Why Not Flip a Unit for the Co-op?

One of the easiest ways for a cooperative corporation or a condominium association to raise significant amounts of funds without borrowing or assessment is to exercise a right of first refusal (ROFR) – even if it does not have one.
Recently, we were sitting in a mortgage refinancing for a cooperative corporation. The board president raised the topic of rejecting a buyer because the price for the shares and lease was too low. Our eyes lit up. Instantly, and for once, the managing agent (Goldstick) and the attorney (Samson) were on the same page. We first carefully explained the case law about a board’s liability for rejecting transactions based on price; judicial decisions have gone both ways. The president looked disappointed. Clearly, she thought the price was outrageously low.

One of us (Goldstick) then asked the second most important question: “How low is it?” She replied: “$140,000, maybe $150,000” below market.

Then, the primary question was asked. “Would the board buy this apartment at the same low price as the rejected buyer would pay?”

She shrugged. “Sure.”

Another right of first refusal had just been exercised, even though the president did not know it at the time.

One of us (Samson) called the seller’s attorney and notified him that the buyer had been rejected. A violent argument ensued as the seller’s attorney explained his client had committed to buy a house and was depending on the proceeds of the sale to close on the house. He persisted. Then he threatened to sue. The response: “You’ll have no case and no damages.” The attorney quickly offered a laundry list of potential injuries to his client: loss of down- payment on his new residence, loss of the costs of securing finance, etc.

Our argument: the board had a right to reject based on price. The seller’s attorney then uttered the magic words: “Well, if they think the price is so low, why don’t they buy it?”

And the cooperative corporation did. It then resold the apartment, made a $135,000 profit, tax-free – and used that to finance its Local Law 11 project. Many buildings have benefited from exercising their ROFR and substantially augmented their reserve fund to view these opportunities as unique or even rare. One large cooperative complex in Queens bought back six apartments in one year from shareholders and quickly resold them. Generally, it buys one or two a year.

The Basics

What Is a Right of First Refusal? A ROFR is the right of a board of directors of a cooperative corporation or board of managers of a condominium to match the offer of a third party to purchase the apartment from the current owner on the same terms as the proposed third-party purchaser. Most condominiums have ROFR built into their bylaws. A few (but a growing number of) cooperative corporations also have a formal ROFR. But even if your organization does not have one, it does not mean that the opportunity to buy an apartment and resell it at a substantial profit does not exist.

When Should a ROFR Be Used? Even in the hottest real estate market, opportunities arise when the board observes a sales price that is substantially below market. Such opportunities are most likely to occur in insolvency, foreclosure, or estate sales. But there are enough ordinary transactions with low prices so you should constantly be vigilant for opportunities.

How Low Does the Price Have to Be? The board probably knows apartment values better than any other party. It knows the financial and physical condition of the building; it can inspect the apartment to ascertain its physical condition. It reviews applications of other owners seeking to renovate their own apartments so it understands renovation costs. It keeps a list of actual sales prices for other similar apartments. It knows how long apartments in the building sit on the market. Therefore, the board is uniquely qualified to calculate its potential profit and risks. If an apartment needs extensive renovations, it will require a further outlay of cash, slow down the resale, and require special attention from the board. Since situations involving foreclosures, estates, and bankruptcies also rarely involve recently renovated apartments, inspection is essential.

We would not recommend exercising a ROFR for an apartment being sold at 90 percent of market value. The return is too small to justify the effort and a delay in reselling may destroy any profit. On the other hand, a sale at a 25 to 35 percent discount below market offers a significant opportunity if the apartment does not require extensive renovations. A board that can add $100,000 to its reserve fund without a special assessment or a loan has performed a miracle for the owners. Such a profit will go a long way towards the next capital improvement project. This special board knowledge is important. Presumably, the board knows about the value, condition of the apartment, and speed of sale. Coupled with the right to buy apartments, these are valuable assets.

Restrictions on Exercising the ROFR by a Condominium Board. The bylaws of the condominium spell out the method by which the board of managers of the condominium may exercise the ROFR. Most importantly, most condominium bylaws require a unit-owner vote before the ROFR can be exercised. The board has no power to exercise the right – only to waive it. A quorum of unit-owners may be difficult to obtain. The board which actively wishes to pursue purchase opportunities should consider seeking an amendment to its form of power of attorney given by each unit owner to permit the board to use the power to exercise the right of first refusal.

Also, time is very short for exercising the purchase right by the condominium. Usually, it must be exercised within 20 to 30 days after an application is made to sell. However, the board must hold both a board meeting and a unit-owner meeting before the ROFR can be exercised. This will use up 15 to 20 days of the 20- to 30-day period. Time is, therefore, incredibly short. The transfer or managing agent should be alerted to move quickly whenever an application is submitted. The delay of a week may be fatal.

The bylaws should be studied carefully as well as the selling unit-owner’s contract of sale. Failure to follow the precise requirements of the bylaws or the terms of the contract of sale may be fatal to a successful exercise of the right of first refusal.

ROFR Rules

What If Your Building Does Not Have a ROFR? The easy answer: get one. See the section below on amending your organizational documents. Unfortunately, amendments are difficult to implement and boards procrastinate. So what does a board do when it is presented with a sale at 50 percent of market, apartments are selling briskly in the building, and the board has access to plenty of cash? If you are a condominium association, you are out of luck. The board has no authority to demand that the apartment be sold to it at the same price. Cooperative corporations, however, can use their power to reject buyers to leverage into a purchase. Indeed, they have an obligation to protect shareholder investments by blocking a low price sale.

Why? One sale will affect shareholder values for up to a year after closing. It affects appraisals, the amount banks are willing to lend, and future sales prices. If one of the primary obligations of a board is to maximize shareholder values, buying back undervalued shares is not only a legitimate corporate activity, it may be imperative. Big, publicly traded companies repurchase their own shares routinely. It is a legitimate corporate activity.

Finally, is the cooperative corporation hurting the shareholder? Actually, the shareholder may benefit from the exercise of a formal or informal ROFR exercise. First, there is no brokerage commission. Secondly, which does greater damage, an outright rejection of the purchaser or a substitution of buyers? Third, the risk of buyer default is eliminated if the cooperative corporation or condominium elects to buy.

Formal ROFR for Co-ops. Creating a formal ROFR for cooperative corporations requires amendment of the basic corporate documents. We recommend amending both the proprietary lease and bylaws as well as the certificate of incorporation. The bylaw amendment should contain a provision requiring the terms of the ROFR be added as a legend to all stock certificates issued by the cooperative corporation.

Financing the Exercise of a ROFR. Any board seriously considering using a ROFR or exercising an option to buy apartments on the apartment lined up far in advance of any attempt to buy the apartment. The ability to finance and the method of securing funds differ between cooperative corporations and condominium associations. Learn the rules and consult an attorney. Never exercise a ROFR unless the funds to buy are absolutely available. Common available sources of money are as follows:

Reserve Funds (provided they are not restricted by Local Law 70 or some other legal impediment)

Lines of credit from a lender

Refinancing the first mortgage on the building (co-ops only)

Using the apartment as collateral to borrow funds

Special assessment

Using the building’s cash flow and deferring payment of vendor bills

A dramatic example of this last technique occurred in 1995 when we represented the same client. It was a building consisting of almost 1,000 units. The sponsor was in trouble and the board discovered that it could buy over 300 apartments (almost one-third for only $700,000 – less than $2,500 per unit), but it had to act quickly. It had no reserves and no line of credit. The first mortgage had seven more years until maturity and a huge prepayment penalty. The board was only able to secure a $450,000 loan using the apartments as collateral. So to bridge the financing gap, it “borrowed” the water and sewer taxes ($250,000). It had to pay New York City a late payment penalty. Was it the right thing to do? In the last 13 years, it has made more than $10,000,000 profit, tax-free, on its initial $700,000 investment and it still owns half the units! You judge!

Dealing with Foreclosures

Some of the best opportunities for profiting from a ROFR occur when a lender forecloses on a cooperative apartment or condominium unit. Banks routinely stop bidding at the foreclosure auction when the amount due on the mortgage has been reached. Since many loans represent only a tiny fraction of the current apartment value, matching a successful bid could produce a substantial windfall. However, the provisions of the foreclosure contract usually require quick closing on terms which were not negotiated with the buyer.

First, the board must examine the language of its ROFR. Are bank foreclosures exempted? Second, it must keep tract of troubled transactions and scheduled auctions. Third, it should act decisively. Immediately after the auction, notify the foreclosing lender and the successful bidder that the ROFR will be exercised. Do not wait for an application. Also, notify the lender that the board is ready, willing, and able to close immediately. When the lender’s representative starts screaming, the board should not back down. The lender is only entitled to receive the proceeds of the auction, not a windfall on resale.

We have participated in numerous auction situations that begged for the exercise of a ROFR. A very well-known commercial bank that recently reappeared in the news over its subprime loan problems once auctioned a one-bedroom apartment on the Upper East Side of Manhattan for $1,100, and the bank was not the successful bidder! In a second auction, a sponsor defaulted in a complex in Baldwin, New York. His 29 apartments were auctioned for less then $10,000 each. The board elected to exercise its rights on five of the sponsor apartments and matched the high bids for each. The first of the reacquired apartments was resold for $68,000 for a 700 percent profit. The most recent sale was for $225,000.

Amending the Documents

Once a board has examined its ROFR carefully, flaws, ambiguities, and problems often become evident: (1) the 20- to 30-day period for exercise is too short; (2) unit-owner/shareholder approval is required; (3) the unit-owner power of attorney is too restricted; (4) bank foreclosures are exempt; (5) the notice provisions are unclear; and (6) the closing must occur too quickly after exercise. Eventually, it will reach a conclusion that the rules need to be changed. How is that done? For a condominium, a super-majority unit-owner vote is usually required, followed by a filing of the amendment with the county clerk or registrar. Filing is mandatory and often overlooked. Failure to file is fatal.

The unit-owner vote required to amend the condominium bylaws sometimes requires both a high percentage of “common interest” and a high percentage of unit-owners. For a cooperative corporation, amendment procedures depend on where the ROFR is located. If it is in the certificate of incorporation, a shareholder vote will be required. On the other hand, bylaws may be amended by either the board or by shareholders (unless restricted by the business corporation law or the terms of the bylaws). Often the bylaws cannot be amended without sponsor consent as long as the sponsor owns a stated percentage of the cooperative.

The use and exercise of a ROFR is controversial. A board is risking its funds to flip apartments. A wrong decision could be costly to the building. There is also criticism that the board is “stealing” a deal from a third party. This argument ignores the real damage that low sales prices cause to other owners and the entity. The board owes a duty to its owners to protect value. If the selling owner really wants to transfer an apartment at a below-market price, he or she should be permitted to do so. The only question is into whose pocket should the windfall profit go if the sale proceeds.

__HABITAT SIDEBAR__

A porter’s wage adjustment can earn you money – even if you don’t have a porter

By Edward T. Braverman

There are basically two types of escalators currently in use in the New York metropolitan area: cost-of-living adjustments and porter wage adjustments. Each has only a tangential relationship to operating a building in the New York metropolitan area; basically, both are designed to increase profitability.

Cost-of-Living Adjustments. To utilize cost-of-living adjustments (COLA), you need a yardstick to measure increases. In the New York metropolitan area, the yardstick is usually the Consumer Price Index (CPI). To put this escalator into effect, an owner must establish a base amount against which future amounts will be compared. This will create a percentage by which the established base rent will change. Most owners try and fix the month immediately preceding the execution of the lease as the base against which future increases are measured. Changes are then measured and applied annually or semi-annually. Most owner-crafted COLA lease provisions work in one direction only (up) with the contractual provision that the base rent will not be reduced should the CPI take a negative turn.

Porter Wage Adjustments. Like COLA, the porter wage escalator must have a yardstick to measure increases. That yardstick is the “porter wage” category of the union contract. This index has little relationship to an owner’s cost of operating its building. In fact, neither the building nor the commercial space need be serviced by a porter, nor does the building need to be a union building. Utilizing this type of increase, an owner must establish: the union contract to reference; the employee line whose wages will establish the base amount against which future measurements will be made (i.e., porter, superintendent, handyman, other); and the base date against which future increases will be calculated.

In selecting these criteria, an owner should take into consideration that the local union contract is negotiated on a calendar-year basis, running from January 1 of each year to December 31 of some future year, with yearly increases usually taking effect on January 1 of each calendar year (and some times at mid-year). A lease starting on November 1, for instance, with a base date for porter wage adjustment of December 31 of that same year, will increase rent on January 1 – a mere two months after the lease begins. The owner must also be careful to maximize the increase by insisting on the inclusion of fringe benefits in the calculations (i.e., pension, healthcare, vacation, and comp time).

Once the index and base date are established it becomes a relatively simple task to measure the increase in terms of a percentage; that percentage is then applied to the tenant’s base rent to determine the new and increased annual rent. When applying this escalator to tenancies rented by the square foot, the most common increase is “penny-for-penny”: the rent per square foot will be increased by a cent for each cent by which the stated union worker’s wages and benefits are increased.