartments.’ That’s structural, okay, but there’s no distinction in the formula of physically adding a floor to find space to put new apartments in versus taking space that previously hadn’t been used for residential space.”

What’s next? “In the near future,” says Prisand, “they will have to make some decisions about whether they wish to lease or sell additional commercial space, where they have the right to sell. They had only sold half of the allowable space – so they have that other half. There’s still some space that might possibly be sold in the future or retained as commercial income. And commercial income today is almost twice as high as it was back in 1999, when we started to think about these transactions.”